PLR 1024013: IRS approved 40/60 accounting for a naval ship contract

Plain-English summary

A shipbuilding company asked how to account for a Navy construction contract and an earlier design and materials contract. The IRS ruled that the two contracts should not be combined, that the construction date began when the company entered the construction contract, and that the contract qualified for the special naval ship rules. It approved use of the 40/60 percentage-of-completion and capitalized-cost method for five taxable years. It also allowed the company to file an amended return for the first year to implement the ruling without treating that filing as a change in accounting method.

Ruling snapshot

• Question: How should the taxpayer classify and report income from its naval shipbuilding contract?
• Outcome: Approved
• Key authorities: IRC §§ 446, 460, and 708

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201024013 Third Party Communication: None
Release Date: 6/18/2010 Date of Communication: Not Applicable
Index Number: 460.00-00, 460.01-00,
460.05-03, 460.07-00, Person To Contact:
460.09-00 -------------------, ID No. -------------
Telephone Number:
------------------------------------------ ---------------------
----------------------------------------------------- Refer Reply To:
-------------------------------- CC:ITA:B05
----------------------------------------------- PLR-139411-09
Date:
February 26, 2010

     DO: ----------------------TY: -------

Legend

Taxpayer = -------------------------------------------------
Parent = ------------------------------------------
Division 1 = -------------------------------
Division 2 = --------------------------
Trade 1 = -------------------------------------------------------------------------------------------------------

Trade 2 = -------------------------------------------------------------------------------------------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Date 1 = ------------------
Date 2 = -----------------------
Date 3 = ---------------------------
Date 4 = ---------------------------
Date 5 = ---------------------------
Agency = -----------------------------------------
Ship F = ------------------------------
State = ----------
Contract A = -------------------------------------------
Contract B = --------------------------------------------
Contract Modification A-1 = -------------------------------------------------------------------------------
w percent = -----------------
x percent = -----------------
y percent = --------------------
z percent = ---------------
PLR-139411-09 2

Dear ------------------:

In a letter dated August 28, 2009, you requested a private letter ruling on behalf of
Taxpayer under Revenue Procedure 2009-1. On February 17, 2010, you submitted
additional information. With respect to Contract A and Contract B, which Taxpayer
entered into on Date 1 and on Date 3 respectively, you requested the following rulings:

1. That, under section 1.460-1(e) of the Income Tax Regulations, Contract A and
   Contract B are not aggregated so as to be treated as a single contract;

2. That, under section 708(c)(3) of the American Jobs Creation Act of 2004, Pub. L.
   108-357 (JOBS Act), the construction commencement date of Contract B did not
   occur before Date 3, when Taxpayer entered into Contract B;

3. That Contract B is a qualified naval ship contract under section 708(c)(1) of the
   JOBS Act;

4. That, for five taxable years beginning with Year 4, the proper method for
   Taxpayer to determine the taxable income from Contract B is the percentage-of-
   completion/capitalized-cost method (PCCM) with 40 percent of contract income
   determined under the percentage-of-completion method (PCM) and with the
   remaining 60 percent of contract income determined under the completed
   contract method (CCM); and

5. That, in the event the Service makes the requested rulings on the four issues
   above, it will not constitute a change in accounting method for Taxpayer to file an
   amended return for Year 4 to implement those rulings.

FACTS

Taxpayer, wholly owned by Parent, is a member of an affiliated group of corporations
with Parent as its common parent that files consolidated Federal income tax returns.

Taxpayer's business is conducted through two separate operating divisions, namely,
Division 1 and Division 2. Division 1 is engaged in Trade 1. Division 2 is engaged in
Trade 2. Prior to the close of Year 4, Taxpayer was engaged in only one trade or
business, that of Division 1.

Prior to the enactment of section 460 of the Internal Revenue Code in 1986, Taxpayer,
then unaffiliated with Parent, used the CCM to account for all items of income and
expenses from its long-term contracts. For long-term contracts entered into after the
effective date of section 460 as originally enacted, Taxpayer used the PCCM as then
PLR-139411-09 3

required under section 460. In Year 1, for the first time, Taxpayer entered into
commercial shipbuilding contracts that it expected to complete within 5 years. For Year
1 and subsequent taxable years, Taxpayer used the PCCM to determine the taxable
income from those commercial shipbuilding contracts, with 40 percent of contract
income determined under PCM and with the remaining 60 percent of contract income
determined under CCM.

In Year 2, Parent acquired all of Taxpayer's outstanding stock and began including
Taxpayer in its consolidated Federal income tax returns.

In Year 3, Taxpayer entered into Contract A with Agency. Agency is an acquisition arm
of the United States Navy. Under Contract A, Taxpayer was required to perform design
work, long lead time materials procurement, advance construction of components and
engineering services, all relating to a ship, Ship F. Contract A also provided options,
exercisable by Agency, for additional work in the same categories. Contract A neither
required the construction of Ship F, nor obligated either party to enter into such a
contract. As of Date 1, Congress had not appropriated the funds necessary for
construction and delivery of a complete ship.

Contract A was a cost-reimbursement-type contract with a fixed-fee structure, in which
the amount of the fixed fee was calculated as a percentage of allowable costs with the
fee percentage rate varying according to the category of work. The fixed fee
percentages ranged between w percent and x percent. In addition, Contract A provided
for various incentive fee arrangements and fee reduction possibilities linked to
Taxpayer’s performance.

Between Date 1 and Date 3, Contract A underwent numerous modifications, most of
which reflected Agency's exercise of the options provided in that contract. In Contract
Modification A-1 dated Date 2, the parties added a new category of advance
construction work. In subsequent modifications that occurred between Date 2 and Date
3, Taxpayer and Agency increased the funding for the advance construction category
and agreed that the increased funding and any costs incurred against it would be
transferred to the ship construction contract, "when and if awarded."

In Year 4, Taxpayer entered into Contract B with Agency. Contract B required Taxpayer
to construct Ship F and deliver the vessel with on board repair parts to Agency on Date

4. Taxpayer will construct Ship F at its plant located in State. Pursuant to modifications
   to Contract A and terms of Contract B, certain funding increases and costs incurred
   under Contract A were transferred to Contract B.

Unlike in Contract A, the pricing structure of Contract B consisted of cost-
reimbursement and an incentive fee regime. Upon completion of the contract, if the
total actual allowable cost of completing Ship F is less than the target cost, Taxpayer
will be entitled to an additional fee. If the total actual allowable cost of completing Ship
F is greater than the target cost, Taxpayer's fee will be reduced. In no event may
PLR-139411-09 4

Taxpayer's fee be greater than y percent of the target cost or less than z percent of the
target cost. In addition to the basic incentive fee described, Contract B provides for
various incentive fee arrangements for strong performance.

In accordance with the Federal Acquisition Regulations, taxpayer expects that Agency
will issue DD Form 250 on Date 4, when Taxpayer delivers the completed Ship F.
Taxpayer represents that DD Form 250 constitutes a standard letter of acceptance in
delivery and acceptance of hardware produced for the Department of Defense. The DD
Form 250 is issued to "provide evidence of Government contract quality assurance at
origin or destination [and] to provide evidence of acceptance at origin or destination."
48 C.F.R. Ch. 2, App. F, § F-103(a).

For Year 3 and all relevant taxable years thereafter, Taxpayer used PCM to take into
account the portions of Contract A relating to the advance construction of components.
Parent filed its consolidated Federal income tax return for Year 4, after Taxpayer
submitted the request for a letter ruling. On that consolidated return, Taxpayer used
PCM to determine the taxable income from Contract B.

LAW AND ANALYSIS

Ruling Request 1. Applicability of the aggregation rules

Section 460(a) of the Internal Revenue Code generally requires taxpayers to determine
the taxable income from long-term contracts under PCM. For purposes of Federal
income taxation, "the term 'long-term contract' means any contract for the manufacture,
building, installation, or construction of property if such contract is not completed within
the taxable year in which such contract is entered into." § 460(f)(1).

Section 1.460-1(e) of the Income Tax Regulations, promulgated under section 460(f)(3)
of the Code, provides that, to reflect income clearly, the Commissioner or a taxpayer
may treat one agreement as two or more contracts and two or more agreements as one
contract. In general, the "taxpayer must determine whether to sever an agreement or to
aggregate two or more agreements based on the facts and circumstances known at the
end of the contracting year." § 1.460-1(e)(1) of the Income Tax Regs.

Under section 1.460-1(e)(2) of the Income Tax Regulations, whether to aggregate two
or more agreements into one contract depends on two factors: pricing and a reasonable
businessperson's behavior. Regarding pricing, two or more agreements will not be
aggregated into one contract in the absence of interdependent pricing of items in the
separate agreements. The regulations further provide that a “single price negotiation for
similar items ordered under one or more agreements indicates that the items are
interdependently priced.” See § 1.460-1(e)(2)(i) of the Income Tax Regs.
PLR-139411-09 5

Regarding the expected behavior of a reasonable businessperson, the regulations
provide that "Two or more agreements . . . may not be aggregated into one contract,
unless a reasonable businessperson would not have entered into one of the
agreements for the terms agreed upon without also entering into the other
agreement(s)." § 1.460-1(e)(2)(iii) of the Income Tax Regs. "Analyzing the reasonable
businessperson standard requires an analysis of all facts and circumstances of the
business arrangement between the taxpayer and the customer." Id. For purposes of
applying the reasonable businessperson factor, the "taxpayer's expectation that the
parties would enter into another agreement, when agreeing to the terms contained in
the first agreement, is not relevant." Id.

Examples 10 and 11 of section 1.460-1(j) contain applications of the aggregation rule to
taxpayers entering into multiple agreements. Example 10 deals with two agreements,
each for construction of a submarine, which were the result of a single negotiation.
Treated separately, one of the contracts will result in a substantial loss to the taxpayer-
contractor, while the other will produce a substantial profit. Because the pricing of the
two agreements was interdependent, and because a reasonable businessperson would
not have entered into one agreement without entering into the other, aggregation is
required. See § 1.460-1(j) Ex. 10 of the Income Tax Regs.

In contrast, Example 11 analyzes a situation where two agreements, each for
manufacture of a certain type of military aircraft, are negotiated two years apart. The
pricing under each agreement reflects the taxpayer-contractor's expected total cost of
manufacturing the aircraft as ordered, the risks and opportunities associated with the
agreement, and other factors considered relevant, and is expected to result in a profit to
the taxpayer-contractor. Because the pricing of each agreement standing alone is
independent from that of the other, and because a reasonable businessperson would
have entered into the first agreement without regard to the other, aggregating the two
agreements into one contract is not permitted. It is irrelevant to application of the
aggregation rule that, in the year when it enters into the first agreement, the taxpayer-
contractor anticipates to receive additional orders for the same type of aircraft over the
next few decades. See § 1.460-1(j) Ex. 11 of the Income Tax Regs.

The relationship between Contract A and Contract B is akin to that of the two
agreements described in Example 11 of section 1.460-1(j) of the Income Tax
Regulations.

First, the pricing arrangements of Contract A and of Contract B were independent and
not interdependent. Contract A provided for primarily a fixed fee arrangement, although
it did contain some incentive fee provisions. In contrast, Contract B provided for a
pricing structure based on an incentive fee formula and contained no fixed fee provision.
The pricing structure of each contract, which is based on the costs expected to be
incurred under that contract only, was independent from the pricing structure of the
other contract. In addition, the interval of more than four years between the execution
of the two contracts and the absence of congressional authorization for the construction
PLR-139411-09 6

of a complete ship as of Date 1 both indicate that Contract A and Contract B were
negotiated separately.

Second, Contract A and Contract B each have provided, or are expected to provide,
Taxpayer with a reasonable profit. With a fixed fee structure in place, a reasonable
businessperson would have entered into Contract A without entering into Contract B.
Conversely, with a floor to the fee set at z percent of the total actual costs, a reasonable
businessperson would have entered into Contract B without entering into Contract A.

In sum, the two agreements are independently priced, and a reasonable
businessperson would have entered into one contract without regard to the other.
Accordingly, we hold that Contract A and Contract B should not be aggregated so as to
be treated as a single contract for Federal income tax purposes.

Ruling Request 2. Construction Commencement Date

Section 708 of the JOBS Act requires that the taxable income from a qualified naval
ship contract be determined by a method identical to that used in the case of a qualified
ship contract, for the five taxable year period beginning with the taxable year in which
the construction commencement date occurs. § 708(a). Qualified ship contracts are
reported under 40/60 PCCM or PCM. Under 40/60 PCCM, 40 percent of contract
income is reported using PCM, with the remaining 60 percent reported under the
taxpayer’s exempt method, e.g., CCM.

For purposes of section 708 of the JOBS Act, a qualified naval ship contract is any
contract, or portion thereof, to construct a ship or a submarine in the United States for
the Federal Government "if the taxpayer reasonably expects the acceptance date will
occur no later than 9 years after the construction commencement date." § 708(c)(1).
"The term 'acceptance date' means the date 1 year after the date on which the Federal
Government issues a letter of acceptance or other similar document for the ship or
submarine. § 708(c)(2). "The term 'construction commencement date' means the date
on which the physical fabrication of any section or component of the ship or submarine
begins in the taxpayer's shipyard." § 708(c)(3). Section 708 of the JOBS Act applies to
contracts for the manufacture of ships or submarines if the construction commencement
date occurs after the enactment date (October 22, 2004). § 708(e).

Construing the term "construction commencement date" as a date that can precede the
date a taxpayer enters into a contract for the manufacture of a ship or submarine would
render section 708 inadministrable. In the case of a qualified naval shipbuilding
contract, section 708 permits use of the 40/60 PCCM, for five taxable years, beginning
with the taxable year including the construction commencement date. Prior to entering
into a qualified naval shipbuilding contract, a taxpayer cannot determine whether it has
a qualified naval shipbuilding contract eligible for the special method. The taxpayer also
could lack information necessary to estimate the contract price and costs to be reported
under the method. In sum, construing the term “construction commencement date” as a
PLR-139411-09 7

date that can precede the date a contract for the manufacture of a ship or submarine is
entered into would require taxpayers to begin using the 40/60 PCCM before they can
determine whether they are eligible to use the method and before they have the
contract price and cost information necessary to apply the method. It is improbable that
Congress intended to create a provision that is impossible for taxpayers to comply with
and unreasonable for the Service to enforce.

In construing a statute, courts have recognized that "a statute is to be read as a whole, .
. . since the meaning of statutory language, plain or not, depends on context." King v.
St. Vincent's Hosp., 502 U.S. 215, 221 (1991). Congress employed the term
"construction commencement date" in the context of requiring taxpayers to use
specified methods of accounting for income from qualified naval ship contracts. The
context in which the term is employed indicates that the “construction commencement
date” must occur after a taxpayer has entered into a qualified naval ship contract.
Accordingly, we hold that the construction commencement date of Contract B did not
occur before Date 3 when Taxpayer entered into that contract.

Ruling Request 3. Qualified Naval Ship Contract

Contract B obligates Taxpayer to construct a complete ship for the United States Navy,
an instrument of the Federal Government. Taxpayer will construct Ship F in State and
is required to deliver the completed Ship F on Date 4. On Date 4, Taxpayer expects
Agency to issue a DD Form 250 as evidence of acceptance. Thus, the first anniversary
of the anticipated issuance of the DD Form 250 will fall on Date 5. Date 5, therefore, is
the acceptance date of the ship within the meaning of section 708(c)(2) of the JOBS
Act. Because the construction commencement date occurred on Date 3, when
Taxpayer entered into Contract B, the acceptance date is expected to occur no later
than nine years after the construction commencement date.

Accordingly, Contract B satisfies the requirements of a qualified naval ship contract set
forth in section 708(c)(1) of the JOBS Act.

Ruling Request 4. Applicability of the 40/60 PCCM

Section 708 of the JOBS Act refers to the method of accounting used in the case of a
qualified ship contract.1 Under section 10203(b)(2) of the Revenue Act of 1987, Pub. L.
No. 100-203, taxpayers may use PCCM to determine the taxable income from qualified
ship contracts. Section 1.460-2(d) of the Income Tax Regulations, moreover, permits
use of PCM. A taxpayer using the PCCM "determines the income from a long-term
contract using the PCM for the applicable percentage of the contract and its exempt

1
For purposes of accounting for long-term contracts, a qualified ship contract is any contract to construct
not more than 5 ships in the United States "if . . . (i) such ships will not be constructed (directly or
indirectly) for the Federal Government, and (ii) the taxpayer reasonably expects to complete such
contract within 5 years of the contract commencement date." Revenue Act of 1987, Pub. L. No. 100-203,
§ 10203(b)(2)(B); see also § 1.460-2(d) of the Income Tax Regs.
PLR-139411-09 8

contract method . . . for the remaining percentage of the contract." For a qualified ship
contract, the applicable percentage is 40 percent. See § 1.460-4(e) of the Income Tax
Regs.

Prior to the 1986 enactment of section 460, Taxpayer established the CCM as its
method of accounting for items attributable to long-term contracts. In years following
the enactment of section 460, taxpayer continued to use the CCM to account for
portions of long-term contracts exempt from the PCM use requirement. For instance,
Taxpayer accounted for items relating to qualified ship contracts that it entered into in
Year 1 and thereafter by using the PCCM with the CCM as the method used for the 60-
percent exempt portions. Taxpayer's proper method of accounting for qualified ship
contracts is the 40/60 PCCM. Accordingly, for taxable years beginning with Year 4, the
proper method to determine Taxpayer's taxable income from Contract B is the 40/60
PCCM.

Ruling Request 5. Implementation of the Present Letter Ruling by Filing an Amended
Return

Section 446(e) provides that a taxpayer may not change its method of accounting
without first obtaining the Commissioner's consent to make the change. Section 1.446-
1(e)(2)(i) of the Income Tax Regulations further provides that "[c]onsent must be
secured whether or not such method is proper or is permitted" under the Code or the
regulations thereunder. See also § 2.06 of Rev. Proc. 2002-18, 2002-1 C.B. 678.

Revenue Ruling 90-38, 1990-1 C.B. 57, concludes that a taxpayer adopts an erroneous
method of accounting when it files the second consecutive return using that method.
The Revenue Ruling holds that the taxpayer may not, without the Commissioner's
consent, retroactively change from an improper to a proper method of accounting by
filing an amended return, even if the period of limitations for the first year for which the
improper method was used remains open. See also § 2.03 of Rev. Proc. 2002-18.

As noted earlier, Taxpayer had not obtained the Commissioner's consent to change its
exempt method of accounting from the CCM to the PCM for Year 4. Accordingly,
Taxpayer was required by section 446(e) to continue to use the CCM as its exempt
contract method in Year 4. Thus, PCM was an improper method of accounting for
Contract B in Year 4. Nonetheless, Taxpayer used the PCM to account for Contract B
on its consolidated Federal income tax return for Year 4.

Because PCM was an improper method used for only one taxable year, it has not been
adopted as the method of accounting for qualified naval shipbuilding contracts.
Accordingly, under the principle underlying Revenue Ruling 90-38, Taxpayer may file an
amended return for Year 4 to implement the rulings herein. Such an amended return
will not constitute a change in accounting method.
PLR-139411-09 9

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referred to in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representative.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by Taxpayer and accompanied by a penalty of perjury statement executed by
an appropriate party. While this office has not verified any of the material submitted in
support of the request for rulings, it is subject to verification on examination.

                                               Sincerely,




                                   John M. Aramburu
                                   Senior Counsel, Branch 5
                                   Office of Associate Chief Counsel
                                   (Income Tax & Accounting)

Enclosures

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