Industry Director Directive #2 on Mixed Service Costs
DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE
WASHINGTON, D.C. 20224
Large and Mid-Size Business Division
Impacted IRM 4.51.5
May 1, 2007
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, FIELD SPECIALISTS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, INTERNATIONAL COMPLIANCE STRATEGY AND POLICY
FROM: Keith Jones /s/ Keith M. Jones
Natural Resources and Construction
SUBJECT: LMSB Tier I Mixed Service Costs Issue - Field Directive on Guidance Published for 263A Mixed Service Costs - #2
This Directive provides field assistance on the Tier I Mixed Service Costs Issue by offering direction on how to distinguish between resellers’ merchandising departments and producers’ purchasing departments.
Section 263A Mixed Service Costs is a Tier 1 issue as a result of over sixty producers (mostly utilities) filing requests to change their methods of accounting for section 263A mixed service costs. The proposed negative section 481(a) adjustments total over $50 billion. The majority of the method change applications result from a marketed product by one of the big four accounting firms (National Firms). The pivotal issue arising from these method change requests is whether the self-constructed assets treated as property eligible for the simplified service cost method (SSCM) meet the requirements of eligible property under Treas. Reg. § 1.263A-1(h)(2)(i)(D). In addition, the Service is questioning several other aspects of these proposed method changes, including whether the mixed service costs claimed by taxpayers are in fact mixed service costs. The reasoning in TAM 200609018 and TAM 200613003 addresses this mixed service costs issue with respect to producers.
Significantly, during this same time period, the Service also received an influx of accounting method change requests from retail taxpayers seeking to reclassify their purchasing costs as mixed service costs. The retailers argued that their merchandising departments gave rise to mixed service costs allocable to resale activities and to non-resale (deductible service) activities.
For producers, the enactment of section 263A expanded the types of costs taxpayers were already required to capitalize to inventory under the full-absorption rules. In contrast, section 263A required resellers for the first time to capitalize indirect costs to inventory. Although resellers are required to capitalize all indirect costs that are incurred by reason of or that directly benefit their resale activities, these costs consist primarily of purchasing, storage and handling costs. Notwithstanding, retail taxpayers filed method change requests that would effectively eliminate the capitalization of purchasing costs, by seeking consent to treat purchasing costs as mixed service costs. Effectively, this would mean that all of the purchasing costs that a retail taxpayer incurs in its merchandising department (or elsewhere in its organization) would be treated as mixed service costs. Taxpayers would either continue to use or contemporaneously seek consent to use the simplified service cost method in conjunction with a labor-based allocation ratio. The numerator of the labor-based allocation ratio comprises section 263A labor costs (defined as “total labor costs excluding labor costs included in mixed service costs.”) Because all of the labor costs relating to purchasing would be mixed service costs, none of these costs would be capitalized under the proposed method. This result contravenes the section 263A regulations governing resellers, retailers, and wholesalers.
The reasoning found in TAM 200446024 supports the argument that a retailer’s merchandising (or purchasing) department is not a service department under the section 263A regulations, and thus, the costs incurred by such a department are not mixed service costs. The reasoning found in TAM 200609018 involving purchasing (procurement) costs of a producer is distinguishable. The reasoning in this TAM in no way suggests that purchasing costs incurred by a retailer are mixed service costs within the meaning of the section 263A regulations.
Project Code 0511 Tracking Code 1511
SSCM Issue: UIL 263A-07-00; SAIN 707; Second Tier SAIN 190
Fact & Circumstances: (2005 and later years) UIL 263A.06-01; SAIN 707; Second Tier SAIN 191
Planning and Examination Guidance:
For producers with self-constructed assets, the issue can be identified on returns by reviewing Schedule M-3 adjustments decreasing taxable income.
As discussed above, retailers’, resellers’, and wholesalers’ treatment of merchandising department costs as mixed service costs is a marketed tax product. The issue has been identified on Forms 3115 filed with the National Office, and consents may have been given in certain of these method change requests which should be challenged upon examination. The issue also has been identified through informal claims filed at or near the end of examination cycles.
Agents should be aware that there should be a significant book/tax difference for the 263A computation. Therefore, an in-depth review of the Schedule M-3 difference is warranted. To the extent that a taxpayer’s section 263A computation reflects no purchasing costs being capitalized under the simplified resale method or reflects a purchasing costs absorption ratio of zero, this indicates the issue may exist.
Planning and Examination Risk Analysis
The issue is a Tier I issue, and therefore, a mandatory examination item. Upon identifying the issue, agents in all industries should contact the Utility Technical Advisors or the Retail Technical Advisor, as appropriate, for instructions.
Agent’s examination techniques should include reviewing the engineering time sheets to determine if time is directly chargeable to a work order. Amounts that are determined to be direct labor should be removed from the mixed service costs pool. Remaining amounts should be scrutinized to ascertain if the departments are indeed mixed service departments. The flowchart noted above is helpful in making this assessment.
Direction and assistance on evaluating the information gathered may be coordinated with the Utilities/Section 263A Technical Advisors.
Direction and assistance in developing the issue must be coordinated with the Retail Technical Advisor.
Retailers have argued that their merchandising departments are mixed service costs departments because their costs are allocable to both resale activities and to deductible activities. This argument, however, does not properly consider the definition of mixed service costs found under Treas. Reg. §1.263A-1(e)(4)(ii)(C). Mixed service costs are defined as service costs that are partially allocable to production or resale activities (capitalizable mixed service costs) and partially allocable to non-production or non-resale activities (deductible mixed service costs).
Retailers also have argued that their merchandising departments give rise to mixed service costs, asserting that the costs incurred by the merchandising department are allocable both to resale activities and to non-resale activities. In support of this position, taxpayers cite Treas. Reg. §1.263A-1(e)(4)(iii), which provides examples of capitalizable service departments. Example (C) provides that purchasing operations, including purchasing materials and equipment, scheduling and coordinating delivery of materials and equipment to or from factories or job sites, and expediting and follow-up are an example of a capitalizable service cost.
The Service’s position is that a retailer’s merchandising, or purchasing, department is not a service department under the section 263A regulations, and accordingly, the costs incurred by this department are not mixed service costs. Before a cost can be a mixed service cost, it must be a service cost. A service cost is an indirect cost that can be identified specifically with a service department or function or that directly benefits or is incurred by reason of a service department or function. Treas. Reg. § 1.263A-1(e)(4)(i)(A). Traditionally, cost accounting has distinguished between operating departments and service departments. An operating department (also called a production department for a manufacturer) adds value to a product or service. On the other hand, a service department is a department that assists or supports other internal departments so that its costs are allocable to such departments. Service departments are those activities that are necessary to facilitate a company’s core activities, but in which the core activities themselves are not performed. In the context of a manufacturer, the purchasing department is often a service department because such department does not directly engage in the production of the manufacturer’s products, but only assists or supports the production departments. The example in the regulations cited by taxpayers recognizes this. The example assumes that because the materials and equipment are delivered to a factory (a manufacturing facility), the purchasing costs are incurred by a service department. In contrast, with regard to retailers, the purchasing department is generally akin to the manufacturer’s production departments. These departments directly act on the products and goods that will be sold to the retailer’s customers. Accordingly, retailers’ purchasing departments generally are not service departments and therefore cannot be treated as mixed service departments. Section 1.263A-1(e)(3)(ii)(F), which provides that purchasing costs are an indirect cost that must be capitalized to the extent such costs are properly allocable to property acquired for resale, further supports this conclusion. See also the cross-reference to Treas. Reg. § 1.263A-3(c)(3), providing that resellers must capitalize the cost of property acquired for resale and purchasing costs that are properly allocable to property acquired for resale.
In TAM 200609018, the Service reasoned that the costs of a taxpayer’s procurement (purchasing) department were mixed service costs. This TAM, however, dealt with a producer, rather than a reseller. The reasoning in this TAM, which would apply to the engineering and procurement departments of a utility company, has no application to the purchasing costs of a retail taxpayer. Nor does the reasoning found in TAM 200613033, which deals with a producer in the utility industry, apply to a reseller’s purchasing costs. Rather, the reasoning found in TAM 200446024 would apply.
Effect on Other Guidance:
For all industries except retail taxpayers:
Frank Genet, Utilities Technical Advisor, 330-253-7340
Marge Lopez, Utilities Technical Advisor, 619-557-6125
For retail taxpayers:
Dave Moser, Retail Technical Advisor, 636-255-1246
This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.
CC: Commissioner, LMSB
Deputy Commissioner, Operations
Deputy Commissioner, International
Division Counsel, LMSB
Directors, Field Operations
Director, Performance, Quality and Audit Assistance