PLR 1037017: IRS approved changes to inventory-cost allocation methods

Plain-English summary

The IRS granted a subsidiary consent to change its method for identifying and allocating inventory costs under IRC § 263A after the subsidiary merged into another company. The approved methods cover required capitalization, freight-in, purchasing, quality-control and inspection costs, mixed-service and administrative costs, the de minimis rule, a simplified service-cost method, a one-third/two-thirds labor allocation rule, and a simplified resale method. The IRS required the subsidiary to compute a section 481 adjustment for the accounting-method change in the year including the merger date. The ruling does not determine whether particular costs or departments qualify, or whether the merger and prior methods otherwise satisfy the applicable rules.

Ruling snapshot

• Question: Could the subsidiary change its inventory-cost identification and allocation methods after the merger?
• Outcome: Approved
• Key authorities: IRC §§ 263A and 381; Treas. Reg. §§ 1.263A-1, 1.263A-3, and 1.381(c)(5)-1

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201037017 Third Party Communication: None
Release Date: 9/17/2010 Date of Communication: Not Applicable
Index Number: 263A.00-00, 263A.03-02,
263A.04-00, 263A.04-06, Person To Contact:
381.05-04 ---------------, ID No. ------------
Telephone Number:
---------------------------- ---------------------
--------------------------- Refer Reply To:
--------------------------- CC:ITA:B06
PLR-111450-10
Date:
----------------------------- June 08, 2010

Legend:

Parent = ------------------------------------------------------
S = ---------------------------------------------------------------------------
Date 1 = ---------------------------
Date 2 = -----------------
Target = ---------------

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

Parent’s authorized representative is requesting a ruling under § 1.381(c)(5)-1(d)(1)(i) of
the Income Tax Regulations on behalf of S, one of Parent’s subsidiaries. S is
requesting the Commissioner’s consent to change to a method other than the principal
method of accounting. Specifically, S is requesting consent to change its method of
identifying and allocating costs under § 263A of the Internal Revenue Code and the
regulations thereunder, for the taxable year ending Date 1. S uses an overall accrual
method of accounting.

On Date 2, S merged into Target in a transaction to which § 381(a) applies. The
operations of S and Target were not operated as separate and distinct trades or
businesses immediately after Date 2. On Date 2, the fair market value of the inventory
held by S was greater than the fair market value of inventory held by Target, requiring S
to use its methods as the principal methods of identifying and allocating costs under
§ 263A. See § 1.381(c)(5)-1(c)(2). S will use the principal method to capitalize the
direct cost of property acquired for resale, except freight-in. However, S is not permitted
to continue to use all of the principal methods of identifying and allocating costs under
§ 263A, because some of those methods do not clearly reflect S’s income. See
§ 1.381(c)(5)-1(c)(1)(i). Accordingly, S has requested a private letter ruling under
§ 1.381(c)(5)-1(d)(1)(i) to use other methods.
PLR-111450-10 2

S requests that the Commissioner allow it to capitalize all costs required to be
capitalized under § 263A and the regulations thereunder including freight-in, purchasing
costs, quality control and inspection costs, capitalizable mixed service and
administrative costs, and book/tax differences relating to capitalizable costs. S also
requests that it be allowed to discontinue capitalizing costs that are not required to be
capitalized under § 263A and the regulations thereunder. These costs include product
certification costs required as a condition of sale and certain selling costs. In addition, S
requests that it be allowed to use the de minimis rule described in § 1.263A-1(g)(4)(ii) to
determine if any portion or all of a mixed service department's costs are allocable to
property acquired for resale. Additionally, S requests that it be allowed to use the
simplified service cost method with the labor-based allocation ratio to determine
capitalizable mixed service costs for those mixed service departments that are not
treated as engaged exclusively in resale or non-resale activities under the de minimis
rule (because 90 percent or more of the department's costs are not capitalizable service
costs or deductible service costs). See § 1.263A-1(h)(4). S also requests that it be
allowed to use the 1/3-2/3 rule to allocate labor costs of personnel engaged in both
purchasing and non-purchasing activities between these activities. See § 1.263A-
3(c)(3)(ii)(A). Finally, S requests that it be allowed to use the simplified resale method
without the historic absorption ratio election to capitalize additional § 263A costs to
ending inventory. See § 1.263A-3(d)(3). In using the simplified resale method, S
requests that the costs not presently capitalized be treated as additional § 263A costs.

Section § 1.263A-1(g)(4)(ii) provides that if 90 percent or more of a mixed service
department's costs are service costs that do not directly benefit or are not incurred by
reason of the performance of production or resale activities (deductible service costs),
the taxpayer will not allocate any portion of the service department's costs to property
produced and property acquired for resale during the taxable year. If 90 percent or
more of a mixed service department's costs are service costs that directly benefit or are
incurred by reason of the performance of production or resale activities (capitalizable
service costs), the taxpayer will allocate 100 percent of the department's costs to the
property produced and property acquired for resale during the taxable year. The
taxpayer will use reasonable factors or relationships to determine whether 90 percent or
more of a mixed service department's costs are deductible service costs or capitalizable
service costs.

Section 1.263A-1(h)(4) permits the use of the simplified service cost method with the
labor-based allocation ratio for determining capitalizable mixed service costs incurred
during the taxable year with respect to eligible property.

Section 1.263A-3(c)(3)(ii)(A) provides that a taxpayer may use the 1/3-2/3 rule to
allocate labor costs of personnel engaged in both purchasing and non-purchasing
activities between these activities. Under this rule, if less than one-third of a person's
activities are related to purchasing, none of that person's labor costs are allocated to
PLR-111450-10 3

purchasing; if more than two-thirds of a person's activities are related to purchasing, all
of that person's labor costs are allocated to purchasing; and in all other cases, the
taxpayer must reasonably allocate labor costs between purchasing and non-purchasing
activities.

Section 1.263A-3(d)(3) permits the use of the simplified resale method without the
historic absorption ratio election for determining the additional § 263A costs properly
allocable to property acquired for resale and other eligible property on hand at the end
of the taxable year.

The Commissioner has determined that the appropriate method for S to use for
identifying and allocating costs under § 263A is the method that S requested.
Accordingly, the Commissioner under § 1.381(c)(5)-1(d)(1)(i) grants S consent to
capitalize all costs required to be capitalized under § 263A and the regulations
thereunder including freight-in, purchasing costs, quality control and inspection costs,
capitalizable mixed service and administrative costs, and book/tax differences relating
to capitalizable costs; to discontinue capitalizing costs that are not required to be
capitalized under § 263A and the regulations thereunder including product certification
costs required as a condition of sale and certain selling costs; to use the de minimis rule
described in § 1.263A-1(g)(4)(ii) to determine if any portion or all of a mixed service
department's costs are allocable to property acquired for resale; to use the simplified
service cost method with the labor-based allocation ratio to determine capitalizable
mixed service costs for those mixed service departments that are not treated as
engaged exclusively in resale or non-resale activities under the de minimis rule; to use
the 1/3-2/3 rule to allocate labor costs of personnel engaged in both purchasing and
non-purchasing activities between these activities; and to use the simplified resale
method without the historic absorption ratio election to capitalize additional § 263A costs
to ending inventory with costs not presently capitalized treated as additional § 263A
costs.

Pursuant to § 1.381(c)(5)-1(e)(4), S will compute the adjustment necessary to reflect the
change in the method of identifying and allocating § 263A costs. S will take the
adjustment into account in computing taxable income in the taxable year that includes
Date 2.

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 referenced in
this letter. We express no opinion as to whether specific departments and their
associated costs are capitalizable, mixed service, or deductible departments or costs.
We express no opinion regarding the propriety of the factors or relationships used to
determine whether 90 percent or more of a mixed service department=s costs are
deductible service costs or capitalizable service costs under the de minimis rule
described in ' 1.263A-1(g)(4)(ii). We express no opinion regarding the propriety of S’s
method of determining the amount of a person's activities related to purchasing under
PLR-111450-10 4

the 1/3-2/3 rule described in ' 1.263A-3(c)(3)(ii)(A). We also express no opinion as to
whether a particular cost is capitalizable under § 263A and the regulations thereunder.
Additionally, we express no opinion as to whether § 381 applies, that the methods used
by S on Date 2 were the principal methods of accounting under § 1.381(c)(5)-1(c)(2),
and that the methods for identifying and allocating costs failed to clearly reflect S’s
income after Date 2. These determinations are to be made by the director in connection
with the examination of Parent's federal income tax returns.

This ruling is directed only to Parent. Section 6110(k)(3) 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 Parent’s authorized representatives.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, if Parent is filing its federal income tax return electronically it may satisfy
this requirement by attaching a statement to its 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 Parent 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,



                                    Roy A. Hirschhorn
                                    Branch Chief, Branch 6
                                    (Income Tax & Accounting)