REVENUE RULE 90-40

1990-1 C.B. 52, 1990-18 I.R.B. 5.

Internal Revenue Service
Revenue Ruling

CAPITALIZATION OF INTEREST

Published: April 30, 1990

Section 263A. - Capitalization and Inclusion in Inventory Costs of Certain Expenses, 26 CFR 1.263A-1T: Capitalization and inclusion in inventory costs of certain expenses.

(See Also Section 189.)

Capitalization of interest. Interest expenses required to be capitalized may not be reduced by interest income earned from temporary investments.

ISSUE

In determining the amount of interest expense that is required to be capitalized under section 263A(f) and former section 189 of the Internal Revenue Code, may a taxpayer reduce the amount of interest expense required to be capitalized by the amount of interest income earned from temporarily investing unexpended debt proceeds?

FACTS

Situation 1

The taxpayer, X, is a manufacturing corporation that uses an accrual method of accounting and files a return on a calendar-year basis. In 1985, X entered into a contract with Y, under which Y was to construct an addition to X's factory. The contract requires X to make progress payments during the construction of the addition.

X financed the factory addition with restricted tax-exempt private activity bonds (its only borrowing during the period in issue) that have a face amount of $5,000,000 and bear a 7 percent annual rate of interest. The bonds were issued by an industrial development authority created by state M, and the proceeds of the bond issue were lent to X. The agreement between M and X required a trustee to deposit the bond proceeds in a construction fund that was to be used to make payments to Y as progress payments became due under the construction contract. X was restricted by the agreement to use the bond proceeds exclusively for the construction of the factory addition.

During construction, the trustee is required by the agreement to invest any bond proceeds that are not required for progress payments. The trustee also must transfer the interest earned on these investments to a bond sinking fund to pay interest and principal on the bonds. Pursuant to the agreement, the trustee deposited the entire $5,000,000 of bond proceeds in the construction fund on January 1, 1986. The trustee made a progress payment of $500,000 to Y on July 1, 1986, when Y began construction of the factory addition. In addition, X's basis in the land allocable to the factory addition was $500,000.

During 1986, the unexpended bond proceeds were invested in short-term investments that earned a 6 percent annual rate of interest. Thus, for 1986, X incurred total interest expense of $350,000 ($5,000,000 x .07) on the bonds and earned interest income of $285,000 ([$5,000,000 x .06 x 6/12] + [$4,500,000 x . 06 x 6/12]) from the short-term investments held by the trustee. Of the $350,000 total amount of interest expense, $35,000 ($1,000,000 x .07 x 6/12) was related to the underlying land and other construction expenditures. For financial statement purposes, X capitalized, as its total interest cost of constructing the addition for 1986, $350,000 of interest expense that accrued on the bonds less $285,000 of interest income earned from the short-term investments. Because the total capitalized interest expense exceeded the total interest income by $65,000, X increased the cost basis of the factory addition by $65,000 for financial accounting purposes.

This treatment conforms with Financial Accounting Standards Board (FASB) Statement No. 34, Capitalization of Interest Cost (as amended by FASB Statement No. 62). FASB Statement No. 34 generally requires an entity to capitalize the amount of interest expense that could have been avoided if the expenditures had not been made, and prohibits the netting or offsetting of interest income and interest expense. However, a special rule is provided pursuant to FASB Statement No. 62 for the capitalization of interest expense incurred on restricted tax-exempt borrowings. This special rule requires the capitalization of all interest expense incurred less any interest income earned on interest-bearing investments that are acquired with the proceeds of the tax- exempt borrowing.

The first part of this revenue ruling addresses whether X may similarly net interest income and interest expense for purposes of former section 189 of the Code.

Situation 2

Assume the same facts as in Situation 1, except that the construction commenced in 1988 pursuant to a contract between X and Y entered into in 1987. The second part of this ruling addresses whether X may net interest income and interest expense for purposes of section 263A(f) of the Code.

LAW AND ANALYSIS

Under the facts presented, the taxpayers have incurred total tax-exempt borrowings that exceed the cumulative amount of construction expenditures that are subject to former section 189 of the Code or section 263A(f) for the tax years in issue. To the extent that a taxpayer has temporarily invested the excess tax-exempt debt proceeds in income-earning assets, the taxpayer is earning additional interest income that could be used to pay interest expense on construction expenditures. This ruling addresses whether the taxpayers' interest income on the unexpended debt proceeds may reduce the amount of interest expense subject to capitalization for the year.

Taxpayers were required to capitalize real property construction period interest incurred before January 1, 1987, under former section 189(a) of the Code (repealed by the Tax Reform Act of 1986, section 803(b)(1), 1986-3 (Vol. 1) C.B. 272). Former section 189(e)(1)(A) defines real property construction period interest as interest paid or accrued on indebtedness incurred or continued to acquire, construct, or carry real property to the extent such interest is attributable to the construction period and would otherwise be allowable as a deduction for the tax year in which paid or accrued. The construction of an addition to an existing building is a real property construction activity and, thus, is subject to the interest capitalization requirements of former section 189.

The legislative history underlying former section 189 of the Code indicates that rules similar to the avoided cost method required by FASB Statement No. 34, as amended, are appropriate to determine the amount of interest to be capitalized under that section. See H.R. Conf. Rep. No. 760, 97th Cong., 2d Sess. 484-85 (1982), 1982-2 C.B. 600, 608. As described by FASB Statement No. 34, the avoided cost method is a mechanical method for determining the amount of interest expense that is properly treated as a cost of an asset. The amount of interest costs to be capitalized is determined by multiplying the average accumulated expenditures for an asset for the year by the weighted average interest rate applicable to an entity's outstanding borrowings for that year. Under the avoided cost method, except for determining the order in which debt is allocated to expenditures, the use of debt proceeds is irrelevant and, therefore, has no effect on the interest capitalization rate.

In the case of assets that are financed with certain restricted tax- exempt borrowings, FASB Statement No. 62 provides a special capitalization method that expressly departs from the general avoided cost principles. Under this special rule, all interest incurred on a restricted tax-exempt borrowing must be capitalized beginning on the date of the borrowing, and without regard to whether expenditures for construction have been made. In the context of this requirement, interest income earned on related interest-bearing investments acquired with the proceeds of the tax-exempt borrowing is netted against interest expense that would otherwise be capitalized to the asset.

In contrast, the capitalization of interest under former section 189 of the Code begins only after the construction activities have commenced, and only with respect to construction expenditures that have been incurred. Former section 189 contains no exceptions or special rules for assets that are financed with restricted tax-exempt financing. Therefore, for purposes of applying former section 189, a taxpayer may not net interest income against interest expense.

In general, section 263A(a)(1)(B) of the Code requires the capitalization of direct costs and certain indirect costs incurred after December 31, 1986, with respect to real or tangible personal property produced by the taxpayer.

Section 263A(g)(2) of the Code and section 1.263A- 1T(b)(2)(iv)(C) of the temporary Income Tax Regulations provide that a taxpayer is treated as producing any property produced for the taxpayer under a contract with the taxpayer to the extent that the taxpayer makes payments or incurs costs with respect to the property.

Section 263A(f) of the Code provides that interest expense is required to be capitalized with respect to property produced by the taxpayer if the property has a long useful life (real property or tangible personal property with a class life of 20 years or more), has an estimated production period exceeding 2 years, or has an estimated production period exceeding 1 year and a cost exceeding $1,000,000. The construction of an addition to an existing building is a real property production activity and, thus, is subject to the interest capitalization requirements of section 263A(f).

Notice 88-99, 1988-2 C.B. 422, provides guidance concerning the requirement to capitalize interest with respect to property that is subject to section 263A(f) of the Code. In general, a taxpayer must capitalize the interest expense that is incurred on the total debt directly attributable to production activities ('traced debt'). If the taxpayer's accumulated production expenditures exceed the amount of traced debt, interest on the taxpayer's other outstanding debt is also required to be allocated to accumulated production expenditures, to the extent of the excess ('avoided cost debt').

Under the method described in Notice 88-99, a taxpayer capitalizes the amount of interest expense that would have been avoided if the taxpayer had used its accumulated production expenditures to repay its outstanding traced and avoided cost debt. If the taxpayer's accumulated production expenditures exceed the total amount of its traced and avoided cost debt, the maximum amount of interest expense that is capitalized is the total amount of interest expense actually incurred by the taxpayer. See S. Rep. No. 313, 99th Cong., 2d Sess. 144(1986), 1986-3 (Vol. 3) C.B. 144.

In enacting section 263A(f) of the Code, Congress stated that rules similar to those applicable under former section 189 are to determine whether debt is incurred or continued to finance the production of property. Thus, section 263A(f) also incorporates the general principles of FASB Statement No. 34, as amended by FASB Statement No. 62, for applying the avoided cost method. S. Rep. No. 313, 99th Cong., 2d Sess. 144(1986), 1986-3 (Vol. 3) C.B. 144; see also 2 H.R. Conf. Rep. No. 841, 99th Cong., 2d Sess. II-309(1986), 1986-3 (Vol. 4) C.B. 309.

As with former section 189 of the Code, the capitalization of interest under section 263A(f) begins only after the production activities have commenced and only with respect to production expenditures that have been incurred. Accordingly, the netting of interest income and expense in the case of assets that are financed with restricted tax-exempt borrowings as provided by FASB Statement No. 34, as amended by FASB Statement No. 62, is similarly inconsistent with the interest capitalization required by section 263A(f). Therefore, for purposes of applying section 263A(f), a taxpayer may not net interest income against interest expense. See also section III of Notice 88-99, Example (3).

HOLDING

In determining the amount of interest expense that is required to be capitalized under former section 189 of the Code and section 263A(f), a taxpayer may not reduce the amount of interest expense required to be capitalized by the amount of interest income earned from temporarily investing unexpended debt proceeds.

Situation (1)

X is required to capitalize under former section 189 of the Code construction period interest attributable to indebtedness incurred or continued to acquire, construct, or carry the factory addition. Under former section 189, X has cumulative construction expenditures for 1986 equal to the $500,000 progress payment to Y on July 1, 1986, plus X's $500,000 basis in the land allocable to the factory addition, for a total of $1,000,000. Therefore, beginning on July 1, 1986, $1,000,000 of the total bond principal is treated as indebtedness incurred or continued to acquire the factory addition. Because this $1,000,000 portion of the bond principal accrued interest expense for 6 months at an annual rate of 7 percent, X is required to capitalize interest expense of $35,000 for 1986 without an offsetting reduction for the amount of interest income earned on the short-term investments.

Situation (2)

X is required to capitalize under section 263A(f) of the Code interest paid or incurred on indebtedness allocable to accumulated production expenditures for the factory addition. Under section 1.263A-1T(b)(2)(iv)(C) of the temporary regulations and Notice 88- 99, X is treated as producing the factory addition to the extent of progress payments that are made to Y and costs incurred directly by X. Under section 263A(f), X has cumulative construction expenditures for 1988 equal to the x $500,000 progress payment to Y on July 1, 1988, plus X's $500,000 basis in the land allocable to the factory addition, for a total of $1,000,000. Therefore, beginning on July 1, 1988, $1,000,000 of the total bond principal is allocable to the production of property subject to section 263A(f). (As described in Notice 88-99, the remaining $4,000,000 of bond principal is treated as avoided cost debt to the extent that X has production expenditures for other activities that are subject to section 263A(f).) Because this $1,000,000 portion of the bond principal accrued interest expense for 6 months at an annual rate of 7 percent, X is required to capitalize interest expense of $35,000 for 1988 without a reduction for the amount of interest income earned on the short-term investments.

APPLICATION

A change to the method of capitalizing interest described in the holding of this revenue ruling is a change in method of accounting to which sections 446(e) and 481 of the Code and the related regulations apply. Accordingly, taxpayers who netted interest income and interest expense in determining the amount of interest capitalized under former section 189 or section 263A(f) are required to change their method of accounting to the extent that the net amount of interest previously capitalized has not been recovered through amortization, depreciation, or cost of goods sold. This change in method of accounting must be made in accordance with the requirements of Rev. Proc. 84-74, 1984-2 C.B. 736. Accordingly, taxpayers must file Form 3115 (Application for Change in Accounting Method) with the National Office within 180 days after the beginning of the year for which the change is requested. Moreover, with respect to this change in method of accounting, this ruling is identified as a designated ruling pursuant to section 5.12(2) of Rev. Proc. 84- 74.

DRAFTING INFORMATION

The principal author of this revenue ruling is Carol Conjura of the Office of Assistant Chief Counsel (Income Tax and Accounting). For further information regarding this revenue ruling, contact Ms. Conjura on (202) 535-9363 (not a toll-free call).

Rev. Rul. 90-40, 1990-1 C.B. 52, 1990-18 I.R.B. 5.