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Rules Governing Practice before IRS

Allocating Mixed Service Costs Under I.R.C. Section 263A to Certain Self-Constructed Property of Electric and Natural Gas Utilities

OCT 14 2014

LB&I Control No: LB&I-LB7I-04-0814-007
Impacted IRM 4.51.2

Impacted IRM 4.51.2

FROM: Heather C. Maloy
Commissioner, Large Business & International Division
SUBJECT: Large Business & International Directive for Allocating Mixed Service Costs Under I.R.C. Section 263A to Certain Self-Constructed Property of Electric and Natural Gas Utilities

This directive provides guidance to Large Business & International (LB&I) examiners in determining whether a taxpayer’s method for allocating Mixed Service Costs (MSC) to certain self-constructed tangible personal property (self-constructed property) is appropriate and should not be challenged.  This directive applies to examination activity relating to electric utilities, natural gas utilities, and combined electric and natural gas utilities.  


Utility industry taxpayers may not use the Simplified Service Cost Method (SSCM) to allocate MSC to self-constructed property that is not mass-produced or does not have a high degree of turnover.  See Treas. Reg. § 1.263A-1(d)(1), (h)(1), (h)(2)(i)(D); see also Rev. Rul. 2005-53, 2005-2 C.B. 425.  For property that is not eligible for the SSCM, utility industry taxpayers should allocate MSC based on a reasonable allocation method such as the “facts and circumstances” method.  See Treas. Reg. § 1.263A-1(f)(1), (f)(4), (g)(4).  

Examination Guidance:

1.  Examiners should not challenge the reasonableness of the following MSC allocation method used by a utility industry taxpayer:  

a. Step 1 - A consistent headcount ratio - The taxpayer allocates MSC among (i) transmission and distribution (T&D) and other departments, and between (ii) capital (i.e., production or resale) and non-capital activities within a T&D department based on an annually determined headcount ratio that is calculated in the following manner:

(i) The taxpayer categorizes total MSC among company-wide MSC, MSC attributable to deductible service departments, and MSC attributable to other non-company-wide departments (e.g., fleet, stores, engineering, electric transmission and distribution (Electric T&D), natural gas transmission and distribution (Gas T&D), and generation);  

(ii) The taxpayer allocates the company-wide MSC between capitalizable MSC and non-capitalizable MSC within the various departments based on a company-wide headcount ratio; and  

(iii) The taxpayer allocates the non-company-wide MSC between capitalizable MSC and non-capitalizable MSC within the various departments based on a headcount ratio method that is consistently applied for the various departments.  The denominator for a non-company-wide department’s capital/non-capital allocation ratio includes only those department employees who actually benefited from the MSC being allocated.  The non-capitalizable MSC are treated as deductible MSC, and the capitalizable MSC are further allocated between inventory and self-constructed property based on the production cost ratio calculated in step 2.

b. Step 2 - A production cost ratio with a limited reduction for purchased electricity and purchased natural gas - The taxpayer allocates capitalizable MSC among capital activities according to a production cost ratio that is computed as follows:

(i) Numerator - The numerator equals the total Section 263A costs of self-constructed property of both Electric T&D and Gas T&D, less all MSC capitalized, less the interest capitalized to Electric T&D and Gas T&D self-constructed property .

(ii) Denominator - The denominator equals the total Section 263A costs of Electric T&D and Gas T&D  self-constructed property, plus the Section 263A costs of electricity and natural gas sold, less 50 percent of the cost of the taxpayer's purchased electricity and purchased natural gas, less all MSC capitalized, less the interest capitalized to Electric T&D and Gas T&D  self-constructed property.  The denominator of the production cost ratio does not include depreciation expense and does not include the cost of purchased electricity or gas sold outside the taxpayer’s service area (e.g., non-native load).  

(iii) Application - The production cost ratio is then multiplied by capitalizable MSC to arrive at the amount of MSC to be allocated to Electric T&D and Gas T&D  self-constructed property.  The remaining capitalizable MSC is allocated between electricity and natural gas inventory based on a reasonable cost ratio.

(iv) Reductions for temporary solutions - The use of the headcount ratio and the production cost ratio takes into consideration the amount of costs that may have been capitalized to temporary solutions.  Therefore, further reductions in the amount capitalized for temporary solutions should not be made.

2. This Directive does not apply if the taxpayer includes any of the following elements in its MSC allocation methods:  

a. Additional costs of working in an energized environment treated as costs of maintaining electric service - The taxpayer treats the additional costs of working more slowly in an energized environment as deductible costs of maintaining electric service instead of capitalizing the costs to self-constructed property.  The taxpayer analogizes these costs to the costs of temporary relocations of existing power lines to maintain continuous service during a construction period of less than a year, as described in Revenue Ruling 73-203, 1973-1 C.B. 146.  

b. Overly broad or other inappropriate cost drivers - The taxpayer uses cost drivers that are overly broad or inappropriate, such as cost drivers that result in the allocation of MSC to departments that receive no benefit from the MSC.

c. Imputation of production costs based on hypothetical events - The taxpayer uses a production ratio based on the estimated cost that would have been paid for generating power instead of purchasing power or an estimated headcount based on the number of employees that would have been required to generate the electricity instead of purchasing it.

3. This Directive does not address the following threshold issues:

a. Whether a particular cost is a mixed service cost, as defined in § 1.263A-1(e)(4)(ii)(C); or

b. Whether a department is a service department that generates both capitalizable service costs, as defined in § 1.263A-1(e)(4)(ii)(A), and deductible service costs, as defined in § 1.263A-1(e)(4)(ii)(B) (i.e., is a mixed service department).  


If you have any questions, please contact the Inventory & 263A IPG.

This Directive is not an official pronouncement of law, and should not be used, cited, or relied upon as such.  In addition, nothing in this Directive should be construed as affecting the operation of any other provision of the Code, regulations, or related guidance.

cc: Division Counsel, LB&I
     Chief, Appeals