Historic absorption ratio provides easier administration of sec. 263A uniform cost capitalization.

• Author: Tovig, Barry A.

The final Sec. 263A regulations contain a new method of accounting, the historic absorption ratio method, for taxpayers using either the simplified production method or the simplified resale method to capitalize Sec. 263A costs. A taxpayer electing to use the historic absorption ratio method could significantly reduce compliance time required without a substantial adverse tax effect.

The historic absorption ratio method permits a taxpayer to use an absorption ratio computed under either of the simplified methods as the total Sec. 263A costs incurred over the three-year period before the year of election (the "test period") divided by the total Sec. 471 costs incurred over the test period. This average absorption ratio is then used for the five-year period beginning with the year in which the method is elected (the "qualifying period").

In the sixth year (the "recomputation year"), the actual absorption ratio must be computed and compared to the historic absorption ratio. To continue use of the historic absorption ratio for the recomputation year and the following five tax years, the two ratios must be within one-half of one percentage point of each other, either positively or negatively. If not, the taxpayer must use actual absorption ratios for the next three years (the "updated test period"). In the ninth year, the year after this updated test period, the taxpayer must again compute its historic absorption ratio based on the average of the total Sec. 263A costs incurred during the updated test period divided by the total Sec. 471 costs incurred during the updated test period, and use this new historic absorption ratio for the next five tax years. This process repeats itself every five years to ensure that the historic absorption ratio remains reasonably representative for purposes of allocating additional Sec. 263A costs to inventory. The example on the left illustrates the operation of the historic absorption ratio method.

The ability to elect the historic absorption ratio method without advance consent is generally limited to taxpayers that use the simplified production method or simplified resale method. However, under a transitional rule, the historic absorption ratio method may be automatically elected by a taxpayer not employing either of the simplified methods in the first, second or third tax year beginning after Dec. 31, 1993. Such taxpayers must compute their historic absorption ratio as though they had employed the simplified...