| REG-208156-91 |
April 30, 1999 |
Accounting for Long-Term Contracts
DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-208156-91] RIN 1545-AQ30
TITLE: Accounting for Long-Term Contracts
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking and notice of public hearing.
SUMMARY: This document contains proposed regulations describing how
income from a long-term contract must be accounted for under section
460 of the Internal Revenue Code, which was enacted by the Tax
Reform Act of 1986. A taxpayer manufacturing or constructing
property under a long-term contract will be affected by these
proposed regulations. This document also provides notice of a public
hearing on the proposed regulations.
DATES: Written comments and outlines of oral comments to be
presented at the public hearing scheduled for September 14, 1999, at
10 a.m. must be received by August 3, 1999.
ADDRESSES: Send submissions to CC:DOM:CORP:R (REG-208156-91), room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday
through Friday between the hours of 8 a.m. and 5 p.m. to:
CC:DOM:CORP:R (REG-208156-91), Courier's Desk, Internal Revenue
Service, 1111 Constitution Avenue, NW., Washington, DC.
Alternatively, taxpayers may submit comments electronically via the
Internet by selecting the "Tax Regs" option on the IRS Home Page, or
by submitting comments directly to the IRS Internet site at
http://www.irs.ustreas.gov/tax_regs/regslist.html. The public
hearing will be held in the IRS Auditorium, 7th Floor, Internal
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed
regulations, John M. Aramburu or Leo F. Nolan II at (202) 622- 4960;
concerning submissions of comments, the hearing, and/or to be placed
on the building access list to attend the hearing, Michael L.
Slaughter of the Regulations Unit at (202) 622-7180 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and
Budget for review in accordance with the Paperwork Reduction Act of
1995 (44 U.S.C. 3507(d)). Comments on the collections of information
should be sent to the Office of Management and Budget, Attn: Desk
Officer for the Department of the Treasury, Office of Information
and Regulatory Affairs, Washington, DC 20503, with copies to the
Internal Revenue Service, Attn: IRS Reports Clearance Officer,
OP:FS:FP, Washington, DC 20224. Comments on the collections of
information should be received by July 6, 1999. Comments are
specifically requested concerning:
Whether the proposed collections of information are necessary for
the proper performance of the functions of the Internal Revenue
Service, including whether the information will have practical
utility; The accuracy of the estimated burden associated with the
proposed collections of information (see below); How the quality,
utility, and clarity of the information to be collected may be
enhanced; How the burden of complying with the proposed collections
of information may be minimized, including through the application
of automated collection techniques or other forms of information
technology; and Estimates of capital or start-up costs and costs of
operation, maintenance, and purchase of services to provide
information.
The collection of information in this proposed regulation is in
§1.460-1(e)(4). The information collected in §1.460-1(e)(4) is
required to notify the Commissioner of the taxpayer's decision to
sever or aggregate one or more contracts under the regulations. This
collection of information is mandatory. The likely respondents are
for-profit entities.
Estimated total reporting burden: 50,000 hoU.S.
Estimated average burden per respondent: 1 hour.
Estimated number of respondents: 50,000.
Estimated annual frequency of responses: On occasion.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless the collection of
information displays a valid OMB control number.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns
and tax return information are confidential, as required by 26
U.S.C. 6103.
Background
Section 460, which was enacted by section 804 of the Tax Reform Act
of 1986 (1986 Act), Public Law 99-514 (100 Stat. 2085, 2358-2361),
generally requires a taxpayer to determine the taxable income from a
long-term contract using the percentage-of-completion method.
Section 460 was amended by section 10203 of the Omnibus Budget
Reconciliation Act of 1987, Public Law 100-203 (101 Stat. 1330,
1330-394); by sections 1008(c) and 5041 of the Technical and
Miscellaneous Revenue Act of 1988, Public Law 100- 647 (102 Stat.
3342, 3438-3439 and 3673-3676); by sections 7621 and 7811(e) of the
Omnibus Budget Reconciliation Act of 1989, Public Law 101-239 (103
Stat. 2106, 2375-2377 and 2408-2409); by section 11812 of the
Omnibus Budget Reconciliation Act of 1990, Public Law 101-508 (104
Stat. 1388, 1388-534 to 1388-536); by sections 1702(h)(15) and
1704(t)(28) of the Small Business Job Protection Act of 1996, Public
Law 104-188 (110 Stat. 1755, 1874, 1888); and by section 1211 of the
Taxpayer Relief Act of 1997, Public Law 105-34 (111 Stat. 788,
998-1000).
Section 460(h) directs the Secretary to prescribe regulations to the
extent necessary or appropriate to carry out the purpose of section
460, including regulations to prevent a taxpayer from avoiding
section 460 by using related parties, pass-through entities,
intermediaries, options, and other similar arrangements.
Explanation of Provisions 1. Overview Before the enactment of
section 460, §1.451-3 of the Income Tax Regulations permitted a
taxpayer to determine the income from a long-term contract using
either the completed-contract method (CCM) or the percentage-of-
completion method, in addition to the cash receipts and
disbursements method, if otherwise permissible, or an accrual
method. Under the CCM, a taxpayer does not report income until a
contract is complete, even though payments are received in years
prior to completion. The percentage-of-completion method, on the
other hand, requires a taxpayer to recognize income according to the
percentage of the contract that is completed during each taxable
year.
Section 460 generally requires the income from a long-term contract
to be determined using the percentage-of-completion method based on
a cost-to-cost comparison (PCM). However, the income from certain
exempt construction contracts still may be determined using the CCM,
the exempt-contract percentage-of-completion method (EPCM), or any
other permissible method.
Contracts that are not long-term contracts must be accounted for
using a permissible method of accounting other than a long-term
contract method (i.e., a method other than the PCM, the CCM, or the
EPCM). See section 446 and the regulations thereunder.
The IRS and Treasury Department provided guidance on section 460 in
Notice 89-15 (1989-1 C.B. 634) and in Notice 87-61 (1987-2 C.B.
370). These proposed regulations generally incorporate the relevant
provisions of §1.451-3 and the notices under section 460. However,
these proposed regulations also modify and amplify certain rules
provided in §1.451-3 and notices under section 460.
Specifically, for example, these regulations provide an exception
for de minimis construction activities, modify the contract
completion rules, clarify the treatment of non-long-term contract
activities, modify the severing and aggregating rules to emphasize
pricing and to prevent severance by taxpayers of contracts accounted
for using the PCM, clarify the consistency rule provided in Notice
89-15, provide an inventory exception to the related party rules,
provide safe harbors for determining whether a manufactured item is
unique, and modify the normal time to complete an item to conform to
the production period in section 263A.
These proposed regulations will apply to any contract entered into
on or after final regulations are published in the Federal Register.
2. Definition of Long-Term Contract
Under section 460(f), long-term contract generally means any
contract for the manufacture, building, installation, or
construction of property if the contract is not completed within the
taxable year the taxpayer enters into the contract (contracting
year). For this purpose, manufacturing concerns only personal
property, and building, installation, and construction
(construction) concern only real property.
Section 460 continues the policy established in §1.451- 3(b)(1) of
excluding a manufacturing contract from the definition of long-term
contract unless the contract involves the manufacture of (1) a
unique item of a type that is not normally included in the finished
goods inventory of the taxpayer or (2) an item normally requiring
more than 12 calendar months to complete, regardless of the duration
of the contract.
A contract is a contract for the manufacture or construction of
property if such activities are necessary for the taxpayer's
contractual obligations to be fulfilled and are not complete when
the parties enter into the contract. However, a contract is not a
construction contract if it requires the provision of land by the
taxpayer and the estimated total allocable contract costs
attributable to the taxpayer's construction activities are less than
10 percent of the total contract price. This de minimis construction
rule may affect the result of facts similar to those in Foothill
Ranch Company Partnership v. Commissioner, 110 T.C.
No. 8 (1998), in which the Tax Court concluded that the sale of land
could be accounted for using the PCM since construction of buildings
and improvements was necessary to fulfill the taxpayer's obligations
under the sales agreements and those obligations were not completed
in the tax year of the sale.
3. Date Taxpayer Enters Into A Long-Term Contract
The proposed regulations provide that a taxpayer enters into a long-
term contract in the taxable year that the contract binds both the
taxpayer and the customer under applicable law. If a taxpayer delays
entering into a contract to avoid section 460, however, the taxpayer
will be treated as having entered into the contract on the date the
taxpayer or a related party incurs any allocable contract costs,
other than bidding or negotiating costs. If a taxpayer must sever an
accepted change order or exercised option from a long-term contract,
the taxpayer enters into another contract with the customer when the
change order is accepted by the taxpayer or when the option is
exercised by the customer, whichever is applicable.
4. Date Taxpayer Completes A Long-Term Contract
The proposed regulations provide that a long-term contract is
completed in the earlier taxable year (completion year) that:
(1) the customer uses the subject matter for any purpose (other than
testing) and 5 percent or less of the total allocable contract costs
attributable to the subject matter remain to be incurred by the
taxpayer; or (2) the subject matter of the contract is finally
completed and accepted. A taxpayer must determine whether a contract
has been finally completed and accepted during the taxable year
based upon an analysis of all relevant facts and circumstances. To
the extent that the "use" rule requires a taxpayer to treat a
contract as completed before final completion and acceptance have
occurred, the proposed regulations explicitly adopt a rule different
from that considered in Ball, Ball and Brosamer, Inc. v.
Commissioner, 964 F.2d 890 (9th Cir. 1992), aff'g T.C. Memo.
1990-454. In Ball, the Ninth Circuit held that the contract for
construction of a space shuttle complex was not completed in 1983,
notwithstanding that the performance report indicated the contract
was 100 percent complete and the customer was using the subject
matter for its intended purpose, since the remaining work to be done
in 1984 (such as installing runway extensions, airfield lighting,
drainage and a laser tracking system) was an integral part of the
contract and the contract specifically provided that use was not
deemed acceptance.
The regulations also provide that if a contract accounted for using
the CCM requires the construction of a primary subject matter and a
secondary subject matter, the contract is completed when the primary
subject matter is completed. A taxpayer must separate the gross
receipts and costs related to the incomplete secondary item(s) from
the long-term contract and account for them using a permissible
method of accounting.
5. Non-Long-Term Contract Activities
The performance of any activity other than manufacturing or
construction is a non-long-term contract activity. If the
performance of a non-long-term contract activity, such as
engineering and designing, is incident to or necessary for the
manufacture or construction of the subject matter of one or more of
the taxpayer's long-term contracts, the taxpayer must allocate the
gross receipts and costs attributable to that activity to the long-
term contract(s) benefitted. Otherwise, the proposed regulations
require the taxpayer to account for such gross receipts and costs
using a permissible method of accounting other than a long-term
contract method of accounting. See Rev. Rul.
82-134 (1982-2 C.B. 88) (engineering and construction management
services); Rev. Rul. 80-18 (1980-1 C.B. 103) (engineering and
construction management services); and Rev. Rul. 70-67 (1970-1 C.B.
117) (architectural services).
6. Severing And Aggregating Contracts
Section 460(f)(3) provides that the Secretary may prescribe
regulations to treat two or more contracts which are interdependent
as one contract and to respect a contract which is properly treated
as an aggregation of separate contracts. The proposed regulations
allow the Commissioner, and generally require a taxpayer, to sever
and aggregate contracts when necessary to clearly reflect income.
The proposed rules provide three criteria for determining whether
severance or aggregation is required. First, independent pricing of
items is necessary for an agreement to be severed into two or more
contracts. On the other hand, interdependent pricing of items in
separate agreements is necessary for two or more agreements to be
aggregated into one contract. Second, an agreement may not be
severed into two or more contracts, unless it provides for separate
delivery or separate acceptance of portions of the subject matter of
the agreement. However, separate delivery or separate acceptance of
portions of the subject matter of the agreement by itself does not
necessarily require severance of the agreement. Third, an agreement
may not be severed into two or more contracts if a reasonable
businessperson would not have entered into separate agreements
containing the terms allocable to each severed contract.
Similarly, two or more agreements may not be aggregated into one
contract, unless a reasonable businessperson would not have entered
into one of the agreements for the terms agreed upon without also
entering into the other agreement. The criteria adopted in the
proposed regulations generally are consistent with the Tax Court's
conclusions in Sierracin Corporation v.
Commissioner, 90 T.C. 341 (1988), acq. 1990-2 C.B. 1, and General
Dynamics Corporation v. Commissioner, T.C. Memo 1997-420.
Under the proposed regulations, a taxpayer may not apply the
severance rule described in the preceding paragraph if the entire
contract would be accounted for using the PCM. However, the
Commissioner may sever a contract accounted for using the PCM as
necessary to clearly reflect income. In addition, a taxpayer must
sever a long-term contract (not accounted for using the PCM) that
increases the number of units to be supplied to the customer, such
as through the exercise of an option or the acceptance of a "change
order," if the contract provides for separate delivery or separate
acceptance of the additional units.
7. Classifying Long-Term Contracts
The proposed regulations provide that a taxpayer's method of
classifying contracts is a method of accounting. Thus, a taxpayer
must request the consent of the Commissioner to change its method of
classifying contracts. However, if the classification of a
particular type of contract is no longer appropriate for subsequent
contracts of that type as a result of a change in underlying facts,
such as when a manufactured item no longer is unique due to a
reduction in the extent of design or no longer requires 12 months to
produce, a change in the classification of such subsequent contracts
is not a change in method of accounting. To the extent that the
consistency rule in Notice 89-15 (Q&A-7) was interpreted to prevent
taxpayers from changing the classification of a particular type of
subsequent contracts when the underlying facts have changed, the
proposed regulations clarify the consistency rule.
Under the proposed regulations, a taxpayer must classify a contract
that requires the taxpayer to manufacture personal property and to
construct real property separately as a manufacturing and a
construction contract, unless 95 percent or more of the estimated
total allocable contract costs are reasonably allocable to the
manufacturing activities or to the construction activities (in which
case the taxpayer may chose to classify as either a manufacturing or
a construction contract, as appropriate).
8. Long-Term Contracts of Related Parties
The proposed regulations contain rules similar to those in Notice
89-15 (Q&A-8) for an activity of a taxpayer that is incident to or
necessary for a related party's long-term contract subject to PCM.
The taxpayer must account for the gross receipts and costs from such
an activity using the PCM, even if this activity is not otherwise
subject to section 460. The proposed regulations contain an
inventory exception for subassemblies and components sold to a
related party, however, when the taxpayer regularly carries these
items in its finished goods inventories and 80 percent or more of
the gross receipts from the sale of these items typically comes from
unrelated parties.
To determine the percentage of the contract that has been completed
by the end of the taxable year (completion factor), the taxpayer
with the long-term contract must take into account the related
party's activity that is incident to or necessary for its long-term
contract at the time it incurs the liability to the related party,
rather than when the related party incurs costs to perform the
activity.
9. Unique Items
Section 460 applies if a taxpayer manufactures a unique item of a
type that is not normally included in the finished goods inventory
of the taxpayer and if the contract is not completed by the close of
the contracting year. As in §1.451-3(b)(1)(ii), the proposed
regulations provide that unique means specifically designed for the
needs of a customer. Thus, a contract may require the taxpayer to
manufacture more than one unit of a unique item.
The proposed regulations contain three safe harbors concerning
contracts to manufacture unique items. First, an item is not unique
if the taxpayer normally completes the item within 90 days. Second,
an item customized from a taxpayer's existing design is not unique
if the total allocable contract costs attributable to customizing
activities that are incident to or necessary for the production of
the item does not exceed 5 percent of the estimated total costs
allocable to the item.
Thus, contracts to manufacture items that do not require either
significant design or lengthy production periods ordinarily will not
be subject to section 460. Third, a unique item ceases to be unique
no later than when the taxpayer normally carries similar items in
its finished goods inventory.
The proposed regulations adopt criteria different from those in
Sierracin, supra, which was decided two years after the enactment of
section 460, but concerned the taxpayer's use of the CCM for taxable
years ending before the enactment of section 460.
In Sierracin, the Tax Court developed a two-prong test for
determining whether an item is unique. That test provided that an
item is unique if (1) it is designed for the needs of a specific
customer and (2) the taxpayer's contracts are subject to
unpredictable manufacturing risks that make it difficult for the
taxpayer to determine the ultimate profit or loss on an interim
basis.
The regulations incorporate the Sierracin criterion regarding
design, but exclude the criterion regarding unpredictable
manufacturing risk because that criterion was developed primarily to
justify the taxpayer's use of the CCM.
See, e.g., GCM 7998 (IX-2 C.B. 206, 208); Rev. Rul. 70-67 (1970-1
C.B. 117); STAFF OF JOINT COMM. ON TAXATION, 99TH CONG., 1ST SESS.,
TAX REFORM PROPOSALS: ACCOUNTING ISSUES (JCS-39-86) 46 (Comm. Print
1985). Manufacturing risk is not relevant under the PCM because the
taxpayer is required to use reasonable estimates, adjusted annually,
while the contract is being performed and because the taxpayer is
required to use the look-back method to correct for estimation
errors when the contract is completed. Thus, the rationale
supporting the consideration of manufacturing risk as a prerequisite
to the use of the CCM, that the taxpayer is unable to determine its
total contract costs, is not applicable to contracts subject to the
PCM.
10. 12-Month Completion Period
The proposed regulations provide that a manufactured item normally
requires more than 12 months to complete if its production period,
as defined in §1.263A-12, is reasonably expected to exceed 12
months, determined at the end of the contracting year. In general,
the production period for an item or unit begins when the taxpayer's
incurs at least 5 percent of the estimated total allocable contract
costs, including planning and design expenditures, allocable to the
item or unit, and the production period ends when the item or unit
is ready for shipment to the taxpayer's customer. In the case of
components that have to be assembled or reassembled into an item or
unit at the customer's facility by the taxpayer's employees or
agents, the production period ends when the components are assembled
or reassembled into an operable item or unit.
For this purpose, the proposed regulations contain rules requiring a
taxpayer to treat the activities of a related party as the
activities of the taxpayer to prevent the taxpayer from avoiding
section 460. However, if the inventory exception discussed in
paragraph 8 above is satisfied, a taxpayer considers the activities
of a related party as it incurs the liability to the related party
rather than as the related party performs the activity.
11. Definition Of Construction Contract
Section 460(e)(4) and the proposed regulations provide that a
construction contract is any contract for the building,
construction, reconstruction, or rehabilitation of, or the
installation of any integral component to, or improvements of, real
property. Thus, a contract to install an integral component to real
property can be subject to section 460 even if the installation
activity is not accompanied by any other construction activity.
12. Exempt Construction Contracts
Section 460(e)(1) exempts two types of construction contracts from
the general scope of section 460. These exempt construction
contracts are: (1) home construction contracts and (2) 2-year
construction contracts of a small contractor. A small contractor is
a taxpayer that satisfies the $10,000,000 gross receipts test
discussed below. The 2-year construction requirement is satisfied if
the taxpayer reasonably estimates, when entering into the contract,
that the contract will be completed within 2 years from the contract
commencement date.
13. Home Construction Contracts
Section 460(e)(6) provides that a construction contract is a home
construction contract if the taxpayer (including a subcontractor
working for a general contractor) reasonably expects to attribute 80
percent or more of the estimated total contract costs, determined at
the close of the contracting year, to the construction of (1) a
dwelling unit or a building containing four or fewer dwelling units
and (2) improvements to real property directly related to the
dwelling units and located on the site of the dwelling units. For
this purpose, a dwelling unit means a house or an apartment used to
provide living accommodations in a building or structure, but does
not include a unit in a hotel, motel, or other establishment more
than one-half of the units in which are used on a transient basis.
In addition, a taxpayer must treat each townhouse or rowhouse as a
separate building. The proposed regulations provide that a taxpayer
includes in the cost of the dwelling units their allocable share of
the cost of any common improvements (e.g., sewers, roads,
clubhouses) that benefit the dwelling unit and that the taxpayer is
contractually obligated, or required by law, to construct within the
tract or tracts of land containing the dwelling units.
14. $10,000,000 Gross Receipts Test
Section 460(e)(1)(B)(ii) provides that the $10,000,000 gross
receipts test is satisfied if the taxpayer's average annual gross
receipts for the three taxable years preceding the contracting year
do not exceed $10,000,000. For this purpose, section 460(e)(2)
mandates the aggregation of gross receipts of all trades or
businesses under common control with the taxpayer.
Section 460(e)(2) also provides that the Secretary shall prescribe
regulations providing attribution rules that take into account
taxpayers who engage in construction contracts through partnerships,
joint ventures, and corporations.
The proposed regulations require the aggregation of gross receipts
under the common control rules in §1.263A-3(b)(3), other than the
rules applicable to single employers under section 414(m) and the
regulations thereunder. In addition, the regulations require the
attribution of construction-related gross receipts of persons that
own, or are owned by, the taxpayer, but that are not subject to
§1.263A-3(b)(3). These rules are similar to those that applied to
the $25,000,000 gross receipts test under prior law.
15. Accounting For Long-Term Contracts--In General
The proposed regulations prescribe permissible methods of accounting
for long-term contracts subject to section 460(a). A taxpayer must
use the PCM and may elect to use the 10-percent method. In addition,
the regulations prescribe permissible methods of accounting for
exempt construction contracts (exempt contract methods). Permissible
exempt contract methods of accounting include the PCM, the EPCM, the
CCM, or any other permissible method.
Section 460(e)(5) allows a taxpayer to determine the income from a
residential construction contract using the percentage-of-
completion/ capitalized-cost method (PCCM). A taxpayer also may
determine the income from a qualified ship contract using the PCCM.
Under this method, a taxpayer must determine the income from the
long-term contract using the PCM for the applicable percentage and
using its exempt contract method for the remaining percentage of the
contract.
The proposed regulations reserve on the accounting for mid-contract
change in taxpayers. The IRS and Treasury Department request
comments regarding the treatment of transfers of long-term contracts
prior to completion.
16. Percentage-of-Completion Method
The proposed regulations provide that under the PCM, a taxpayer
generally includes a portion of the total contract price in income
for each taxable year that the taxpayer incurs contract costs
allocable to the long-term contract. To determine the income from a
long-term contract, the taxpayer first computes the completion
factor for the contract, which is the percentage of the estimated
total allocable contract costs that the taxpayer has incurred (based
on the all events test of section 461, including economic
performance, regardless of the taxpayer's method of accounting)
through the end of the taxable year.
Second, the taxpayer computes the amount of cumulative gross
receipts from the contract by multiplying the completion factor by
the total contract price, which is the amount that the taxpayer
reasonably expects to receive under the contract.
Third, the taxpayer computes the amount of current-year gross
receipts, which is the difference between the cumulative gross
receipts for the current taxable year and the cumulative gross
receipts for the immediately preceding taxable year. This difference
may be a loss (a negative number) if a taxpayer has overstated its
completion factor for the immediately preceding taxable year.
Fourth, the taxpayer takes into account both the current-year gross
receipts and the amount of allocable contract costs actually
incurred during the taxable year. To the extent any portion of the
total contract price has not been included in taxable income by the
completion year, section 460(b)(1) and the proposed regulations
require the taxpayer to include that portion in income for the
taxable year following the completion year.
Under the proposed regulations, total contract price includes all
bonuses, awards, and incentive payments if it is reasonably
estimated that they will be received, even if the all events test
has not yet been met. If, by the end of the completion year, a
taxpayer cannot reasonably estimate whether a contingency will be
satisfied, the bonus, award, or incentive payment is not includible
in total contract price. If it is determined after the taxable year
following the completion year that an amount included in total
contract price will not be earned, the taxpayer should deduct that
amount in the year of the determination.
The proposed regulations provide that allocable contract costs under
the PCM are determined using either of the following prescribed cost
allocation methods--a method based on the extended period contract
allocation rules in §1.451-3(d)(6) or the simplified cost-to-cost
method.
17. 10-Percent Method
Section 460 generally permits a taxpayer to elect to delay the
application of the PCM to each long-term contract until the taxable
year the taxpayer has incurred at least 10 percent of the estimated
total allocable contract costs. Once elected, the 10- percent method
applies to all of the taxpayer's long-term contracts entered into
during and after the election year. Under section 460(b)(5),
however, a taxpayer may not elect the 10- percent method if the
taxpayer determines allocable direct and indirect costs using the
simplified cost-to-cost method.
18. Cost Allocation Rules
Section 460(c) provides cost allocation rules for long-term
contracts subject to the PCM. Section 460(c)(1) provides generally
that all costs which directly benefit, or are incurred by reason of,
the long-term contract activities of the taxpayer must be allocated
to the long-term contract in the same manner as costs are allocated
to extended-period long-term contracts under section 451 and the
regulations thereunder (§1.451-3(d)(6) through (9)). Section 460(c)
(2), however, also requires a taxpayer to allocate costs identified
under a cost-plus long-term contract or a federal long-term contract
even if these costs would not be allocable under the cost allocation
rules for extended-period long-term contracts. In addition, section
460(c)(3) requires a taxpayer to allocate interest expense to a
long-term contract (whether or not the contract is subject to the
PCM) as if the rules of section 263A(f) (concerning the allocation
of interest costs to property produced by the taxpayer) apply.
Finally, sections 460(c)(4) and (5) describe costs that generally
are not allocable to long-term contracts.
Because many taxpayers subject to the cost allocation rules of
section 460 also are subject to the cost allocation rules of section
263A for non-long-term contracts, and because the cost allocation
rules of section 263A generally follow the cost allocation rules
applicable to extended-period long-term contracts, the proposed
regulations provide that a taxpayer generally must allocate costs to
a contract subject to section 460(a) in the same manner as direct
and indirect costs are capitalized to property produced by a
taxpayer under section 263A. The regulations provide exceptions,
however, that reflect the differences in the cost allocation rules
of sections 263A and 460.
19. Simplified Cost-To-Cost Method
The proposed regulations permit a taxpayer to elect to allocate
contract costs using the simplified cost-to-cost method.
Under the simplified cost-to-cost method, a taxpayer must determine
a contract's completion factor based upon only direct material
costs; direct labor costs; and depreciation, amortization, and cost
recovery allowances on equipment and facilities directly used to
manufacture or construct property under the contract. A taxpayer may
allocate costs using the simplified cost-to-cost method only if the
taxpayer determines the taxable income from all long-term contracts
using the PCM.
20. Cost Allocation Rules For Exempt Construction Contracts
The proposed regulations, which supersede §1.451-3(d) (concerning
the CCM), provide cost allocation rules for exempt construction
contracts accounted for using the CCM. These rules provide that a
taxpayer may allocate direct and indirect contract costs in the same
way as currently required under §1.451-3(d)(5) for long-term
contracts that are not extended-period long-term contracts. The
regulations also permit a taxpayer to allocate indirect costs as
provided in section 263A. A homebuilder, however, is required to
capitalize the costs of its home construction contracts under
section 263A and the regulations thereunder, unless the contract
will be completed within 2 years of the contract commencement date
and the taxpayer satisfies the $10,000,000 gross receipts test
previously discussed.
21. Alternative Minimum Taxable Income
Section 56 generally requires a taxpayer (not exempt under section
55(e)) to determine the amount of alternative minimum taxable income
(AMTI) from a long-term contract using the PCM.
Though section 56(a)(3) excludes all home construction contracts
from this requirement, the Internal Revenue Code does not exclude
the exempt construction contracts of a small contractor, residential
construction contracts, or qualified ship contracts.
Section 56(a)(3) requires a small contractor to use the simplified
cost-to-cost method to determine the completion factor of an exempt
construction contract when computing AMTI.
Because the Code sometimes requires a taxpayer to compute AMTI and
taxable income using different rules, a taxpayer generally must
determine a contract's completion factor using the AMTI-modified,
cost-to-cost PCM. The proposed regulations adopt the provisions of
section IX of Notice 87-61, which permit a taxpayer to elect to
determine a contract's completion factor for AMTI purposes using the
accounting and cost allocation methods used to compute regular
taxable income. A taxpayer is required, however, to comply with
section 55 when computing AMTI.
22. Changes in Method Of Accounting
For the first taxable year that includes the date these regulations
are published as final regulations in the Federal Register, the
proposed regulations generally grant a taxpayer consent to change
its method of accounting to comply with the provisions of these
regulations for contracts entered into on or after the date these
regulations are published as final regulations in the Federal
Register. Because this change is made on a cutoff basis, a section
481(a) adjustment is not required.
23. Request For Comments
The IRS and Treasury Department invite comments regarding the
application and effectiveness of the de minimis construction rule.
The IRS and Treasury Department also welcome comments concerning the
application of the unique-item rule, including the usefulness and
terms of the safe harbors and approaches for determining when an
item will cease being unique. Comments are requested concerning the
12-month production period rule, especially with respect to the
application of §1.263A-12 and consideration of related party
activities.
Proposed Effective Date
These regulations are proposed to be effective for contracts entered
into on or after the date they are published in the Federal Register
as final regulations.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in EO 12866.
Therefore, a regulatory assessment is not required.
It also has been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these regulations. Pursuant to section 7805(f) of the Internal
Revenue Code, this notice of proposed rulemaking will be submitted
to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business. It is
hereby certified that the collection of information in this notice
of proposed rulemaking will not have a significant economic impact
on a substantial number of small entities. The regulations require a
taxpayer to attach a statement to its original Federal income tax
return if the taxpayer severs or aggregates a long-term contract.
The statement is needed so the Commissioner can determine whether
the taxpayer properly severed or aggregated the contract. It is
uncommon for a taxpayer that has a long-term contract to sever or
aggregate that contract. In addition, if a contract is severed or
aggregated and a statement is required, it is estimated that it
will, on average, only take one hour to complete.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic or written comments (a
signed original and eight (8) copies) that are submitted timely to
the IRS. The IRS and Treasury specifically request comments on the
clarity of the proposed rule and how it may be made easier to
understand. All comments will be available for public inspection and
copying.
A public hearing has been scheduled for September 14, 1999, at 10
a.m. in the IRS Auditorium, 7th Floor, Internal Revenue Building,
1111 Constitution Avenue, NW., Washington, DC. Due to building
security procedures, visitors must enter at the 10th Street
entrance, located between Constitution and Pennsylvania Avenue, NW.
In addition, all visitors must present photo identification to enter
the building. Because of access restrictions, visitors will not be
admitted beyond the immediate entrance area more than 15 minutes
before the hearing starts.
For information about having your name placed on the building access
list to attend the hearing, see the "FOR FURTHER INFORMATION
CONTACT" section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing.
Persons who wish to present oral comments at the hearing must submit
written comments and an outline of the topics to be discussed and
the time to be devoted to each topic (signed original and eight (8)
copies by August 3, 1999. A period of 10 minutes will be allotted to
each person for making comments. An agenda showing the scheduling of
the speakers will be prepared after the deadline for receiving
outlines has passed. Copies of the agenda will be available free of
charge at the hearing.
Drafting Information The principal author of these proposed
regulations is Leo F.
Nolan II, Office of Assistant Chief Counsel (Income Tax and
Accounting). However, other personnel from the IRS and Treasury
Department participated in their development.
List of Subjects in 26 CFR Part 1 Income taxes, Reporting and
recordkeeping requirements.
Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is
proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation is amended by removing the entry
for §1.460-4 and adding the following entries in numerical order to
read in part as follows:
Authority: 26 U.S.C. 7805 * * *
§1.460-1 also issued under 26 U.S.C. 460(h).
§1.460-2 also issued under 26 U.S.C. 460(h).
§1.460-3 also issued under 26 U.S.C. 460(h).
§1.460-4 also issued under 26 U.S.C. 460(h) and 1502.
§1.460-5 also issued under 26 U.S.C. 460(h). * * * §1.4646 [Amended]
Par. 2. Section 1.446-1 is amended as follows:
1. In the second sentence of paragraph (c)(1)(iii), the language
"451" is removed and "460" is added in its place.
2. In the fourth sentence of paragraph (e)(2)(ii)(a), the language
"§1.451-3" is removed and "§1.460-4" is added in its place.
§1.451-3 [Removed] Par. 3. Section 1.451-3 is removed.
§1.451-5 [Amended] Par. 4. Section 1.451-5 is amended, in the first
sentence of paragraph (b)(3), by removing the language "§1.451-3"
and adding "§1.460-4" in its place.
Par. 5. Section 1.460-0 is amended by:
1. Revising the introductory text.
2. Revising the entries for §§1.460-1 through 1.460-3,
1.460-4(a)-(i), and 1.460-5.
3. Revising the entry for §1.460-6(c)(4)(iv).
4. Removing the entries for §§1.460-7 and 1.460-8.
The revisions read as follows:
§1.460-0 Outline of regulations under section 460.
This section lists the paragraphs contained in §1.460-1 through
§1.460-6.
§1.460-1 Long-term contracts.
(a) Overview.
(1) In general.
(2) Exceptions to required use of PCM.
(i) Exempt construction contract.
(ii) Qualified ship or residential construction contract.
(b) Definitions.
(1) Long-term contract.
(2) Contract for the manufacture, building, installation, or
construction of property.
(i) In general.
(ii) De minimis construction activities.
(3) Allocable contract costs.
(4) Related party.
(5) Contracting year.
(6) Completion year.
(7) Contract commencement date.
(8) Incurred.
(c) Entering into and completing long-term contracts.
(1) In general.
(2) Date contract entered into.
(i) In general.
(ii) Options and change orders.
(3) Date contract completed.
(i) In general.
(ii) Secondary items.
(iii) Subcontracts.
(iv) Final completion and acceptance.
(A) In general.
(B) Contingent compensation.
(C) Assembly or installation.
(D) Disputes.
(d) Allocation among activities.
(1) In general.
(2) Non-long-term contract activity.
(e) Severing and aggregating contracts.
(1) In general.
(2) Facts and circumstances.
(i) Independent pricing.
(ii) Interdependent pricing.
(iii) Separate delivery or acceptance.
(iv) Reasonable businessperson.
(3) Exceptions.
(i) No severance for PCM.
(ii) Options and change orders.
(4) Statement with return.
(f) Classifying contracts.
(1) In general.
(2) Hybrid contracts.
(3) Method of accounting.
(4) Use of estimates.
(i) Estimating length of contract.
(ii) Estimating allocable contract costs.
(g) Special rules for activities benefitting long-term contracts of
a related party.
(1) Related party use of PCM.
(i) In general.
(ii) Inventory exception.
(2) Total contract price.
(3) Completion factor.
(h) Effective date.
(1) In general.
(2) Change in method of accounting.
(i) [Reserved] (j) Examples.
§1.460-2 Long-term manufacturing contracts.
(a) In general.
(b) Unique.
(1) In general.
(2) Safe harbors.
(i) Short production period.
(ii) Customized item.
(iii) Inventoried item.
(c) Normal time to complete.
(1) In general.
(2) Production by related parties.
(d) Qualified ship contracts.
(e) Examples. §1.460-3 Long-term construction contracts.
(a) In general.
(b) Exempt construction contracts.
(1) In general.
(2) Home construction contract.
(i) In general.
(ii) Townhouses and rowhouses.
(iii) Common improvements.
(iv) Mixed use costs.
(3) $10,000,000 gross receipts test.
(i) In general.
(ii) Single employer.
(iii) Attribution of gross receipts.
(c) Residential construction contracts.
§1.460-4 Methods of accounting for long-term contracts.
(a) Overview.
(b) Percentage-of-completion method.
(1) In general.
(2) Computations.
(3) Post-completion-year income.
(4) Total contract price.
(i) In general.
(A) Definition.
(B) Contingent compensation.
(C) Non-long-term contract activities.
(ii) Estimating total contract price.
(5) Completion factor.
(i) Allocable contract costs.
(ii) Cumulative allocable contract costs incurred.
(iii) Estimating total allocable contract costs.
(iv) Pre-contracting-year costs.
(v) Post-completion-year costs.
(6) 10-percent method.
(i) In general.
(ii) Election.
(c) Exempt contract methods.
(1) In general.
(2) Exempt-contract percentage-of-completion method.
(i) In general.
(ii) Determination of work performed.
(d) Completed-contract method.
(1) In general.
(2) Post-completion-year income and costs.
(3) Gross contract price.
(4) Contracts with disputed claims.
(i) In general.
(ii) Taxpayer assured of profit or loss.
(iii) Taxpayer unable to determine profit or loss.
(iv) Dispute resolved.
(e) Percentage-of-completion/capitalized-cost method.
(f) Alternative minimum taxable income.
(1) In general.
(2) Election to use regular completion factors.
(g) Method of accounting.
(h) Examples.
(i) Mid-contract change in taxpayer. [Reserved]
* * * * *
§1.460-5 Cost allocation rules.
(a) Overview.
(b) Cost allocation method for contracts subject to PCM.
(1) In general.
(2) Special rules.
(i) Direct material costs.
(ii) Components and subassemblies.
(iii) Simplified production methods.
(iv) Costs identified under cost-plus long-term contracts and
federal long-term contracts.
(v) Interest.
(A) In general.
(B) Production period.
(C) Application of section 263A(f).
(vi) Research and experimental expenses.
(vii) Service costs.
(A) Simplified service cost method.
(1) In general.
(2) Example.
(B) Jobsite costs.
(C) Limitation on other reasonable cost allocation methods.
(c) Simplified cost-to-cost method.
(1) In general.
(2) Election.
(d) Cost allocation rules for exempt construction contracts reported
using CCM.
(1) In general.
(2) Indirect costs.
(i) Indirect costs allocable to exempt construction contracts.
(ii) Indirect costs not allocable to exempt construction contracts.
(3) Large homebuilders.
(e) Cost allocation rules for contracts subject to the PCCM.
(f) Special rules applicable to costs allocated under this section.
(1) Nondeductible costs.
(2) Costs incurred for non-long-term contract activities.
(g) Method of accounting.
§1.460-6 Look-back method.
* * * * *
(c) * * *
(4) * * *
(iv) Additional interest due on look-back interest only after tax
liability due.
* * * * *
Par. 6. Sections 1.460-1 through 1.460-3 are revised to read as
follows:
§1.460-1 Long-term contracts.
(a) Overview--(1) In general. This section provides rules for
determining whether a contract for the manufacture, building,
installation, or construction of property is a long-term contract
under section 460 and what activities must be accounted for as a
single long-term contract. Specific rules for long-term
manufacturing and construction contracts are provided in §§1.460- 2
and 3, respectively. A taxpayer generally must determine the income
from a long-term contract using the percentage-of-completion method
described in §1.460-4(b) (PCM) and the cost allocation rules
described in §1.460-5(b) or (c). In addition, after a contract
subject to the PCM is completed, a taxpayer generally must apply the
look-back method described in §1.460-6 to determine the amount of
interest owed on any hypothetical underpayment of tax, or earned on
any hypothetical overpayment of tax, attributable to accounting for
the long-term contract under the PCM.
(2) Exceptions to required use of PCM--(i) Exempt construction
contract. The requirement to use the PCM does not apply to any
exempt construction contract described in §1.460- 3(b). Thus, a
taxpayer may determine the income from an exempt construction
contract using any accounting method permitted by §1.460-4(c) and,
for contracts accounted for using the completed-contract method
(CCM), any cost allocation method permitted by §1.460-5(d).
(ii) Qualified ship or residential construction contract.
The requirement to use the PCM applies only to a portion of a
qualified ship contract described in §1.460-2(d) or residential
construction contract described in §1.460-3(c). A taxpayer generally
may determine the income from a qualified ship contract or
residential construction contract using the percentage-of-
completion/ capitalized-cost method (PCCM) described in §1.460-
4(e), but must use a cost allocation method described in §1.460-
5(b) for the entire contract.
(b) Definitions--(1) Long-term contract. A long-term contract
generally is any contract for the manufacture, building,
installation, or construction of property if the contract is not
completed within the contracting year, as defined in paragraph (b)
(5) of this section. However, a contract for the manufacture of
property is a long-term contract only if it also satisfies either
the unique item or 12-month requirements described in §1.460-2. A
contract for the manufacture of personal property is a manufacturing
contract. In contrast, a contract for the building, installation, or
construction of real property is a construction contract.
(2) Contract for the manufacture, building, installation, or
construction of property--(i) In general. A contract is a contract
for the manufacture, building, installation, or construction of
property if the manufacture, building, installation, or construction
of the subject matter of the contract is necessary for the
taxpayer's contractual obligations to be fulfilled and if the
manufacture, building, installation, or construction has not been
completed when the parties enter into the contract. Whether the
customer has title to, or control over, the property (or bears the
risk of loss from the property) is not relevant. Furthermore, how
the parties characterize their agreement (e.g., as a contract for
the sale of property) is not relevant.
(ii) De minimis construction activities. Notwithstanding paragraph
(b)(2)(i) of this section, a contract is not a construction contract
for purposes of section 460 if the contract includes the provision
of land by the taxpayer and the estimated total allocable contract
costs, as defined in paragraph (b)(3) of this section, attributable
to the taxpayer's construction activities are less than 10 percent
of the contract's total contract price, as defined in §1.460-4(b)(4)
(i). For this purpose, a contract's estimated total allocable
contract costs include a proportionate share of the estimated cost
of any common improvement that benefits the subject matter of the
contract if the taxpayer is contractually obligated, or required by
law, to construct the common improvement.
(3) Allocable contract costs. Allocable contract costs are costs
that are allocable to a long-term contract under §1.460-5.
(4) Related party. A related party is a person whose relationship to
a taxpayer is described in section 707(b) or 267(b), determined
without regard to section 267(f)(1)(A) and determined by
substituting "at least 80 percent" for "more than 50 percent" with
regard to the ownership of the stock of a corporation in sections
267(b)(2), (8), (10)(A), and (12).
(5) Contracting year. The contracting year is the taxable year in
which a taxpayer enters into a contract as described in paragraph
(c)(2) of this section.
(6) Completion year. The completion year is the taxable year in
which a taxpayer completes a contract as described in paragraph (c)
(3) of this section.
(7) Contract commencement date. The contract commencement date is
the date that a taxpayer or related party first incurs any allocable
contract costs, such as design and engineering costs, other than
expenses attributable to bidding and negotiating activities.
Generally, the contract commencement date is relevant in applying
§1.460-6(b)(3) (concerning the de minimis exception to the look-back
method under section 460(b)(3)(B)); §1.460-5(b)(2)(v)(B)(1)(i)
(concerning the production period subject to interest allocation);
§1.460-2(d) (concerning qualified ship contracts); and §1.460-3(b)
(1)(ii) (concerning the construction period for exempt construction
contracts).
(8) Incurred. Incurred has the meaning given in §1.461- 1(a)(2)
(concerning the taxable year of deduction under the accrual method
of accounting), regardless of a taxpayer's overall method of
accounting. See §1.461-4(d)(2)(ii) for economic performance rules
concerning the PCM.
(c) Entering into and completing long-term contracts--(1) In
general. To determine when a contract is entered into under
paragraph (c)(2) of this section, and when a contract is completed
under paragraph (c)(3) of this section, a taxpayer must consider all
relevant activities performed by itself, by related parties, and by
the customer, that are incident to or necessary for the long-term
contract. In addition, to determine whether a contract is completed
in the contracting year, the taxpayer may not consider when it
expects to complete the contract.
(2) Date contract entered into--(i) In general. A taxpayer enters
into a contract on the date that the contract binds both the
taxpayer and the customer under applicable law, even if the contract
is subject to unsatisfied conditions not within the taxpayer's
control (such as obtaining financing). If a taxpayer delays entering
into a contract for a principal purpose of avoiding section 460,
however, the taxpayer will be treated as having entered into a
contract not later than the contract commencement date.
(ii) Options and change orders. A taxpayer enters into a new
contract on the date that the customer exercises an option or
similar provision in a contract if that option or similar provision
must be severed from the contract under paragraph (e) of this
section. Similarly, a taxpayer enters into a new contract on the
date that it accepts a change order or other similar agreement if
the change order or other similar agreement must be severed from the
contract under paragraph (e) of this section.
(3) Date contract completed--(i) In general. A taxpayer's contract
is completed upon the earlier of B
(A) Use of the subject matter of the contract by the customer (other
than for testing) and at least 95 percent of the total allocable
contract costs attributable to the subject matter have been incurred
by the taxpayer; or
(B) Final completion and acceptance of the subject matter of the
contract.
(ii) Secondary items. The date a contract accounted for using the
CCM is completed is determined without regard to whether one or more
secondary items have been used or finally completed and accepted. If
any secondary items are incomplete at the end of the taxable year in
which the primary subject matter of a contract is completed, the
taxpayer must separate the portion of the gross contract price and
the allocable contract costs attributable to the incomplete
secondary item(s) from the completed contract and account for them
using a permissible method of accounting. A permissible method of
accounting includes a long-term contract method of accounting only
if a separate contract for the secondary item(s) would be a long-
term contract, as defined in paragraph (b)(1) of this section.
(iii) Subcontracts. In the case of a subcontract, the subject matter
of the subcontract is the relevant subject matter under paragraph
(c)(3)(i) of this section.
(iv) Final completion and acceptance--(A) In general.
Except as otherwise provided in this paragraph (c)(3)(iv), to
determine whether final completion and acceptance of the subject
matter of a contract have occurred, a taxpayer must consider all
relevant facts and circumstances. Nevertheless, a taxpayer may not
delay the completion of a contract for the principal purpose of
deferring federal income tax.
(B) Contingent compensation. Final completion and acceptance is
determined without regard to any contractual term that provides for
additional compensation that is contingent on the successful
performance of the subject matter of the contract.
A taxpayer must account for all contingent compensation that is not
includible in total contract price under §1.460-4(b)(4)(i), or in
gross contract price under §1.460-4(d)(3), using a permissible
method of accounting. For application of the look-back method for
contracts accounted for using the PCM, see §1.460-6(c)(1)(ii) and
(2)(vi).
(C) Assembly or installation. Final completion and acceptance is
determined without regard to whether the taxpayer has an obligation
to assist or supervise assembly or installation of the subject
matter of the contract where the assembly or installation is not
performed by the taxpayer or a related party.
A taxpayer must account for the gross receipts and costs
attributable to such an obligation using a permissible method of
accounting, other than a long-term contract method.
(D) Disputes. Final completion and acceptance is determined without
regard to whether a dispute exists at the time the taxpayer tenders
the subject matter of the contract to the customer. For contracts
accounted for using the CCM, see §1.460- 4(d)(4). For application of
the look-back method for contracts accounted for using the PCM, see
§1.460-6(c)(1)(ii) and (2)(vi).
(d) Allocation among activities--(1) In general. Long-term contract
methods of accounting (the PCM, the CCM, the PCCM, and the exempt-
contract percentage-of-completion method (EPCM)) apply only to the
gross receipts and costs attributable to long-term contract
activities. Gross receipts and costs attributable to long-term
contract activities means amounts included in total contract price
or gross contract price, whichever is applicable, as determined
under §1.460-4, and costs allocable to the contract, as determined
under §1.460-5. Gross receipts and costs attributable to non-long-
term contract activities (as defined in paragraph (d)(2) of this
section) generally must be taken into account using permissible
methods of accounting other than a long-term contract method. See
section 446(c) and §1.446-1(c).
However, if the performance of a non-long-term contract activity is
incident to or necessary for the manufacture, building,
installation, or construction of the subject matter of one or more
of the taxpayer's long-term contracts, the gross receipts and costs
attributable to that activity must be allocated to the long-term
contract(s) benefitted as provided in §§1.460- 4(b)(4)(i) and
1.460-5(f)(2), respectively. Similarly, if a single long-term
contract requires a taxpayer to perform a non-long- term contract
activity that is not incident to or necessary for the manufacture,
building, installation, or construction of the subject matter of the
long-term contract, the gross receipts and costs attributable to
that non-long-term contract activity must be separated from the
contract and accounted for using a permissible method of accounting
other than a long-term contract method. But see paragraph (g) of
this section for related party rules.
(2) Non-long-term contract activity. Non-long-term contract activity
means the performance of an activity other than manufacturing,
building, installation, or construction, such as the provision of
architectural, design, engineering, and construction management
services; the performance under a guarantee, warranty, and
maintenance agreement; and the development of software.
(e) Severing and aggregating contracts--(1) In general.
After application of the allocation rules of paragraph (d) of this
section, the severing and aggregating rules of this paragraph (e)
may be applied by the Commissioner or the taxpayer as necessary to
clearly reflect income (such as, to prevent the unreasonable
deferral of recognition of income or the premature recognition of
loss). Under the severing and aggregating rules, one agreement may
be treated as two or more contracts, and two or more agreements may
be treated as one contract. Except as provided in paragraph (e)(3)
(ii) of this section, a taxpayer must determine whether to sever an
agreement or to aggregate two or more agreements based on all the
facts and circumstances known at the end of the contracting year.
(2) Facts and circumstances. Whether an agreement should be severed,
or two or more agreements should be aggregated, depends on the
following factors:
(i) Independent pricing. Independent pricing of items in an
agreement is necessary for the agreement to be severed into two or
more contracts. In the case of an agreement for several similar
items, if the price to be paid for the items is determined under
different terms or formulas (for example, if some items are priced
under a cost-plus incentive fee arrangement and later items are to
be priced under a fixed-price arrangement), then the difference in
the pricing terms or formulas indicates that the items are
independently priced.
(ii) Interdependent pricing. Interdependent pricing of items in
separate agreements is necessary for two or more agreements to be
aggregated into one contract. A single price negotiation for similar
items ordered under one or more agreements indicates that the items
are interdependently priced.
(iii) Separate delivery or acceptance. An agreement may not be
severed into two or more contracts unless it provides for separate
delivery or separate acceptance of items that are the subject matter
of the agreement. However, the separate delivery or separate
acceptance of items by itself does not necessarily require an
agreement to be severed.
(iv) Reasonable businessperson. Two or more agreements to perform
manufacturing or construction activities may not be aggregated into
one contract unless a reasonable businessperson would not have
entered into one of the agreements for the terms agreed upon without
also entering into the other agreement(s).
Similarly, an agreement to perform manufacturing or construction
activities may not be severed into two or more contracts if a
reasonable businessperson would not have entered into separate
agreements containing terms allocable to each severed contract.
For example, a single agreement to manufacture a prototype of an
item, which would result in a substantial loss, and ten additional
units of the item, which would result in a substantial gain, may not
be severed into one contract for the prototype and another contract
for the ten additional units under this paragraph (e)(2)(iv) because
a reasonable businessperson would not have entered into a separate
contract to manufacture the prototype. For purposes of this
paragraph (e)(2)(iv), a taxpayer's expectation that the parties
would enter into another agreement, when agreeing to the terms
contained in the first agreement, is irrelevant.
(3) Exceptions--(i) No severance for PCM. A taxpayer may not sever
under this paragraph (e) a long-term contract that would be
accounted for using the PCM.
(ii) Options and change orders. Except as provided in paragraph (e)
(3)(i) of this section, a taxpayer must sever an agreement that
increases the number of units to be supplied to the customer, such
as through the exercise of an option or the acceptance of a change
order, if the agreement provides for separate delivery or separate
acceptance of the additional units.
(4) Statement with return. If a taxpayer severs an agreement or
aggregates two or more agreements under this paragraph (e) during
the taxable year, the taxpayer must attach a statement to its
original Federal income tax return for that year. This statement
must contain the following information B
(i) The legend NOTIFICATION OF SEVERANCE OR AGGREGATION UNDER SEC.
1.460-1(e);
(ii) The taxpayer's name;
(iii) The taxpayer's employer identification number or social
security number;
(iv) The identity of each agreement being severed or aggregated;
(v) The method of accounting used for each contract; and
(vi) A description of the reason(s) for severance or aggregation.
(f) Classifying contracts--(1) In general. A taxpayer must determine
the classification of a contract (e.g., as a long-term manufacturing
contract, long-term construction contract, non-long- term contract)
based on all the facts and circumstances known no later than the end
of the contracting year.
(2) Hybrid contracts. A long-term contract that requires a taxpayer
to perform both manufacturing and construction activities (hybrid
contract) generally must be classified as two contracts, a
manufacturing contract and a construction contract.
However, a hybrid contract may be classified as a manufacturing (or
construction) contract if at least 95 percent of the estimated total
allocable contract costs are reasonably allocable to the
manufacturing (or construction) activities.
(3) Method of accounting. A taxpayer's method of classifying
contracts is a method of accounting under section 446 and, thus, may
not be changed without the Commissioner's consent.
If a taxpayer's method of classifying contracts is unreasonable,
that classification method is an impermissible accounting method.
(4) Use of estimates--(i) Estimating length of contract. A taxpayer
must use a reasonable estimate of the time required to complete a
contract when necessary to classify the contract (e.g., to determine
whether the five-year completion rule for qualified ship contracts
under §1.460-2(d), or the two-year completion rule for exempt
construction contracts under §1.460- 3(b), is satisfied; but, not to
determine whether a contract is completed within the contracting
year under paragraph (b)(1) of this section). To be considered
reasonable, an estimate of the time required to complete the
contract must include anticipated time for delay, rework, change
orders, technology or design problems, or other problems that
reasonably can be anticipated considering the nature of the contract
and prior experience. A contract term that specifies an expected
completion or delivery date may be considered evidence that the
taxpayer reasonably expects to complete or deliver the subject
matter of the contract on or about the date specified, especially if
the contract provides bona fide penalties for failing to meet the
specified date. If a taxpayer classifies a contract based on a
reasonable estimate of completion time, the contract will not be
reclassified based on the actual (or another reasonable estimate of)
completion time. A taxpayer's estimate of completion time will not
be considered unreasonable if a contract is not completed within the
estimated time primarily because of unforeseeable factors not within
the taxpayer's control, such as third-party litigation, extreme
weather conditions, strikes, or delays in securing permits or
licenses.
(ii) Estimating allocable contract costs. A taxpayer must use a
reasonable estimate of total allocable contract costs when necessary
to classify the contract (e.g., to determine whether a contract is a
home construction contract under §1.460-(3)(b)(2)).
If a taxpayer classifies a contract based on a reasonable estimate
of total allocable contract costs, the contract will not be
reclassified based on the actual (or another reasonable estimate of)
total allocable contract costs.
(g) Special rules for activities benefitting long-term contracts of
a related party--(1) Related party use of PCM--(i) In general.
Except as provided in paragraph (g)(1)(ii) of this section, if a
related party and its customer enter into a long-term contract
subject to the PCM, and a taxpayer performs any activity that is
incident to or necessary for the related party's long-term contract,
the taxpayer must account for the gross receipts and costs
attributable to such activity using the PCM, even if this activity
is not otherwise subject to section 460(a).
This type of activity may include, for example, the performance of
engineering and design services, and the production of components
and subassemblies that are reasonably expected to be used in the
production of the subject matter of the related party's contract.
(ii) Inventory exception. A taxpayer is not required to use the PCM
under this paragraph (g) to account for components and subassemblies
if the taxpayer regularly carries these items in its finished goods
inventories and 80 percent or more of the gross receipts from the
sale of these items typically comes from unrelated parties.
(2) Total contract price. If a taxpayer is required to use the PCM
under paragraph (g)(1)(i) of this section, the total contract price
(as defined in §1.460-4(b)(4)(i)) is the fair market value of the
taxpayer's activity that is incident to or necessary for the
performance of the related party's long-term contract. The related
party also must use the fair market value of the taxpayer's activity
as the cost it incurs for the activity. The fair market value of the
taxpayer's activity may or may not be the same as the amount the
related party pays the taxpayer for that activity.
(3) Completion factor. To compute a contract's completion factor (as
described in §1.460-4(b)(5)), the related party must take into
account the fair market value of the taxpayer's activity that is
incident to or necessary for the performance of the related party's
long-term contract when the related party incurs the liability to
the taxpayer for the activity, rather than when the taxpayer incurs
the costs to perform the activity.
(h) Effective date--(1) In general. Except as otherwise provided,
this section and §§1.460-2 through 1.460-5 are applicable for
contracts entered into on or after the date these regulations are
published as final regulations in the Federal Register.
(2) Change in method of accounting. Any change in a taxpayer's
method of accounting necessary to comply with this section and
§§1.460-2 through 1.460-5 is a change in method of accounting to
which the provisions of section 446 and the regulations thereunder
apply. For the first taxable year that includes the date these
regulations are published as final regulations in the Federal
Register, a taxpayer is granted the consent of the Commissioner to
change its method of accounting to comply with the provisions of
this section and §§1.460-2 through 1.460-5 for long-term contracts
entered into on or after the date this section and §§1.460-2 through
1.460-5 are published as final regulations in the Federal Register.
A taxpayer that wants to change its method of accounting under this
paragraph (h)(2) must follow the automatic consent procedures in
Rev. Proc. 98-60 (1998-51 I.R.B. 16)(see §601.601(d)(2) of this
chapter), except that the scope limitations in section 4.02 of Rev.
Proc. 98-60 do not apply. Because a change under this paragraph (h)
(2) is made on a cutoff basis, a section 481(a) adjustment is not
required.
Moreover, the taxpayer does not receive audit protection under
section 7 of Rev. Proc. 98-60 in connection with a change under this
paragraph (h)(2). A taxpayer that wants to change its exempt-
contract method of accounting is not granted the consent of the
Commissioner under this paragraph (h)(2) and must file a Form 3115,
Application for Change in Accounting Method, to obtain consent. See
Rev. Proc. 97-27 (1997-1 C.B. 680)(see §601.601(d)(2) of this
chapter).
(i) [Reserved]
(j) Examples. The following examples illustrate the rules of this
section:
Example 1. Contract for manufacture of property. B notifies C, an
aircraft manufacturer, that it wants to purchase an aircraft of a
particular type. At the time C receives the order, C has on hand
several partially completed aircraft of this type; however, C does
not have any completed aircraft of this type on hand. C and B agree
that B will purchase one of these aircraft after it has been
completed. C retains title to and risk of loss with respect to the
aircraft until the sale takes place. The agreement between C and B
is a contract for the manufacture of property under paragraph (b)(2)
(i) of this section, even if labeled as a contract for the sale of
property, because the manufacture of the aircraft is necessary for
C's obligations under the agreement to be fulfilled and the
manufacturing was not complete when B and C entered into the
agreement.
Example 2. De minimis construction activity. C, a master developer
that uses a calendar taxable year, owns 5,000 acres of undeveloped
land worth $50,000,000. To obtain permission from the local county
government to improve this land, a service road must be constructed
on this land to benefit all 5,000 acres. In 2001, C enters into a
contract to sell a 1,000-acre parcel of undeveloped land to B, a
residential developer, for its fair market value, $10,000,000. In
this contract, C agrees to construct a service road running through
the land that C is selling to B and through the 4,000 adjacent acres
of undeveloped land that C has sold to several other residential
developers for its fair market value, $40,000,000. C reasonably
estimates that it will incur a liability of $50,000 to construct
this service road, which will be owned and maintained by the county.
C must reasonably allocate the cost of the service road among the
benefitted parcels. The portion of the estimated total allocable
contract costs that C allocates to the 1,000 acre parcel being sold
to B (based upon its fair market value) is $10,000 ($50,000 x
($10,000,000/$50,000,000)). Construction of the service road is
finished in 2002. Because the estimated total allocable contract
costs attributable to C's construction activities, $10,000, are less
than 10 percent of the contract's total contract price, $10,000,000,
C's contract with B is not a construction contract under paragraph
(b)(2)(ii) of this section.
Thus, C's contract with B is not a long-term contract under
paragraph (b)(2)(i) of this section, notwithstanding that
construction of the service road is not completed in 2001.
Example 3. Completion--customer use. In 2002, C, a calendar year
taxpayer, enters into a contract to construct a building for B. In
November of 2003, the building is completed in every respect
necessary for its intended use, and B occupies the building. In
early December of 2003, B notifies C of some minor deficiencies that
need to be corrected, and C agrees to correct them in January 2004.
C reasonably estimates that the cost of correcting these
deficiencies will be less than five percent of the total allocable
contract costs. C's contract is complete under paragraph (c)(3)(i)
(A) of this section in 2003 because in that year, B used the
building and C had incurred at least 95 percent of the total
allocable contract costs attributable to the building. C must use a
permissible method of accounting for any deficiency-related costs
incurred after 2003.
Example 4. Completion--customer use. In 1999, C, whose taxable year
ends December 31, agrees to construct a shopping center, which
includes an adjoining parking lot, for B. By October 2000, C has
finished constructing the retail portion of the shopping center. By
December 2000, C has graded the entire parking lot, but has paved
only one-fourth of it because inclement weather conditions prevented
C from laying asphalt on the remaining three-fourths. In December
2000, B opens the retail portion of the shopping center and the
paved portion of the parking lot to the general public. C reasonably
estimates that the cost of paving the remaining three-fourths of the
parking lot when whether permits will exceed 5 percent of C's total
allocable contract costs. Even though B is using the subject matter
of the contract, C's contract is not completed in December 2000
under paragraph (c)(3)(i)(A) of this section because C has not
incurred at least 95 percent of the total allocable contract costs
attributable to the subject matter.
Example 5. Non-long-term contract activity. On January 1, 1999, C,
whose taxable year ends December 31, enters into a single long-term
contract to design and manufacture a satellite and to develop
computer software enabling B to operate the satellite. At the end of
1999, C has not finished manufacturing the satellite. Designing the
satellite and developing the computer software are non-long-term
contract activities that are incident to and necessary for the
taxpayer's manufacturing of the subject matter of a long-term
contract because the satellite could not be manufactured without the
design and would not operate without the software. Thus, under
paragraph (d)(1) of this section, C must allocate these non-long-
term contract activities to the long-term contract and account for
the gross receipts and costs attributable to designing the satellite
and developing computer software using the PCM.
Example 6. Non-long-term contract activity. C agrees to manufacture
equipment for B under a long-term contract. In a separate contract,
C agrees to design the equipment being manufactured for B under the
long-term contract. Under paragraph (d)(1) of this section, C must
allocate the gross receipts and costs related to the design to the
long-term contract because designing the equipment is a non-long-
term contract activity that is incident to and necessary for the
manufacture of the subject matter of the long-term contract.
Example 7. Severance. On January 1, 1999, C, a construction
contractor, and B, a real estate investor, enter into an agreement
requiring C to build two office buildings in different areas of a
large city. The agreement provides that the two office buildings
will be completed by C and accepted by B in 1999 and 2000,
respectively, and that C will be paid $1,000,000 and $1,500,000 for
the two office buildings, respectively. The agreement will provide C
with a reasonable profit from the construction of each building.
Unless C is required to use the PCM to account for the contract, the
taxpayer is required to sever this contract under paragraph (e)(2)
of this section because the buildings are independently priced, the
agreement provides for separate delivery and acceptance of the
buildings, and, as each building will generate a reasonable profit,
a reasonable businessperson would have entered into separate
agreements for the terms agreed upon for each building.
Example 8. Severance. C, a large construction contractor with a
calendar taxable year, accounts for its construction contracts using
the PCM and has elected to use the 10-percent method described in
§1.460-4(b)(6). In September 1999, C enters into an agreement to
construct 4 buildings in 4 different cities.
The buildings are independently priced and the contract provides a
reasonable profit for each of the buildings. In addition, the
agreement requires C to deliver one building per year in 2000, 2001,
2002, and 2003. As of December 31, 1999, C has incurred 25 percent
of the estimated total allocable contract costs attributable to one
of the buildings, but only 5 percent of the estimated total
allocable contract costs attributable to all 4 buildings included in
the agreement. Under paragraph (e)(3)(i) of this section, C may not
sever this contract because it is accounted for using the PCM. Using
the 10-percent method, C does not take into account any portion of
the total contract price or any incurred allocable contract costs
attributable to this agreement in 1999. Upon examination of C's 1999
tax return, the Commissioner determines that C entered into one
agreement for 4 buildings rather than 4 separate agreements each for
one building solely to take advantage of the deferral obtained under
the 10- percent method. Consequently, in order to clearly reflect
the taxpayer's income, the Commissioner may require C to sever the
agreement into 4 separate contracts under paragraph (e)(2) of this
section because the buildings are independently priced, the
agreement provides for separate delivery and acceptance of the
buildings, and a reasonable businessperson would have entered into
separate agreements for these buildings.
Example 9. Aggregation. In 1999, C, a shipbuilder, enters into two
agreements with the Department of the Navy as the result of a single
negotiation. Each agreement obligates C to manufacture a submarine.
Because the submarines are of the same class, their specifications
are similar. Because C has never manufactured submarines of this
class, however, C anticipates that it will incur substantially
higher costs to manufacture the first submarine, to be delivered in
2005, than to manufacture the second submarine, to be delivered in
2008. If the agreements are treated as separate contracts, the first
contract probably will produce a substantial loss, while the second
contract probably will produce substantial profit. Based upon these
facts, aggregation is required under paragraph (e)(2) of this
section because the submarines are interdependently priced and a
reasonable businessperson would not have entered the first agreement
without also entering into the second.
Example 10. Aggregation. In 1999, C, a manufacturer of aircraft and
related equipment, agrees to manufacture 10 military aircraft for
foreign government B and to deliver the aircraft by the end of 2001.
When entering into the agreement, C anticipates that it might
receive production orders from B over the next 20 years for as many
as 300 more of these aircraft. The negotiated contract price
reflects C's and B's consideration of the expected total cost of
manufacturing the 10 aircraft, the risks and opportunities
associated with the agreement, and the additional factors the
parties considered relevant. The negotiated price provides a profit
on the sale of the 10 aircraft even if C does not expect to receive
any additional production orders from B.
It is unlikely, however, that C actually would have wanted to
manufacture the 10 aircraft but for the expectation that it would
receive additional production orders from B. In 2001, B accepts
delivery of the 10 aircraft. At that time, B orders an additional 20
aircraft of the same type for delivery in 2005.
When negotiating the price for the additional 20 aircraft, C and B
consider the fact that the expected unit cost for this production
run of 20 aircraft will be lower than the unit cost of the 10
aircraft completed and accepted in 2001, but substantially higher
than the expected unit cost of future production rU.S. Based upon
these facts, aggregation is not permitted under paragraph (e)(2) of
this section. Because the parties negotiated the prices of both
agreements considering only the expected production costs and risks
for each agreement standing alone, the terms and conditions agreed
upon for the first agreement are independent of the terms and
conditions agreed upon for the second agreement. The fact that the
agreement to manufacture 10 aircraft provides a profit for C
indicates that a reasonable businessperson would have entered into
that agreement without entering into the agreement to manufacture
the additional 20 aircraft.
Example 11. Classification and completion. In 1999, C agrees to
manufacture and install an industrial machine for B.
The agreement requires C to deliver the machine in August 2001 and
to install and test the machine in B's factory. At least 95 percent
of the estimated total allocable contract costs are reasonably
allocable to C's manufacturing activities. In addition, the
agreement requires B to accept the machine when the tests prove that
the machine's performance will satisfy the environmental standards
set by the Environmental Protection Agency (EPA), even if B has not
obtained the required operating permit. Because of technical
difficulties, C cannot deliver the machine until December 2001, when
B conditionally accepts delivery. C classifies the agreement as a
manufacturing contract under paragraph (f) of this section because
95 percent of the total allocable contract costs are attributable to
C's manufacturing activities. C, whose taxable year ends December
31, installs the machine in December 2001 and then tests it through
February 2002. B accepts the machine in February 2002, but does not
obtain the operating permit from the EPA until January 2003. Under
paragraph (c)(3)(i)(B) of this section, C's contract is finally
completed and accepted in February 2002, even though B does not
obtain the operating permit until January 2003, because C completed
all its obligations under the contract and B accepted the machine in
2002.
§1.460-2 Long-term manufacturing contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term manufacturing contract using
the percentage-of-completion method described in §1.460- 4(b) (PCM).
A contract not completed in the contracting year is a long-term
manufacturing contract if it involves the manufacture of personal
property that is B
(1) A unique item of a type that is not normally carried in the
finished goods inventory of the taxpayer; or
(2) An item that normally requires more than 12 calendar months to
complete (regardless of the duration of the contract or the time to
complete a deliverable quantity of the item).
(b) Unique--(1) In general. Unique means designed for the needs of a
specific customer. A contract may require the taxpayer to
manufacture more than one unit of a unique item. To determine
whether an item is designed for the needs of a specific customer, a
taxpayer must consider the extent to which research, development,
design, engineering, retooling, and similar activities are required
to produce the item. In addition, a taxpayer must consider whether
the same item could be sold to other customers (with or without
minor modifications).
(2) Safe harbors. Notwithstanding paragraph (b)(1) of this section,
an item is not unique if it satisfies one or more of the following
safe harbors--
(i) Short production period. An item is not unique if it normally
requires 90 days or less to complete the item;
(ii) Customized item. An item is not unique if the total allocable
contract costs attributable to customizing (such as research,
development, design, engineering, retooling, and similar activities)
that are incident to or necessary for the production of the item
does not exceed 5 percent of the estimated total allocable contract
costs allocable to the item; or
(iii) Inventoried item. A unique item ceases to be unique no later
than when the taxpayer normally carries similar items in its
finished goods inventory.
(c) Normal time to complete--(1) In general. The amount of time
normally required to complete an item is the item's reasonably
expected production period, as described in §1.263A-12, determined
at the end of the contracting year. Thus, the expected production
period for an item generally would begin when a taxpayer incurs at
least five percent of the costs allocable to the item and end when
the item is ready to be held for sale and all reasonably expected
production activities are complete. In the case of components that
are assembled or reassembled into an item or unit at the customer's
facility by the taxpayer's employees or agents, the production
period ends when the components are assembled or reassembled into an
operable item or unit. To the extent that several distinct
activities related to the production of the item are expected to
occur simultaneously, the period during which these distinct
activities occur is not counted more than once.
(2) Production by related parties. To determine the time normally
required to complete an item, a taxpayer must consider all relevant
production activities performed by itself and by related parties, as
defined in §1.460-1(b)(4). For example, if a taxpayer's item
requires a component or subassembly manufactured by a related party,
the taxpayer must consider the time the related party takes to
complete the component or subassembly and, for purposes of
determining the beginning of an item's production period, the costs
incurred by the related party that are allocable to the component or
subassembly. However, if both requirements of the inventory
exception under §1.460-1(g)(1)(ii) are satisfied, a taxpayer does
not consider the activities performed or the costs incurred by a
related party when determining the normal time to complete an item.
(d) Qualified ship contracts. A taxpayer may determine the income
from a long-term manufacturing contract that is a qualified ship
contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in
§1.460-4(e). A qualified ship contract is any contract entered into
after February 28, 1986, to manufacture in the United States not
more than 5 seagoing vessels if the vessels will not be manufactured
directly or indirectly for the United States Government and if the
taxpayer reasonably expects to complete the contract within 5 years
of the contract commencement date. Under §1.460-1(e)(3)(i), a
contract to produce more than 5 vessels for which the PCM would be
required cannot be severed in order to be classified as a qualified
ship contract.
(e) Examples. The following examples illustrate the rules of this
section:
Example 1. Unique item and classification. In December 1999, C
enters into a contract with B to design and manufacture a new type
of industrial equipment. C reasonably expects the normal production
period for this type of equipment to be 8 months. Because the new
type of industrial equipment requires a substantial amount of
research, design and engineering to produce, C determines that the
equipment is a unique item and its contract with B is a long-term
contract. After delivering the equipment to B in September 2000, C
contracts with B to produce five additional units of industrial
equipment using the same basic design as the previous unit of
industrial equipment but changing certain specifications. These
additional units, which also are expected to take 8 months to
produce, will be delivered to B in 2001. C determines that the
research, design, engineering, retooling and similar customizing
costs necessary to produce the five additional units of equipment
does not exceed 5% of the estimated total allocable contract costs.
Consequently, the additional units of equipment satisfy the safe
harbor in paragraph (b)(2)(ii) of this section and are not unique
items.
Although C's contract with B to produce the five additional units is
not completed within the contracting year, the contract is not a
long-term contract since the additional units of equipment are not
unique items and do not normally require more than 12 months to
produce. C must classify its second contract with B as a non-long
term contract, notwithstanding that it classified the previous
contract with B for a similar item as a long-term contract, because
the determination of whether a contract is a long-term contract is
made on a contract by contract basis. Such a change in
classification is not a change in method of accounting because the
change in classification results from a change in underlying facts.
Example 2. 12-month rule--related party. C manufactures cranes that
it regularly carries in finished goods inventory. C purchases one of
the crane's components from R, a related party under §1.460-1(b)(4).
R does not carry this crane component in finished goods inventory;
therefore, C does not satisfy the inventory exception and must
consider the activities of R as R incurs costs and performs the
activities rather than as C incurs a liability to R. The normal time
period between the time that both C and R incur 5% of the costs
allocable to the crane and the time that R completes the component
is 5 months. C normally requires an additional 8 months to complete
production of the crane after receiving the integral component from
R. C's crane is an item of a type that normally requires more than
12 months to complete under paragraph (c) of this section because
the production period from the time that both C and R incur 5% of
the costs allocable to the crane until the time that production of
the crane is complete is normally 13 months.
Example 3. 12-month rule--duration of contract. The facts are the
same as in Example 2, except that C enters into a sales contract
with B on December 31, 1999 (the last day of C's taxable year), and
delivers a completed crane to B on February 1, 2000.
C's contract with B is a long-term contract under paragraph (a)(2)
of this section because the contract is not completed in the
contracting year, 1999, and the crane is an item that normally
requires more than 12 calendar months to complete (regardless of the
duration of the contract).
Example 4. 12-month rule--normal time to complete. The facts are the
same as in Example 3, except that C (and R) actually complete B's
crane in only 10 calendar months. The contract is a long-term
contract because the normal time to complete a crane, not the actual
time to complete a crane, is the relevant criterion for determining
whether an item is subject to paragraph (a)(2) of this section.
§1.460-3 Long-term construction contracts.
(a) In general. Section 460 generally requires a taxpayer to
determine the income from a long-term construction contract using
the percentage-of-completion method described in §1.460- 4(b) (PCM).
A contract not completed in the contracting year is a long-term
construction contract if it involves the building, construction,
reconstruction, or rehabilitation of real property; the installation
of an integral component to real property; or the improvement of
real property (collectively referred to as construction). Real
property means land, buildings, and inherently permanent structures,
as defined in §1.263A-8(c)(3), such as roadways, dams, and bridges.
Real property does not include vessels, offshore drilling platforms,
or unsevered natural products of land. An integral component to real
property includes property not produced at the site of the real
property but intended to be permanently affixed to the real
property, such as elevators and central heating and cooling systems.
Thus, for example, a contract to install an elevator in a building
is a construction contract because a building is real property, but
a contract to install an elevator in a ship is not a construction
contract because a ship is not real property.
(b) Exempt construction contracts--(1) In general. The general
requirement to use the PCM and the cost allocation rules described
in §1.460-5(b) or (c) does not apply to any long-term construction
contract described in this paragraph (b) (exempt construction
contract). Exempt construction contract means any B
(i) Home construction contract; and
(ii) Other construction contract that a taxpayer estimates (when
entering into the contract) will be completed within 2 years of the
contract commencement date, provided the taxpayer satisfies the
$10,000,000 gross receipts test described in paragraph (b)(3) of
this section.
(2) Home construction contract--(i) In general. A long-term
construction contract is a home construction contract if a taxpayer
(including a subcontractor working for a general contractor)
reasonably expects to attribute 80 percent or more of the estimated
total allocable contract costs (including the cost of land,
materials, and services), determined as of the close of the
contracting year, to the construction of--
(A) Dwelling units, as defined in section 168(e)(2)(A)(ii)(I),
contained in buildings containing 4 or fewer dwelling units
(including buildings with 4 or fewer dwelling units that also have
commercial units); and
(B) Improvements to real property directly related to, and located
at the site of, the dwelling units.
(ii) Townhouses and rowhouses. Each townhouse or rowhouse is a
separate building.
(iii) Common improvements. A taxpayer includes in the cost of the
dwelling units their allocable share of the cost that the taxpayer
reasonably expects to incur for any common improvements (e.g.,
sewers, roads, clubhouses) that benefit the dwelling units and that
the taxpayer is contractually obligated, or required by law, to
construct within the tract or tracts of land that contain the
dwelling units.
(iv) Mixed use costs. If a contract involves the construction of
both commercial units and dwelling units within the same building, a
taxpayer must allocate the costs among the commercial units and
dwelling units using a reasonable method or combination of
reasonable methods, such as specific identification, square footage,
or fair market value.
(3) $10,000,000 gross receipts test--(i) In general. The $10,000,000
gross receipts test is satisfied if a taxpayer's (or predecessor's)
average annual gross receipts for the 3 taxable years preceding the
contracting year do not exceed $10,000,000, as determined using the
principles of the gross receipts test for small resellers under
§1.263A-3(b), except as otherwise provided in paragraphs (b)(3)(ii)
and (iii) of this section.
(ii) Single employer. To apply the gross receipts test, a taxpayer
is not required to aggregate the gross receipts of persons treated
as a single employer solely under section 414(m) and any regulations
prescribed under section 414.
(iii) Attribution of gross receipts. A taxpayer must aggregate a
proportionate share of the construction-related gross receipts of
any person that has a five percent or greater interest in the
taxpayer. In addition, a taxpayer must aggregate a proportionate
share of the construction-related gross receipts of any person in
which the taxpayer has a five percent or greater interest. For this
purpose, a taxpayer must determine ownership interests as of the
first day of the taxpayer's contracting year and must include
indirect interests in any corporation, partnership, estate, trust,
or sole proprietorship according to principles similar to the
constructive ownership rules under sections 1563(e), (f)(2), and (f)
(3)(A). However, a taxpayer is not required to aggregate under this
paragraph (b)(3)(iii) any construction-related gross receipts
required to be aggregated under paragraph (b)(3)(i) of this section.
(c) Residential construction contracts. A taxpayer may determine the
income from a long-term construction contract that is a residential
construction contract using either the PCM or the percentage-of-
completion/capitalized-cost method (PCCM) of accounting described in
§1.460-4(e). A residential construction contract is a home
construction contract, as defined in paragraph (b)(2) of this
section, except that the building or buildings being constructed
contain more than 4 dwelling units.
Par. 7. Section 1.460-4 is amended by adding paragraphs (a) through
(i) to read as follows:
§1.460-4 Methods of accounting for long-term contracts.
(a) Overview. This section prescribes permissible methods of
accounting for long-term contracts. Paragraph (b) of this section
describes the percentage-of-completion method under section 460(b)
(PCM) that a taxpayer generally must use to determine the income
from a long-term contract. Paragraph (c) of this section lists
permissible methods of accounting for exempt construction contracts
described in §1.460-3(b)(1) and describes the exempt-contract
percentage-of-completion method (EPCM).
Paragraph (d) of this section describes the completed-contract
method (CCM), which is one of the permissible methods of accounting
for exempt construction contracts. Paragraph (e) describes the
percentage-of-completion/capitalized-cost method (PCCM), which is a
permissible method of accounting for qualified ship contracts
described in §1.460-2(d) and residential construction contracts
described in §1.460-3(c). Paragraph (f) of this section provides
rules for determining the alternative minimum taxable income (AMTI)
from long-term contracts that are not exempted under section 56.
Paragraph (g) of this section provides rules concerning consistency
in methods of accounting for long-term contracts. Paragraph (h) of
this section provides examples illustrating the principles of this
section. Finally, paragraph (j) of this section provides rules for
taxpayers that file consolidated tax returns.
(b) Percentage-of-completion method--(1) In general. Under the PCM,
a taxpayer generally must include in income the portion of the total
contract price, as defined in paragraph (b)(4)(i) of this section,
that corresponds to the percentage of the entire contract that the
taxpayer has completed during the taxable year.
The percentage of completion must be determined by comparing
allocable contract costs incurred with estimated total allocable
contract costs. Thus, the taxpayer includes a portion of the total
contract price in gross income as the taxpayer incurs allocable
contract costs.
(2) Computations. To determine the income from a long-term contract,
a taxpayer--
(i) Computes the completion factor for the contract, which is the
ratio of the cumulative allocable contract costs that the taxpayer
has incurred through the end of the taxable year to the estimated
total allocable contract costs that the taxpayer reasonably expects
to incur under the contract;
(ii) Computes the amount of cumulative gross receipts from the
contract by multiplying the completion factor by the total contract
price;
(iii) Computes the amount of current-year gross receipts, which is
the difference between the amount of cumulative gross receipts for
the current taxable year and the amount of cumulative gross receipts
for the immediately preceding taxable year (the difference can be a
positive or negative number); and (iv) Takes both the current-year
gross receipts and the allocable contract costs incurred during the
current year into account in computing taxable income.
(3) Post-completion-year income. If a taxpayer has not included the
total contract price in gross income by the completion year, as
defined in §1.460-1(b)(6), the taxpayer must include the remaining
portion of the total contract price in gross income for the taxable
year following the completion year.
For the treatment of post-completion costs, see paragraph (b)(5)(v)
of this section. See §1.460-6(c)(1)(ii) for application of the look-
back method as a result of adjustments to total contract price.
(4) Total contract price--(i) In general--(A) Definition.
Total contract price means the amount that a taxpayer reasonably
expects to receive under a long-term contract, including holdbacks,
retainages, and cost reimbursements. See §1.460- 6(c)(1)(ii) and (2)
(vi) for application of the look-back method as a result of changes
in total contract price.
(B) Contingent compensation. Any amounts related to contingent
rights or obligations, such as bonuses, awards, incentive payments,
and amounts in dispute, are included in total contract price as soon
as it is reasonably estimated that they will be received, even if
the all events test has not yet been met. For example, if a bonus is
payable to a taxpayer for meeting an early completion date, the
bonus is includible in total contract price at the time (and to the
extent) that the taxpayer can predict the achievement of the
corresponding objective with reasonable certainty. Similarly, a
portion of the contract price that is in dispute is included in
total contract price at the time and to the extent that the taxpayer
can reasonably expect the dispute will be resolved in the taxpayer's
favor (without regard to when the taxpayer receives payment for the
amount in dispute or when the dispute is finally resolved.) If a
taxpayer has not included an amount of contingent compensation in
total contract price under this paragraph (b)(4)(i) by the taxable
year following the completion year, the taxpayer must account for
that amount of contingent compensation using a permissible method of
accounting. If it is determined after the taxable year following the
completion year that an amount included in total contract price will
not be earned, the taxpayer should deduct that amount in the year of
the determination.
(C) Non-long-term contract activities. Total contract price includes
an allocable share of the gross receipts attributable to a non-long-
term contract activity, as defined in §1.460-1(d)(2), if the
activity is incident to or necessary for the manufacture, building,
installation, or construction of the subject matter of the long-term
contract. Total contract price also includes amounts reimbursed for
independent research and development costs, or bidding and proposal
costs, under a federal or cost- plus long-term contract (as defined
in section 460(d)), regardless of whether the research and
development, or bidding and proposal, activities are incident to or
necessary for the performance of that long-term contract.
(ii) Estimating total contract price. A taxpayer must estimate the
total contract price based upon all the facts and circumstances
known as of the last day of the taxable year. For this purpose, an
event that occurs after the end of the taxable year must be taken
into account if its occurrence was reasonably foreseeable and its
income was subject to reasonable estimation as of the last day of
that taxable year.
(5) Completion factor--(i) Allocable contract costs. A taxpayer must
use a cost allocation method permitted under either §1.460-5(b) or
(c) to determine the amount of cumulative allocable contract costs
and estimated total allocable contract costs that are used to
determine a contract's completion factor.
Allocable contract costs include a reimbursable cost that is
allocable to the contract.
(ii) Cumulative allocable contract costs incurred. To determine a
contract's completion factor for a taxable year, a taxpayer must
take into account the cumulative allocable contract costs that have
been incurred, as defined in §1.460-1(b)(8), through the end of the
taxable year.
(iii) Estimating total allocable contract costs. A taxpayer must
estimate total allocable contract costs for each long-term contract
based upon all the facts and circumstances known as of the last day
of the taxable year. For this purpose, an event that occurs after
the end of the taxable year must be taken into account if its
occurrence was reasonably foreseeable and its cost was subject to
reasonable estimation as of the last day of that taxable year. To be
considered reasonable, an estimate of total allocable contract costs
must include costs attributable to delay, rework, change orders,
technology or design problems, or other problems that reasonably can
be anticipated considering the nature of the contract and prior
experience. However, estimated total allocable contract costs do not
include any contingency allowance for costs that, as of the end of
the taxable year, are not reasonably expected to be incurred in the
performance of the contract. For example, estimated total allocable
contract costs do not include any costs attributable to factors not
reasonably foreseeable at the end of the taxable year, such as
third-party litigation, extreme weather conditions, strikes, and
delays in securing required permits and licenses. In addition, the
estimated costs of performing other agreements that are not
aggregated with the contract under §1.460-1(e) that the taxpayer
expects to incur with the same customer (e.g., follow-on contracts)
are not included in estimated total allocable contract costs for the
initial contract.
(iv) Pre-contracting-year costs. If a taxpayer reasonably expects to
enter into a long-term contract in a future taxable year, the
taxpayer must capitalize all costs incurred prior to entering into
the contract that will be allocable to that contract (e.g., bidding
and proposal costs). A taxpayer is not required to compute a
completion factor, or to include in gross income any amount, related
to allocable contract costs for any taxable year ending before the
contracting year or, if applicable, the 10-percent year defined in
paragraph (b)(6)(i) of this section. In that year, the taxpayer is
required to compute a completion factor that includes all allocable
contract costs that have been incurred as of the end of that taxable
year (whether previously capitalized or deducted) and to take into
account in computing taxable income the related gross receipts and
the previously capitalized allocable contract costs.
(v) Post-completion-year costs. If a taxpayer incurs an allocable
contract cost after the completion year, the taxpayer must account
for that cost using a permissible method of accounting. See
§1.460-6(c)(1)(ii) for application of the look-back method as a
result of adjustments to allocable contract costs.
(6) 10-percent method--(i) In general. Instead of determining the
income from a long-term contract beginning with the contracting
year, a taxpayer may elect to use the 10-percent method under
section 460(b)(5). Under the 10-percent method, a taxpayer does not
include in gross income any amount related to allocable contract
costs until the taxable year in which the taxpayer has incurred at
least 10 percent of the estimated total allocable contract costs
(10-percent year). A taxpayer must treat costs incurred before the
10-percent year as pre- contracting-year costs described in
paragraph (b)(5)(iv) of this section.
(ii) Election. A taxpayer makes an election under this paragraph (b)
(6) by using the 10-percent method for all long-term contracts
entered into during the taxable year of the election on its original
federal income tax return for the election year.
This election is a method of accounting and, thus, applies to all
long-term contracts entered into during and after the taxable year
of the election. An electing taxpayer must use the 10- percent
method to apply the look-back method under §1.460-6 and to determine
alternative minimum taxable income under paragraph (f) of this
section. This election is not available if a taxpayer uses the
simplified cost-to-cost method described in §1.460-5(c) to compute
the completion factor of a long-term contract.
(c) Exempt contract methods--(1) In general. An exempt contract
method means the method of accounting that a taxpayer must use to
account for all its long-term contracts (and any portion of a long-
term contract) that are exempt from the requirements of section
460(a). Thus, an exempt contract method applies to exempt
construction contracts, as defined in §1.460- 3(b); the non-PCM
portion of a qualified ship contract, as defined in §1.460-2(d); and
the non-PCM portion of a residential construction contract, as
defined in §1.460-3(c). Permissible exempt contract methods include
the PCM, the EPCM described in paragraph (c)(2) of this section, the
CCM described in paragraph (d) of this section, or any other
permissible method. See section 446.
(2) Exempt-contract percentage-of-completion method--(i) In general.
Similar to the PCM described in paragraph (b) of this section, a
taxpayer using the EPCM generally must include in income the portion
of the total contract price, as described in paragraph (b)(4) of
this section, that corresponds to the percentage of the entire
contract that the taxpayer has completed during the taxable year.
However, under the EPCM, the percentage of completion may be
determined as of the end of the taxable year by using any method of
cost comparison (such as comparing direct labor costs incurred to
date to estimated total direct labor costs) or by comparing the work
performed on the contract with the estimated total work to be
performed, rather than by using the cost-to-cost comparison required
by paragraphs (b)(2)(i) and (5) of this section, provided such
method is used consistently and clearly reflects income. In
addition, paragraph (b)(3) of this section (regarding post-
completion-year income), paragraph (b)(6) of this section (regarding
the 10-percent method) and §1.460-6 (regarding the look-back method)
do not apply to the EPCM.
(ii) Determination of work performed. For purposes of the EPCM, the
criteria used to compare the work performed on a contract as of the
end of the taxable year with the estimated total work to be
performed must clearly reflect the earning of income with respect to
the contract. For example, in the case of a roadbuilder, a standard
of completion solely based on miles of roadway completed in a case
where the terrain is substantially different may not clearly reflect
the earning of income with respect to the contract.
(d) Completed-contract method--(1) In general. Except as otherwise
provided in paragraph (d)(4) of this section, a taxpayer using the
CCM to account for a long-term contract must take into account in
the contract's completion year, as defined in §1.460-1(b)(6), the
gross contract price and all allocable contract costs incurred by
the completion year. A taxpayer may not treat the cost of any
materials and supplies that were allocated to a contract, but
actually remain on hand when the contract is completed, as an
allocable contract cost.
(2) Post-completion-year income and costs. If a taxpayer has not
included an item of contingent compensation (i.e. amounts for which
the all events test has not been satisfied) in gross contract price
under paragraph (d)(3) of this section by the completion year, the
taxpayer must account for this item of contingent compensation using
a permissible method of accounting.
If a taxpayer incurs an allocable contract cost after the completion
year, the taxpayer must account for that cost using a permissible
method of accounting.
(3) Gross contract price. Gross contract price includes all amounts
(including holdbacks, retainages, and reimbursements) that a
taxpayer is entitled by law or contract to receive, whether or not
the amounts are due or have been paid. In addition, gross contract
price includes all bonuses, awards, and incentive payments, such as
a bonus for meeting an early completion date, to the extent the all
events test is satisfied.
If a taxpayer performs a non-long-term contract activity, as defined
in §1.460-1(d)(2), that is incident to or necessary for the
manufacture, building, installation, or construction of the subject
matter of one or more of the taxpayer's long-term contracts, the
taxpayer must include an allocable share of the gross receipts
attributable to that activity in the gross contract price of the
contract(s) benefitted by that activity.
Gross contract price also includes amounts reimbursed for
independent research and development costs, or bidding and proposal
costs, under a federal or cost-plus long-term contract (as defined
in section 460(d)), regardless of whether the research and
development, or bidding and proposal, activities are incident to or
necessary for the performance of that long-term contract.
(4) Contracts with disputed claims--(i) In general. The special
rules in this paragraph (d)(4) apply to a long-term contract
accounted for using the CCM with a dispute caused by a customer
requesting a reduction of the gross contract price or the
performance of additional work under the contract or by a taxpayer
requesting an increase in gross contract price, or both, on or after
the date a taxpayer has tendered the subject matter of the contract
to the customer.
(ii) Taxpayer assured of profit or loss. If the disputed amount
relates to a customer's claim for either a reduction in price or
additional work and the taxpayer is assured of either a profit or a
loss on a long-term contract regardless of the outcome of the
dispute, the gross contract price, reduced (but not below zero) by
the amount reasonably in dispute, must be taken into account in the
completion year. If the disputed amount relates to a taxpayer's
claim for an increase in price and the taxpayer is assured of either
a profit or a loss on a long-term contract regardless of the outcome
of the dispute, the gross contract price must be taken into account
in the completion year.
If the taxpayer is assured a profit on the contract, all allocable
contract costs incurred by the end of the completion year are taken
into account in that year. If the taxpayer is assured a loss on the
contract, all allocable contract costs incurred by the end of the
completion year, reduced by the amount reasonably in dispute, are
taken into account in the completion year.
(iii) Taxpayer unable to determine profit or loss. If the amount
reasonably in dispute affects so much of the gross contract price or
allocable contract costs that a taxpayer cannot determine whether a
profit or loss ultimately will be realized from a long-term
contract, the taxpayer may not take any of the gross contract price
or allocable contract costs into account in the completion year.
(iv) Dispute resolved. Any part of the gross contract price and any
allocable contract costs that have not been taken into account
because of the principles described in paragraph (d)(4)(i), (ii) or
(iii) of this section must be taken into account in the taxable year
in which the dispute is resolved. If a taxpayer performs additional
work under the contract because of the dispute, the term taxable
year in which the dispute is resolved means the taxable year the
additional work is completed, rather than the taxable year in which
the outcome of the dispute is determined by agreement, decision, or
otherwise.
(e) Percentage-of-completion/capitalized-cost method. Under the
PCCM, a taxpayer must determine the income from a long-term contract
using the PCM for the applicable percentage of the contract and its
exempt contract method, as defined in paragraph (c) of this section,
for the remaining percentage of the contract. For residential
construction contracts described in §1.460-3(c), the applicable
percentage is 70 percent, and the remaining percentage is 30
percent. For qualified ship contracts described in §1.460-2(d), the
applicable percentage is 40 percent, and the remaining percentage is
60 percent.
(f) Alternative minimum taxable income--(1) In general.
Under section 56(a)(3), a taxpayer (not exempt from the AMT under
section 55(e)) must use the PCM to determine its AMTI from any long-
term contract entered into on or after March 1, 1986, that is not a
home construction contract, as defined in §1.460- 3(b)(2). For AMTI
purposes, the PCM must include any election under paragraph (b)(6)
of this section (concerning the 10-percent method) or under
§1.460-5(c) (concerning the simplified cost-to-cost method) that the
taxpayer has made for regular tax purposes.
For exempt construction contracts described in §1.460- 3(b)(1)(ii),
a taxpayer must use the simplified cost-to-cost method to determine
the completion factor for AMTI purposes.
Except as provided in paragraph (f)(2) of this section, a taxpayer
must use AMTI costs and AMTI methods, such as the depreciation
method described in section 56(a)(1), to determine the completion
factor of a long-term contract (except a home construction contract)
for AMTI purposes.
(2) Election to use regular completion factors. Under this paragraph
(f)(2), a taxpayer may elect for AMTI purposes to determine the
completion factors of all of its long-term contracts using the
methods of accounting and allocable contract costs used for regular
federal income tax purposes. A taxpayer makes this election by using
regular methods and regular costs to compute the completion factors
of all long-term contracts entered into during the taxable year of
the election for AMTI purposes on its original federal income tax
return for the election year.
This election is a method of accounting and, thus, applies to all
long-term contracts entered into during and after the taxable year
of the election. Although a taxpayer may elect to compute the
completion factor of its long-term contracts using regular methods
and regular costs, an election under this paragraph (f)(2) does not
eliminate a taxpayer's obligation to comply with the requirements of
section 55 when computing AMTI. For example, although a taxpayer may
elect to use the depreciation methods used for regular tax purposes
to compute the completion factor of its long-term contracts for AMTI
purposes, the taxpayer must use the depreciation methods permitted
by section 56 to compute AMTI.
(g) Method of accounting. A taxpayer that uses the PCM, EPCM, CCM,
PCCM, or elects the 10-percent method or special AMTI method (or
changes to another method of accounting with the Commissioner's
consent) must apply the method(s) consistently for all similarly
classified long-term contracts, until the taxpayer obtains the
Commissioner's consent under section 446(e) to change to another
method of accounting.
(h) Examples. The following examples illustrate the rules of this
section:
Example 1. PCM--estimating total contract price. On January 1, 1999,
C, who uses a calendar taxable year, enters into a contract to
design and manufacture a satellite (a unique item).
The contract provides that C will be paid $10,000,000 for delivering
the completed satellite by December 1, 2000. The contract also
provides that C will receive a $3,000,000 bonus for delivering the
satellite by July 1, 2000, and an additional $4,000,000 bonus if the
satellite successfully performs its mission for five years. C is
unable to reasonably predict if the satellite will successfully
perform its mission for five years.
If on December 31, 1999, C should reasonably expect to deliver the
satellite by July 1, 2000, the estimated total contract price is
$13,000,000 ($10,000,000 unit price + $3,000,000 production-related
bonus). Otherwise, the estimated total contract price is
$10,000,000. In either event, the $4,000,000 bonus is not includible
in the estimated total contract price as of December 31, 1999,
because C is unable to reasonably predict that the satellite will
successfully perform its mission for five years.
Example 2. PCM--computing income. (i) C, who uses a calendar taxable
year, determines the income from long-term contracts using the PCM.
During 1999, C agrees to manufacture for the customer, B, a unique
item for a total contract price of $1,000,000. Under C's contract, B
is entitled to retain 10 percent of the total contract price until
it accepts the item.
By the end of 1999, C has incurred $200,000 of allocable contract
costs and estimates that the total allocable contract costs will be
$800,000. By the end of 2000, C has incurred $600,000 of allocable
contract costs and estimates that the total allocable contract costs
will be $900,000. In 2001, after completing the contract, C
determines that the actual cost to manufacture the item was
$750,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
Taxable Year
1999 2000 2001
(A) Cumulative incurred costs $200,000 $600,000 $750,000
(B) Estimated total costs 800,000 900,000 750,000
(C) Completion factor: (A) ÷ (B) 25.00% 66.67% 100.00%
(D) Total contract price 1,000,000 1,000,000 1,000,000
(E) Cumulative gross receipts:
(C) x (D) 250,000 666,667 1,000,000
(F) Cumulative gross receipts:
(prior year) (0) (250,000) (666,667)
(G) Current-year gross receipts 250,000 416,667 333,333
(H) Cumulative incurred costs 200,000 600,000 750,000
(I) Cumulative incurred costs:
(prior year) (0) (200,000) (600,000)
(J) Current-year costs 200,000 400,000 150,000
(K) Gross income (G) - (J) $50,000 $16,667 $183,333
Example 3. PCM--computing income with cost sharing. (i) C, who uses
a calendar taxable year, determines the income from long-term
contracts using the PCM. During 1999, C enters into a contract to
manufacture a unique item. The contract specifies a target price of
$1,000,000, a target cost of $600,000, and a target profit of
$400,000. C and B will share the savings of any cost under run
(actual total incurred cost is less than target cost) and the
additional cost of any cost overrun (actual total incurred cost is
greater than target cost) as follows: 30 percent to C and 70 percent
to B. By the end of 1999, C has incurred $200,000 of allocable
contract costs and estimates that the total allocable contract costs
will be $600,000. By the end of 2000, C has incurred $300,000 of
allocable contract costs and estimates that the total allocable
contract costs will be $400,000. In 2001, after completing the
contract, C determines that the actual cost to manufacture the item
was $700,000.
(ii) For each of the taxable years, C's income from the contract is
computed as follows (Note that the sharing of any cost under run or
cost overrun is reflected as an adjustment to C's target price under
paragraph (b)(4)(i) of this section):
Taxable Year
1999 2000 2001
(A) Cumulative incurred costs $200,000 $300,000 $700,000
(B) Estimated total costs 600,000 400,000 700,000
(C) Completion factor: (A) ÷ (B) 33.33% 75.00% 100.00%
(D) Target price $1,000,000 1,000,000 1,000,000
(E) Estimated total costs 600,000 400,000 700,000
(F) Target costs 600,000 600,000 600,000
(G) Cost (under run)/overrun:
(E) - (F) 0 (200,000) 100,000
(H) Adjustment rate 70% 70% 70%
(I) Target price adjustment 0 (140,000) 70,000
(J) Total contract price:
(D) + (I) $1,000,000 $860,000 1,070,000
(K) Cumulative gross receipts:
(C) x (J) $333,333 $645,000 1,070,000
(L) Cumulative gross receipts:
(prior year) (0) (333,333) (645,000)
(M) Current-year gross receipts 333,333 311,667 425,000
(N) Cumulative incurred costs 200,000 300,000 700,000
(O) Cumulative incurred costs:
(prior year) (0) (200,000) (300,000)
(P) Current-year costs 200,000 100,000 400,000
(Q) Gross income: (M) - (P) $133,333 $211,667 $25,000
Example 4. PCM--10 percent method. (i) In November 1999, C, who
determines income using the PCM and who uses a calendar taxable
year, agrees to manufacture a unique item for $1,000,000.
C reasonably estimates that the total allocable contract costs will
be $600,000. By December 31, 1999, C has received $50,000 in
progress payments and incurred $40,000 of costs. C elects to use the
10 percent method effective for 1999 and all subsequent taxable
years. During 2000, C receives $500,000 in progress payments and
incurs $260,000 of costs. In 2001, C incurs an additional $300,000
of costs, C finishes manufacturing the item, and receives the final
$450,000 payment.
(ii) For each of the taxable years, C's income from the contract is
computed as follows:
Taxable Year
1999 2000 2001
(A) Cumulative incurred costs $40,000 $300,000 $600,000
(B) Estimated total costs 600,000 600,000 600,000
(C) Completion factor
(A) ÷ (B) 6.67% 50.00% 100.00%
(D) Total contract price 1,000,000 1,000,000 1,000,000
(E) Cumulative gross receipts:
(C) x (D)* 0 500,000 1,000,000
(F) Cumulative gross receipts:
(prior year) (0) (0) (500,000)
(G) Current-year gross receipts 0 500,000 500,000
(H) Cumulative incurred costs 0 300,000 600,000
(I) Cumulative incurred costs:
(prior year) (0) (0) (300,000)
(J) Current-year costs 0 300,000 300,000
(K) Gross income: (G) - (J) $0 $200,000 $200,000
* Unless (C) < 10 percent.
Example 5. CCM B contracts with disputes from customer claims. In
2001, C, who uses the CCM to account for exempt construction
contracts and uses a calendar taxable year, enters into a contract
to construct a bridge for B. The terms of the contract provide for a
$1,000,000 gross contract price. C finishes the bridge in 2002 at a
cost of $950,000. When B examines the bridge, B insists that C
either repaint several girders or reduce the contract price. The
amount reasonably in dispute is $10,000. In 2003, C and B resolve
their dispute, C repaints the girders at a cost of $6,000, and C and
B agree that the contract price is not to be reduced. Because C is
assured a profit of $40,000 ($1,000,000 - $10,000 - $950,000) in
2002 even if the dispute is resolved in B's favor, C must take this
$40,000 into account in 2002. In 2003, C will earn an additional
$4,000 profit ($1,000,000 - $956,000 - $40,000) from the contract
with B. Thus, C must take into account an additional $10,000 of
gross contract price and $6,000 of additional contract costs in
2003.
Example 6. CCM B contracts with disputes from taxpayer claims. In
2003, C, who uses the CCM to account for exempt construction
contracts and uses a calendar taxable year, enters into a contract
to construct a building for B. The terms of the contract provide for
a $1,000,000 gross contract price. C finishes the building in 2004
at a cost of $1,005,000. B examines the building in 2004 and agrees
that it meets the contract's specifications; however, at the end of
2004, C and B are unable to agree on the merits of C's claim for an
additional $10,000 for items that C alleges are changes in contract
specifications and B alleges are within the scope of the contract's
original specifications. In 2005, B agrees to pay C an additional
$2,000 to satisfy C's claims under the contract.
Because the amount in dispute affects so much of the gross contract
price that C cannot determine in 2004 whether a profit or loss will
ultimately be realized, C may not taken any of the gross contract
price or allocable contract costs into account in 2004. C must take
into account $1,002,000 of gross contract price and $1,005,000 of
allocable contract costs in 2005.
Example 7. CCM--contracts with disputes from taxpayer and customer
claims. C, who uses the CCM to account for exempt construction
contracts and uses a calendar taxable year, constructs a factory for
B pursuant to a long-term contract.
Under the terms of the contract, B agrees to pay C a total of
$1,000,000 for construction of the factory. C finishes construction
of the factory in 1999 at a cost of $1,020,000.
When B takes possession of the factory and begins operations in
December 1999, B is dissatisfied with the location and workmanship
of certain heating ducts. As of the end of 1999, C contends that the
heating ducts as constructed are in accordance with contract
specifications. The amount of the gross contract price reasonably in
dispute with respect to the heating ducts is $6,000. As of this
time, C is claiming $14,000 in addition to the original contract
price for certain changes in contract specifications which C alleges
have increased his costs. B denies that such changes have increased
C's costs. In 2000 the disputes between C and B are resolved by
performance of additional work by C at a cost of $1,000 and by an
agreement that the contract price would be revised downward to
$996,000. Under these circumstances, C must include in his gross
income for 1999, $994,000 (the gross contract price less the amount
reasonably in dispute because of B's claim, or $1,000,000-$6,000).
In 1999, C must also take into account $1,000,000 of allocable
contract costs (costs incurred less the amounts in dispute
attributable to both B and C's claims, or
$1,020,000-$6,000-$14,000). In 2000, C must take into account an
additional $2,000 of gross contract price ($996,000-$994,000) and
$21,000 of allocable contract costs ($1,021,000-$1,000,000).
(i) Mid-contract change in taxpayer. [Reserved]
* * * * *
Par. 8. Section 1.460-5 is revised to read as follows:
§1.460-5 Cost allocation rules.
(a) Overview. This section prescribes methods of allocating costs to
long-term contracts accounted for using the percentage-of-
completion method described in §1.460-4(b) (PCM), the completed-
contract method described in §1.460-4(d) (CCM), or the percentage-
of-completion/capitalized-cost method described in §1.460-4(e)
(PCCM). Exempt construction contracts described in §1.460-3(b)
accounted for using a method other than the PCM, CCM, or PCCM are
not subject to the cost allocation rules of this section (other than
the requirement to allocate production period interest under
paragraph (b)(2)(v) of this section). Paragraph (b) of this section
describes the regular cost allocation methods for contracts subject
to the PCM. Paragraph (c) of this section describes an elective
simplified cost allocation method for contracts subject to the PCM.
Paragraph (d) of this section describes the cost allocation methods
for exempt construction contracts reported using the CCM. Paragraph
(e) of this section describes the cost allocation rules for
contracts subject to the PCCM. Paragraph (f) of this section
describes additional rules applicable to the cost allocation methods
described in this section. Paragraph (g) of this section provides
rules concerning consistency in method of allocating costs to long-
term contracts.
(b) Cost allocation method for contracts subject to PCM--(1) In
general. A taxpayer must allocate costs to each long-term contract
subject to the PCM in the same manner that direct and indirect costs
are capitalized to property produced by a taxpayer under
§1.263A-1(e) through (h), except as otherwise provided in paragraph
(b)(2) of this section. Thus, a taxpayer must allocate to each long-
term contract subject to the PCM all direct costs and certain
indirect costs properly allocable to the long-term contract (i.e.,
all costs that directly benefit or are incurred by reason of the
performance of the long-term contract).
However, see paragraph (c) of this section concerning an election to
allocate contract costs using the simplified cost-to-cost method. As
in section 263A, the use of the practical capacity concept is not
permitted. See §1.263A-2(a)(4).
(2) Special rules--(i) Direct material costs. The costs of direct
materials must be allocated to a long-term contract as of the
earlier of when a direct material is purchased specifically for that
contract or when dedicated, as defined in §1.263A-11( b)(2). For
this purpose, a direct material is purchased specifically for a
long-term contract if, when incurring the liability for the direct
material, a taxpayer reasonably expects to incorporate the direct
material in the subject matter of the contract. A taxpayer
maintaining inventories under §1.471-1 must determine allocable
contract costs attributable to direct materials using its method of
accounting for such inventories (e.g., FIFO, LIFO, specific
identification).
(ii) Components and subassemblies. The costs of a component or
subassembly (component) produced by the taxpayer must be allocated
to a long-term contract as the taxpayer incurs costs to produce the
component if the taxpayer reasonably expects to incorporate the
component into the subject matter of the contract. Similarly, the
cost of a purchased component (including a component purchased from
a related party) must be allocated to a long-term contract as the
taxpayer incurs the cost to purchase the component if the taxpayer
reasonably expects to incorporate the component into the subject
matter of the contract. In all other cases, the cost of a component
must be allocated to a long-term contract when the component is
dedicated, as defined in §1.263A-11(b)(2). A taxpayer maintaining
inventories under §1.471-1 must determine allocable contract costs
attributable to components using its method of accounting for such
inventories (e.g., FIFO, LIFO, specific identification).
(iii) Simplified production methods. A taxpayer may not determine
allocable contract costs using the simplified production methods
described in §1.263A-2(b) and (c).
(iv) Costs identified under cost-plus long-term contracts and
federal long-term contracts. To the extent not otherwise allocated
to the contract under this paragraph (b), a taxpayer must allocate
any identified costs to a cost-plus long-term contract or federal
long-term contract (as defined in section 460(d)). Identified cost
means any cost, including a charge representing the time-value of
money, identified by the taxpayer or related person as being
attributable to the taxpayer's cost-plus long-term contract or
federal long-term contract under the terms of the contract itself or
under federal, state, or local law or regulation.
(v) Interest--(A) In general. If property produced under a long-term
contract is designated property, as defined in §1.263A-8( b)
(without regard to the exclusion for long-term contracts under
§1.263A-8(d)(2)(v)), a taxpayer must allocate interest incurred
during the production period to the long-term contract in the same
manner as interest is allocated to property produced by a taxpayer
under section 263A(f). See §§1.263A-8 to 1.263A-12 generally.
(B) Production period. Notwithstanding §1.263A-12(c) and (d), for
purposes of this paragraph (b)(2)(v), the production period of a
long-term contract B
(1) Begins on the later of B
(i) The contract commencement date, as defined in §1.460- 1(b)(7);
or
(ii) For a taxpayer using the accrual method of accounting for long-
term contracts, the date by which 5 percent or more of the total
estimated costs, including design and planning costs, under the
contract have been incurred; and
(2) Ends on the date that the contract is completed, as defined in
§1.460-1(c)(3).
(C) Application of section 263A(f). For purposes of this paragraph
(b)(2)(v), section 263A(f)(1)(B)(iii) (regarding an estimated
production period exceeding 1 year and a cost exceeding $1,000,000)
must be applied on a contract-by-contract basis; except that, in the
case of a taxpayer using an accrual method of accounting, that
section must be applied on a property-by-property basis.
(vi) Research and experimental expenses. Notwithstanding
§1.263A-1(e)(3)(ii)(P) and (iii)(B), a taxpayer must allocate
research and experimental expenses, other than independent research
and experimental expenses (as defined in section 460(c)(5)), to its
long-term contracts.
(vii) Service costs--(A) Simplified service cost method--(1) In
general. To use the simplified service cost method under
§1.263A-1(h), a taxpayer must allocate the otherwise capitalizable
mixed service costs among its long-term contracts using a reasonable
method. For example, otherwise capitalizable mixed service costs may
be allocated to each long-term contract based on labor hours or
contract costs allocable to the contract.
To be considered reasonable, an allocation method must be applied
consistently and must not disproportionately allocate service costs
to contracts expected to be completed in the near future.
(2) Example. The following example illustrates the rule of this
paragraph (b)(2)(vii)(A):
Example. simplified service cost method. During 1999, C, which uses
a calendar taxable year, produces electronic equipment for inventory
and enters into long-term contracts to manufacture specialized
electronic equipment. C's method of allocating mixed service costs
to the property it produces is the labor-based, simplified service
cost method described in §1.263A-1(h)(4). For 1999, C's total mixed
service costs are $100,000, C's section 263A labor costs are
$500,000, C's section 460 labor costs (i.e.
labor costs allocable to C's long-term contracts) are $250,000, and
C's total labor costs are $1,000,000. To determine the amount of
mixed service costs capitalizable under section 263A for 1999, C
multiplies the "total mixed service costs" incurred during 1999 by
its 1999 "section 263A allocation ratio" (section 263A labor
costs/total labor costs). Thus, C's capitalizable mixed service
costs for 1999 are $50,000 ($100,000 x $500,000/$1,000,000).
Thereafter, C allocates its capitalizable mixed service costs to
property produced remaining in ending inventory using its 263A
allocation method (e.g., burden rate, simplified production).
Similarly, to determine the amount of mixed service costs that are
allocable to C's long-term contracts for 1999, C multiplies the
"total mixed service costs" incurred during 1999 by its 1999
"section 460 allocation ratio" (section 460 labor/total labor
costs). Thus, C's allocable mixed service contract costs for 1999
are $25,000 ($100,000 x $250,000/ 1,000,000). Thereafter, C
allocates its allocable mixed service contract costs to each of its
long-term contracts proportionately based on the 1999 section 460
labor costs allocable to each long-term contract.
(B) Jobsite costs. If an administrative, service, or support
function is performed solely at the jobsite for a specific long-term
contract, the taxpayer may allocate all the direct and indirect
costs of that administrative, service, or support function to that
long-term contract. Similarly, if an administrative, service, or
support function is performed at the jobsite solely for the
taxpayer's long-term contract activities, the taxpayer may allocate
all the direct and indirect costs of that administrative, service,
or support function among all the long-term contracts performed at
that jobsite. For this purpose, jobsite means a production plant or
a construction site.
(C) Limitation on other reasonable cost allocation methods.
A taxpayer may use any other reasonable method of allocating service
costs, as provided in §1.263A-1(f)(4), if, for the taxpayer's long-
term contracts considered as a whole, the--
(1) Total amount of service costs allocated to the contracts does
not differ significantly from the total amount of service costs that
would have been allocated to the contracts under §1.263A-1(f)(2) or
(3);
(2) Service costs are not allocated disproportionately to contracts
expected to be completed in the near future because of the
taxpayer's cost allocation method; and
(3) Taxpayer's cost allocation method is applied consistently.
(c) Simplified cost-to-cost method--(1) In general.
Instead of using the cost allocation method prescribed in paragraph
(b) of this section, a taxpayer may elect to use the simplified
cost-to-cost method, which is authorized under section 460(b)(3)(A).
Under the simplified cost-to-cost method, a taxpayer determines a
contract's completion factor based upon only direct material costs;
direct labor costs; and depreciation, amortization, and cost
recovery allowances on equipment and facilities directly used to
manufacture or construct the subject matter of the contract. An
electing taxpayer must use the simplified cost-to-cost method to
apply the look-back method under §1.460-6 and to determine
alternative minimum taxable income under §1.460-4(f).
(2) Election. A taxpayer makes an election under this paragraph (c)
by using the simplified cost-to-cost method for all long-term
contracts entered into during the taxable year of the election on
its original federal income tax return for the election year. This
election is a method of accounting and, thus, applies to all long-
term contracts entered into during and after the taxable year of the
election. This election is not available if a taxpayer does not use
the PCM to account for all long-term contracts or if a taxpayer
elects to use the 10-percent method described in §1.460-4(b)(6).
(d) Cost allocation rules for exempt construction contracts reported
using the CCM B
(1) In general. For exempt construction contracts reported using the
CCM, other than contracts described in paragraph (d)(3) of this
section, a taxpayer must annually allocate the cost of any activity
that is incident to or necessary for the taxpayer's performance
under a long-term contract. A taxpayer must allocate to each such
exempt construction contract all direct costs as defined in
§1.263A-1( e)(2)(i) and all indirect costs either as provided in
§1.263A-1( e)(3) or as provided in paragraph (d)(2) of this section.
(2) Indirect costs--(i) Indirect costs allocable to exempt
construction contracts. A taxpayer allocating costs under this
paragraph (d)(2) must allocate the following costs to an exempt
construction contract, other than a contract described in paragraph
(d)(3) of this section, to the extent incurred in the performance of
that contract B
(A) Repair of equipment or facilities;
(B) Maintenance of equipment or facilities;
(C) Utilities, such as heat, light, and power, allocable to
equipment or facilities;
(D) Rent of equipment or facilities;
(E) Indirect labor and contract supervisory wages, including basic
compensation, overtime pay, vacation and holiday pay, sick leave pay
(other than payments pursuant to a wage continuation plan under
section 105(d) as it existed prior to its repeal in 1983), shift
differential, payroll taxes, and contributions to a supplemental
unemployment benefits plan;
(F) Indirect materials and supplies;
(G) Noncapitalized tools and equipment;
(H) Quality control and inspection;
(I) Taxes otherwise allowable as a deduction under section 164,
other than state, local, and foreign income taxes, to the extent
attributable to labor, materials, supplies, equipment, or
facilities;
(J) Depreciation, amortization, and cost-recovery allowances
reported for the taxable year for financial purposes on equipment
and facilities to the extent allowable as deductions under chapter 1
of the Internal Revenue Code (Code);
(K) Cost depletion;
(L) Administrative costs other than the cost of selling or any
return on capital;
(M) Compensation paid to officers other than for incidental or
occasional services;
(N) Insurance, such as liability insurance on machinery and
equipment; and
(O) Interest, as required under paragraph (b)(2)(v) of this section.
(ii) Indirect costs not allocable to exempt construction contracts.
A taxpayer allocating costs under this paragraph (d)(2) is not
required to allocate the following costs to an exempt construction
contract reported using the CCM B -
(A) Marketing and selling expenses, including bidding expenses;
(B) Advertising expenses;
(C) Other distribution expenses;
(D) General and administrative expenses attributable to the
performance of services that benefit the taxpayer's activities as a
whole (e.g., payroll expenses, legal and accounting expenses);
(E) Research and experimental expenses (described in section 174 and
the regulations thereunder);
(F) Losses under section 165 and the regulations thereunder;
(G) Percentage of depletion in excess of cost depletion;
(H) Depreciation, amortization, and cost recovery allowances on
equipment and facilities that have been placed in service but are
temporarily idle (for this purpose, an asset is not considered to be
temporarily idle on non-working days, and an asset used in
construction is considered to be idle when it is neither en route to
nor located at a job-site), and depreciation, amortization and cost
recovery allowances under chapter 1 of the Code in excess of
depreciation, amortization, and cost recovery allowances reported by
the taxpayer in the taxpayer's financial reports;
(I) Income taxes attributable to income received from long-term
contracts;
(J) Contributions paid to or under a stock bonus, pension, profit-
sharing, or annuity plan or other plan deferring the receipt of
compensation whether or not the plan qualifies under section 401(a),
and other employee benefit expenses paid or accrued on behalf of
labor, to the extent the contributions or expenses are otherwise
allowable as deductions under chapter 1 of the Code. Other employee
benefit expenses include (but are not limited to): worker's
compensation; amounts deductible or for whose payment reduction in
earnings and profits is allowed under section 404A and the
regulations thereunder; payments pursuant to a wage continuation
plan under section 105(d) as it existed prior to its repeal in 1983;
amounts includible in the gross income of employees under a method
or arrangement of employer contributions or compensation which has
the effect of a stock bonus, pension, profit-sharing, or annuity
plan, or other plan deferring the receipt of compensation or
providing deferred benefits; premiums on life and health insurance;
and miscellaneous benefits provided for employees such as safety,
medical treatment, recreational and eating facilities, membership
dues, etc.;
(K) Cost attributable to strikes, rework labor, scrap and spoilage;
and
(L) Compensation paid to officers attributable to the performance of
services that benefit the taxpayer's activities as a whole.
(3) Large homebuilders. A taxpayer must capitalize the costs of home
construction contracts under section 263A and the regulations
thereunder, unless the contract will be completed within two years
of the contract commencement date and the taxpayer satisfies the
$10,000,000 gross receipts test described in §1.460-3(b)(3).
(e) Cost allocation rules for contracts subject to the PCCM.
A taxpayer must use the cost allocation rules described in paragraph
(b) of this section to determine the costs allocable to the entire
qualified ship contract or residential construction contract
accounted for using the PCCM and may not use the simplified cost-to-
cost method described in paragraph (c) of this section.
(f) Special rules applicable to costs allocated under this
section--(1) Nondeductible costs. A taxpayer may not allocate any
otherwise allocable contract cost to a long-term contract if any
section of the Code disallows a deduction for that type of payment
or expenditure (e.g., an illegal bribe described in section 162(c)).
(2) Costs incurred for non-long-term contract activities.
If a taxpayer performs a non-long-term contract activity, as defined
in §1.460-1(d)(2), that is incident to or necessary for the
manufacture, building, installation, or construction of the subject
matter of one or more of the taxpayer's long-term contracts, the
taxpayer must allocate the costs attributable to that activity to
such contract(s).
(g) Method of accounting. A taxpayer that adopts or elects a cost
allocation method of accounting (or changes to another cost
allocation method of accounting with the Commissioner's consent)
must apply that method consistently for all similarly classified
contracts, until the taxpayer obtains the Commissioner's consent
under section 446(e) to change to another cost allocation method.
Par. 9. Section 1.460-6 is amended as follows:
1. A sentence is added to the end of paragraph (a)(2).
2. In the third sentence of paragraph (b)(1), the language "by
substituting '80 percent' for '50 percent' with" is removed and "by
substituting 'at least 80 percent' for 'more than 50 percent' with"
is added in its place.
3. The first sentence of paragraph (c)(1)(ii)(A) is revised.
4. The last two sentences of paragraph (c)(1)(ii)(B) are removed.
5. In the last sentence of paragraph (c)(1)(ii)(C)(2), the language
"§5h.6" is removed and "§301.9100-8 of this chapter" is added in its
place.
6. In the fourth sentence of paragraph (c)(2)(v)(A), the language
"similarly" is removed.
7. The first, second, fifth, and sixth sentences of paragraph (c)(2)
(v)(A) are removed.
8. In the first sentence of paragraph (c)(2)(vi)(B), the language
"§1.451-3(b)(2)(ii), (iii), (iv), and §1.451-3(d)(2), (3), and (4)"
is removed and "§1.460-4(b)(4)(i)" is added in its place.
9. In the second sentence of paragraph (c)(2)(vi)(B), the language
"the percentage of completion method and" is removed.
10. In the third sentence of paragraph (c)(2)(vi)(B), the language
", for purposes of both the percentage of completion method and the
look-back method" is removed.
11. In the fourth sentence of paragraph (c)(2)(vi)(B), the language
"Similarly, a" is removed and "A" is added in its place.
12. In the first sentence of paragraph (c)(2)(vi)(C), the language
"§1.451-3(e)" is removed and "§1.460-1(e)" is added in its place.
13. The heading of paragraph (c)(4)(iv) is revised and the last two
sentences are revised.
14. In the first sentence of paragraph (d)(4)(ii)(C), the language "
within the meaning of section 1504(a)" is removed and ", as defined
in § 1.1502-1(h)" is added in its place.
15. In the fourth sentence of paragraph (e)(2), the language "within
the meaning of section 1504(a)" is removed and ", as defined in
§1.1502-1(h)" is added in its place.
The revisions and addition read as follows:
§1.460-6 Look-back method.
(a) * * *
(2) * * * Paragraph (j) of this section provides guidance concerning
the election not to apply the look-back method in de minimis cases.
* * * * *
(c) * * *
(1) * * *
(ii) * * *
(A) In general. Except as otherwise provided in section 460(b)(6) or
§1.460-6(e), a taxpayer must apply the look-back method to a long-
term contract in the completion year and in any post-completion year
for which the taxpayer must adjust total contract price or total
allocable contract costs, or both, under the PCM. * * *
* * * * *
(4) * * *
(iv) Additional interest due on look-back interest only after tax
liability due. * * * Unless a taxpayer is entitled to a tax refund
that fully offsets the amount of look-back interest due the
government, the look-back interest owed by the taxpayer compounds
under section 6622 from the initial due date of the return (without
regard to extensions) through the date the return, not the Form
8697, is filed. Similarly, if a taxpayer is entitled to receive
look-back interest, the look-back interest compounds under section
6622 from the initial due date of the return (without regard to
extensions) through the date the return, not the Form 8697, is
filed.
* * * * *
§§1.460-7 and 1.460-8 [Removed] Par. 8. Sections 1.460-7 and 1.460-8
are removed.
Robert E. Wenzel
Deputy Commissioner of Internal Revenue
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