Simplified production method with HAR election is permitted if taxpayer's actual absorption ratio significantly exceeds HAR.

• Author: Conjura, Carol
• Position: Historic absorption ratio

The Service has ruled in Letter Ruling (TAM) 9810003 that a taxpayer may use the simplified production method with historic absorption ratio (HAR) election under Regs. Sec. 1.263A-2(b)(4), even though its actual absorption ratio significantly exceeded its HAR.

In the TAM, the taxpayer was a member of an affiliated group consisting of the parent and four subsidiaries, all of which were engaged in the production of real or tangible personal property. The taxpayer was the only member that used the simplified production method with the HAR. Because the taxpayer had used the simplified production method for more than three tax years immediately prior to the year of change, it elected the HAR method under Regs. Sec. 1.263A-2(b) (4). In the same year the taxpayer elected the HAR, it placed a substantial amount of plant and equipment into service, which resulted in a significant increase in its additional Sec. 263A costs for that year (due to additional allocable depreciation). A substantial portion of the plant and equipment placed in service qualified for a five-year recovery period under Rev. Proc. 87-56. As a result of the increased additional Sec. 263A costs, the taxpayer's actual absorption ratio for the year greatly exceeded its HAR.

Sec. 263A generally requires producers of real or tangible personal property and resellers of real or personal property described in Sec. 1221(1) to capitalize the direct costs of such property and certain indirect costs allocable to such property, including "additional Sec. 263A costs." "Additional Sec. 263A costs" are the indirect costs (other than interest) that must be capitalized under Sec. 263A, but that were not capitalized under the taxpayer's method of accounting immediately prior to the effective date of Sec. 263A.

Further, Regs. Secs. 1.263A-2(b) and -3(d) provide a simplified production and a simplified resale method, respectively, for determining the additional Sec. 263A costs that must be capitalized to ending inventory (or to the current-year increment for a taxpayer using the LIFO inventory method) or other property on hand at year-end. Under these simplified methods, a taxpayer determines the additional Sec. 263A costs that must be capitalized by multiplying Sec. 471 costs (as defined in Regs. Sec. 1.263A-1 (d)(2)) remaining on hand at year-end (or reflected in the current-year increment in the case of a taxpayer using the LIFO inventory method) by an absorption ratio.

In general, the absorption...