[Federal Register Volume 62, Number 150 (Tuesday, August 5, 1997)]
[Rules and Regulations]
[Pages 42051-42062]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-20530]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8728]
RIN 1545-AQ94


Procedure for Changing a Method of Accounting Under Section 263A

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final and temporary regulations.

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SUMMARY: This document contains final regulations relating to the 
requirements for changing a method of accounting for costs subject to 
section 263A. The regulations provide guidance regarding changes in 
method of accounting for costs incurred in producing property and 
acquiring property for resale. The regulations affect taxpayers 
changing their method of accounting for costs subject to section 263A.

DATES: These regulations are effective August 5, 1997.

FOR FURTHER INFORMATION CONTACT: Cheryl Lynn Oseekey, (202) 622-4970 
(not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    On March 30, 1987 and August 7, 1987, temporary regulations under 
section 263A were published in the Federal Register (TD 8131, 52 FR 
10052 and TD 8148, 52 FR 29375), and cross-referenced to notices of 
proposed rulemaking published in the Federal Register on the same date 
(52 FR 10118 and 52 FR 29391). The temporary regulations contain rules 
for taxpayers changing their method of accounting to comply with the 
capitalization rules of section 263A. A public hearing on these 
temporary and proposed regulations was held on December 7, 1987.
    On August 9, 1993, final regulations under section 263A were 
published in the Federal Register (TD 8482, 58 FR 42198). These final 
regulations did not address the accounting method provisions in the 
1987 temporary regulations, which continued in effect. On August 5, 
1994, final and temporary regulations were published in the Federal 
Register (TD 8559, 59 FR 39958). These final regulations address ``pick 
and pack costs'' and other expenses. The August 5, 1994 temporary 
regulations renumbered the accounting method provisions in the 1987 
temporary regulations from Sec. 1.263A-1T(e) to Sec. 1.263A-7T.
    This document adopts, with modifications, Sec. 1.263A-7T as final 
regulations.

Explanation of Provisions

    In 1987, the IRS and the Treasury Department issued temporary 
regulations that provide guidance to taxpayers changing their method of 
accounting to comply with the capitalization rules of section 263A. The 
regulations provide automatic consent for taxpayers required to change 
their method of accounting for the first taxable year section 263A was 
effective.
    Subsequent to promulgation of the 1987 temporary regulations, the 
IRS and the Treasury Department issued various revenue procedures that 
set forth rules and procedures applicable to certain changes in method 
of accounting for costs subject to section 263A for which taxpayers can 
obtain automatic consent. These revenue procedures provide automatic 
consent to change the method of accounting in years other than the 
first taxable year section 263A was effective. Where automatic consent 
is not available by revenue procedure, taxpayers can obtain the 
Commissioner's consent to change a method of accounting for costs 
subject to section 263A under Rev. Proc. 97-27 (1997-21 I.R.B. 10).
    Rev. Proc. 97-27 and the automatic change revenue procedures 
describe how a change in method of accounting may be effected, but they 
do not describe how inventory and other property on hand at the 
beginning of the year of change should be revalued. These final 
regulations provide guidance regarding how taxpayers must revalue 
property in connection with a change in method of accounting for costs 
subject to section 263A. The revaluation rules for inventory are 
substantially similar to the revaluation rules contained in the 1987 
temporary

[[Page 42052]]

regulations. Section 1.263A-7(c) provides guidance regarding how items 
or costs included in beginning inventory in the year of change must be 
revalued. Section 1.263A-7(d) provides guidance regarding how non-
inventory property on hand at the beginning of the year of change must 
be revalued.
    The regulations also provide certain rules that apply to changes in 
method of accounting for costs subject to section 263A, in addition to 
the rules and procedures that apply under the applicable revenue 
procedures. See, Sec. 1.263A-7(b).
    In addition, the regulations clarify whether certain changes are 
changes in method of accounting under section 263A and therefore are 
within the scope of the regulations. For example, a change from one 
permissible capitalization method, such as the simplified resale method 
in former Sec. 1.263A-1T(d)(4), to another permissible capitalization 
method, such as the simplified resale method in Sec. 1.263A-3(d), is a 
change in method of accounting under section 263A and is therefore 
within the scope of the regulations. See Sec. 1.263A-7(a)(5).
    The final regulations delete certain provisions of Sec. 1.263A-7T 
that were primarily applicable to accounting method changes made in 
1987. For example, the final regulations do not incorporate provisions 
such as Sec. 1.263A-7T(e)(2), which provide automatic consent to make 
the change in method of accounting for the first taxable year section 
263A was effective, and Sec. 1.263A-7T(e)(7) (iii), (iv) and (v) and 
Sec. 1.263A-7T(e)(8), which provide special rules for adjusting the 
revaluation factor for costs attributable to different methods of 
accounting for depreciation (including cost recovery) and differences 
in the percentage of fixed indirect production costs that were expensed 
by taxpayers using the practical capacity concept.

Certain Administrative Guidance

    The final regulations incorporate the provisions of Notice 88-23 
(1988-1 C.B. 490) (ordering rules for accounting method changes), and 
sections IV(A) (guidance regarding deferred intercompany exchanges) and 
IV(B) (permission to elect a new base year for taxpayers using the 
last-in, first-out (LIFO) inventory method) of Notice 88-86 (1988-2 
C.B. 401). These notices or portions thereof are withdrawn for taxable 
years to which this Treasury decision applies.

Effect on Other Documents

    The following publications are obsolete as of August 5, 1997: 
Notice 88-23 (1988-1 C.B. 490). Notice 88-86 (1988-2 C.B. 401), 
sections IV(A) and IV(B).

Public Comments

    The IRS and the Treasury Department received a number of comments 
in response to the 1987 temporary and proposed regulations. Most of the 
comments received in response to the temporary regulations issued in 
March 1987 were considered in connection with the temporary regulations 
issued in August 1987. In general, those comments are not discussed 
again here.

Revaluing Beginning Inventory--the 3-Year Average Method

A. Extending Availability of the Method

    Under the temporary regulations, taxpayers using the dollar-value 
LIFO inventory method were permitted to use a 3-year average method for 
revaluing their beginning inventory in the year they changed their 
method of accounting to comply with section 263A. Several commentators 
suggested that taxpayers other than those on the dollar-value LIFO 
inventory method should also be permitted to use this 3-year average 
method for revaluing beginning inventory in the year of change. 
Specifically, commentators suggested that the 3-year average method be 
made available to taxpayers using the specific goods LIFO inventory 
method. Another suggestion was that taxpayers using the first-in, 
first-out (FIFO) inventory method should be permitted to use the 3-year 
average method even though those taxpayers may have sufficient 
information to revalue their inventory under the facts and 
circumstances method.
    The final regulations do not adopt these suggestions. The House and 
Senate Reports to the Tax Reform Act of 1986 indicate Congress intended 
that taxpayers generally revalue their inventory in the year of change 
using the facts and circumstances method. Because Congress realized 
that dollar-value LIFO taxpayers may not have the data needed to use 
the facts and circumstances method, it suggested two other revaluation 
methods that could be used in conjunction with, or in lieu of, the 
facts and circumstances method. The 3-year average method was one of 
those other methods. H.R. Rep. No. 426, 99th Cong., 1st Sess. 633-637 
(1985), 1986-3 (Vol. 2) C.B. 633-637 and S. Rep. No. 313, 99th Cong., 
2nd Sess. 147-152 (1986), 1986-3 (Vol. 3) C.B. 147-152. The IRS and the 
Treasury Department believe that limiting the 3-year average method to 
dollar-value LIFO taxpayers is more consistent with legislative history 
which expresses Congress' concern that dollar-value LIFO taxpayers may 
have particular problems in revaluing inventory. H.R. Rep. No. 426, 
633, 1986-3 (Vol. 2) C.B. 633 and S. Rep. No. 313, 147, 1986-3 (Vol.3) 
C.B. 147.

B. Altering the Mechanics of the Method

    One commentator suggested that taxpayers be permitted to revalue 
items or costs included in beginning inventory in the year of change by 
using data from the year of change instead of data from the prior three 
years, and calculate a section 481(a) adjustment accordingly. This 
commentator further suggested that three years after the year of 
change, the taxpayer would recompute the section 481(a) adjustment 
using data from the three new years to test its original adjustment 
under section 481(a). If the new adjustment were larger than the 
original adjustment by a substantial amount, the taxpayer would be 
required to amend its federal income tax returns. The final regulations 
do not adopt this suggestion. Requiring taxpayers to compute two 
adjustments under section 481(a) would unnecessarily complicate 
application of the 3-year average method.
    Another commentator suggested that some taxpayers be permitted to 
revalue items or costs included in beginning inventory in the year of 
change by using data from the immediately preceding year rather than 
the prior three years. This proposal to use only the prior year's data 
would be limited to taxpayers that can show they have not had a 
significant change in costs over the preceding three years. This 
suggested modification to the 3-year average method was not adopted. 
The suggested modification would not substantially simplify the process 
of revaluing beginning inventory because taxpayers would be required to 
determine whether their costs significantly changed during the 
preceding three-year period.

C. Limiting Costs Subject to Revaluation

    One commentator suggested that LIFO layers should be revalued only 
if the items of inventory comprising those layers are still in 
existence in the year of change. This suggestion was not adopted. 
However, the final regulations continue the rule in the temporary 
regulations that taxpayers may adjust the revaluation factor (under 
either the 3-year average method or the weighted average method) to the 
extent they can show that additional section 263A costs included in the 
calculation of the revaluation factor were not incurred in

[[Page 42053]]

the prior years in which the LIFO layers were accumulated.

D. New Base Year

    Under the 3-year average method, taxpayers generally are required 
to establish a new base year. Several commentators commented that 
requiring link-chain LIFO taxpayers to establish a new base year is 
costly and pointless and suggested that these taxpayers be excluded 
from the general requirement that all dollar-value LIFO taxpayers 
establish a new base year. The IRS and the Treasury Department did not 
adopt this suggestion. If a new base year is not established, the 
current-year index, determined under the taxpayer's new method of 
accounting, would be multiplied by the prior-year cumulative index, 
determined under the taxpayer's former method of accounting, and could 
distort the taxpayer's LIFO inventory valuation. This distortion is 
eliminated when the taxpayer establishes a new base year and 
establishes a new index. Accordingly, the final regulations provide 
that all dollar-value LIFO taxpayers (whether using double extension or 
link-chain) should generally establish a new base year when they use 
the 3-year average method to revalue their inventories under section 
263A.
    Commentators also suggested that taxpayers using the 3-year average 
method and either the simplified production method or the simplified 
resale method be allowed, but not required, to establish a new base 
year. Section IV(B) of Notice 88-86 permits these taxpayers to choose 
whether to establish a new base year. This rule is incorporated into 
the final regulations.
    One commentator noted that the example in the 1987 temporary 
regulations illustrating the 3-year average method did not use the 
current year revaluation factor in computing the updated base year cost 
of inventory. The example has been revised to use the current year 
revaluation factor.

Revaluing Beginning Inventory--Facts and Circumstances Method

    One commentator suggested that specific rules or guidelines be 
adopted to clarify what is a reasonable estimate or procedure for 
revaluing beginning inventory in connection with a change in method of 
accounting. This suggestion was not adopted. What is a reasonable 
estimate or procedure must be decided on a case-by-case basis in light 
of all applicable facts and circumstances. The final regulations 
continue the provision in the temporary regulations that permissible 
estimates and procedures include using information from a more recent 
period to estimate the amount and nature of inventory costs applicable 
to earlier periods, and using information with respect to comparable 
items of inventory to estimate the costs associated with other items of 
inventory.

New Base Year When the 3-Year Average Method Is Not Used

    Several commentators suggested that dollar-value LIFO taxpayers not 
using the 3-year average method to revalue beginning inventory be 
permitted to update their base year if they so choose. Section IV (B) 
of Notice 88-86 permits these taxpayers to establish a new base year. 
The final regulations adopt this rule.

Scope of Accounting Method Change

    Several commentators suggested that the regulations should allow 
taxpayers to change from the specific goods LIFO inventory method to 
the dollar-value LIFO inventory method in connection with changing 
their method of accounting for costs under section 263A without 
obtaining the Commissioner's consent. Generally, taxpayers must secure 
the Commissioner's consent before effecting a change in method of 
accounting under section 446(e) unless this requirement is specifically 
waived. The IRS and the Treasury Department do not believe an exception 
from this general rule is warranted for changes from the specific goods 
LIFO inventory method to the dollar-value LIFO inventory method except 
to the extent permitted by Sec. 1.472-8(f)(1).
    Several commentators also suggested that taxpayers that change 
their method of accounting for costs subject to section 263A be 
permitted to make additional changes in their methods of accounting in 
future tax years under section 263A without obtaining additional 
consents from the Commissioner. The IRS and the Treasury Department 
have issued various revenue procedures that provide automatic consent 
procedures for taxpayers to change their method of accounting for costs 
under section 263A.
    One commentator suggested that the regulations provide that when 
making the change from the full absorption rules of Sec. 1.471-11 to 
the uniform capitalization rules of section 263A, taxpayers may cease 
taking into account any costs not treated as inventoriable under 
section 263A that may have been erroneously inventoried under prior 
law. The temporary regulations issued in August 1987 and the final 
regulations permit this result. In revaluing beginning inventory to 
include additional section 263A costs, taxpayers may cease capitalizing 
costs that had been capitalized but are not required to be capitalized 
under section 263A.

Audit Protection

    Several commentators noted that taxpayers should be guaranteed 
audit protection for costs or items that are part of a change in method 
of accounting under section 263A. The IRS' long-standing administrative 
position is that if a taxpayer files an application to change its 
method of accounting in accordance with the applicable administrative 
guidance, for example, Rev. Proc. 97-27, an examining agent may not 
later propose that the taxpayer change its method of accounting for the 
same item for a taxable year prior to the year of change.

Ordering Rules

    One commentator suggested that overall accounting method changes 
(for example, the cash receipts and disbursements method to an accrual 
method) should be implemented prior to any change in method of 
accounting for costs under section 263A. The temporary regulations 
generally provide that a change in method of accounting for costs under 
section 263A is deemed to occur prior to any other change in method of 
accounting effected during the year of change. The final regulations 
continue that general rule with four modifications. Taxpayers that are 
discontinuing the LIFO inventory method may make that change prior to a 
change in method of accounting under section 263A. Additionally, 
taxpayers that are changing from the specific goods LIFO inventory 
method to the dollar-value LIFO inventory method may make that change 
prior to a change in method of accounting under section 263A. Also, 
taxpayers that are changing their overall method of accounting from the 
cash method to an accrual method must make the change to an accrual 
method prior to a change in method of accounting under section 263A. 
Finally, taxpayers that are changing their method of accounting for 
depreciation when any portion of the depreciation is subject to section 
263A must make the method change for depreciation prior to a change in 
method of accounting under section 263A.

Cost Allocation Method

    Several commentators suggested that the regulations be clarified to 
provide that a taxpayer must use the same cost allocation method to 
restate its beginning inventory and to value its ongoing inventory. The 
final regulations clarify this point. Inventory on hand at

[[Page 42054]]

the beginning of the year of change is revalued as if the taxpayer's 
new method had applied to all prior periods. The same cost allocation 
method must be used both retroactively (for purposes of restating 
beginning inventory) and prospectively (for purposes of the current 
year and all subsequent years, unless the taxpayer seeks specific 
consent from the Commissioner to change this method of accounting).

Intercompany Items

    One commentator suggested that taxpayers be given automatic consent 
to discontinue filing consolidated federal income tax returns so that 
they could avoid the need to revalue the amount of intercompany items 
resulting from the sale or exchange of inventory property in 
intercompany transactions. The regulations do not adopt this 
suggestion. Generally, taxpayers must secure the Commissioner's consent 
before discontinuing the filing of consolidated tax returns. The IRS 
and the Treasury Department do not think an exception from this general 
rule is warranted in this situation.

Effective Date

    These regulations are effective for taxable years beginning on or 
after August 5, 1997.

Special Analyses

    It has been determined that this Treasury decision 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, and because the notice of proposed 
rulemaking preceding the regulations was issued prior to March 29, 
1996, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these 
regulations were submitted to the Small Business Administration for 
comment on their impact on small business.

Drafting Information

    The principal author of these regulations is Cheryl Lynn Oseekey, 
Office of Assistant Chief Counsel (Income Tax and Accounting). However, 
other personnel from the IRS and the Treasury Department participated 
in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.263A-0 is amended by revising the introductory 
text and adding entries for Sec. 1.263A-7 to read as follows:


Sec. 1.263A-0  Outline of regulations under section 263A.

    This section lists the paragraphs in Secs. 1.263A-1 through 1.263A-
3 and Sec. 1.263A-7 through 1.263A-15.
* * * * *


Sec. 1.263A-7  Changing a method of accounting under section 263A.

    (a) Introduction.
    (1) Purpose.
    (2) Taxpayers that adopt a method of accounting under section 263A.
    (3) Taxpayers that change a method of accounting under section 
263A.
    (4) Effective date.
    (5) Definition of change in method of accounting.
    (b) Rules applicable to a change in method of accounting.
    (1) General rules.
    (2) Special rules.
    (i) Ordering rules when multiple changes in method of accounting 
occur in the year of change.
    (A) In general.
    (B) Exceptions to the general ordering rule.
    (1) Change from the LIFO inventory method.
    (2) Change from the specific goods LIFO inventory method.
    (3) Change in overall method of accounting.
    (4) Change in method of accounting for depreciation.
    (ii) Adjustment required by section 481(a).
    (iii) Base year.
    (A) Need for a new base year.
    (1) Facts and circumstances revaluation method used.
    (2) 3-year average method used.
    (i) Simplified method not used.
    (ii) Simplified method used.
    (B) Computing a new base year.
    (c) Inventory
    (1) Need for adjustments.
    (2) Revaluing beginning inventory.
    (i) In general.
    (ii) Methods to revalue inventory.
    (iii) Facts and circumstances revaluation method.
    (A) In general.
    (B) Exception.
    (C) Estimates and procedures allowed.
    (D) Use by dollar-value LIFO taxpayers.
    (E) Examples.
    (iv) Weighted average method.
    (A) In general.
    (B) Weighted average method for FIFO taxpayers.
    (1) In general.
    (2) Example.
    (C) Weighted average method for specific goods LIFO taxpayers.
    (1) In general.
    (2) Example.
    (D) Adjustments to inventory costs from prior years.
    (v) 3-year average method.
    (A) In general.
    (B) Consecutive year requirement.
    (C) Example.
    (D) Short taxable years.
    (E) Adjustments to inventory costs from prior years.
    (1) General rule.
    (2) Examples of costs eligible for restatement adjustment 
procedure.
    (F) Restatement adjustment procedure.
    (1) In general.
    (2) Examples of restatement adjustment procedure.
    (3) Intercompany items.
    (i) Revaluing intercompany transactions.
    (ii) Example.
    (iii) Availability of revaluation methods.
    (4) Anti-abuse rule.
    (i) In general.
    (ii) Deemed avoidance of this section.
    (A) Scope.
    (B) General rule.
    (iii) Election to use transferor's LIFO layers.
    (iv) Tax avoidance intent not required.
    (v) Related corporation.
    (d) Non-inventory property.
    (1) Need for adjustments.
    (2) Revaluing property.


Sec. 1.263A-1  [Amended]

    Par. 3. Section 1.263A-1 is amended by removing ``1.263A-7T(e) 
generally'' from the last sentence in paragraph (a)(2)(i) and replacing 
it with ``1.263A-7''.
    Par. 4. Section 1.263A-7 is added to read as follows:


Sec. 1.263A-7  Changing a method of accounting under section 263A.

    (a) Introduction--(1) Purpose. These regulations provide guidance 
to taxpayers changing their methods of accounting for costs subject to 
section 263A. The principal purpose of these

[[Page 42055]]

regulations is to provide guidance regarding how taxpayers are to 
revalue property on hand at the beginning of the taxable year in which 
they change their method of accounting for costs subject to section 
263A. Paragraph (c) of this section provides guidance regarding how 
items or costs included in beginning inventory in the year of change 
must be revalued. Paragraph (d) of this section provides guidance 
regarding how non-inventory property should be revalued in the year of 
change.
    (2) Taxpayers that adopt a method of accounting under section 263A. 
Taxpayers may adopt a method of accounting for costs subject to section 
263A in the first taxable year in which they engage in resale or 
production activities. For purposes of this section, the adoption of a 
method of accounting has the same meaning as provided in Sec. 1.446-
1(e)(1). Taxpayers are not subject to the provisions of these 
regulations to the extent they adopt, as opposed to change, a method of 
accounting.
    (3) Taxpayers that change a method of accounting under section 
263A. Taxpayers changing their method of accounting for costs subject 
to section 263A are subject to the revaluation and other provisions of 
this section. Taxpayers subject to these regulations include, but are 
not limited to--
    (i) Resellers of personal property whose average annual gross 
receipts for the immediately preceding 3-year period (or lesser period 
if the taxpayer was not in existence for the three preceding taxable 
years) exceed $10,000,000 where the taxpayer was not subject to section 
263A in the prior taxable year;
    (ii) Resellers of real or personal property that are using a method 
that fails to comply with section 263A and desire to change to a method 
of accounting that complies with section 263A;
    (iii) Producers of real or tangible personal property that are 
using a method that fails to comply with section 263A and desire to 
change to a method of accounting that complies with section 263A; and
    (iv) Resellers and producers that desire to change from one 
permissible method of accounting for costs subject to section 263A to 
another permissible method.
    (4) Effective date. The provisions of this section are effective 
for taxable years beginning on or after August 5, 1997. For taxable 
years beginning before August 5, 1997, the rules of Sec. 1.263A-7T 
contained in the 26 CFR part 1 edition revised as of April 1, 1997, as 
modified by other administrative guidance, will apply.
    (5) Definition of change in method of accounting. For purposes of 
this section, a change in method of accounting has the same meaning as 
provided in Sec. 1.446-1(e)(2)(ii). Changes in method of accounting for 
costs subject to section 263A include changes to methods required or 
permitted by section 263A and the regulations thereunder. Changes in 
method of accounting may be described in the preceding sentence 
irrespective of whether the taxpayer's previous method of accounting 
resulted in the capitalization of more (or fewer) costs than the costs 
required to be capitalized under section 263A and the regulations 
thereunder, and irrespective of whether the taxpayer's previous method 
of accounting was a permissible method under the law in effect when the 
method was being used. However, changes in method of accounting for 
costs subject to section 263A do not include changes relating to 
factors other than those described therein. For example, a change in 
method of accounting for costs subject to section 263A does not include 
a change from one inventory identification method to another inventory 
identification method, such as a change from the last-in, first-out 
(LIFO) method to the first-in, first-out (FIFO) method, or vice versa, 
or a change from one inventory valuation method to another inventory 
valuation method under section 471, such as a change from valuing 
inventory at cost to valuing the inventory at cost or market, whichever 
is lower, or vice versa. In addition, a change in method of accounting 
for costs subject to section 263A does not include a change within the 
LIFO inventory method, such as a change from the double extension 
method to the link-chain method, or a change in the method used for 
determining the number of pools. Further, a change from the modified 
resale method set forth in Notice 89-67 (1989-1 C.B. 723), see 
Sec. 601.601(d)(2) of this chapter, to the simplified resale method set 
forth in Sec. 1.263A-3(d) is not a change in method of accounting 
within the meaning of Sec. 1.446-1(e)(2)(ii) and is therefore not 
subject to the provisions of this section. However, a change from the 
simplified resale method set forth in former Sec. 1.263A-1T(d)(4) to 
the simplified resale method set forth in Sec. 1.263A-3(d) is a change 
in method of accounting within the meaning of Sec. 1.446-1(e)(2)(ii) 
and is subject to the provisions of this section.
    (b) Rules applicable to a change in method of accounting--
    (1) General rules. All changes in method of accounting for costs 
subject to section 263A are subject to the rules and procedures 
provided by the Code, regulations, and administrative procedures 
applicable to such changes. The Internal Revenue Service has issued 
specific revenue procedures that govern certain accounting method 
changes for costs subject to section 263A. Where a specific revenue 
procedure is not applicable, changes in method of accounting for costs 
subject to section 263A are subject to the same rules and procedures 
that govern other accounting method changes. See Rev. Proc. 97-27 
(1997-21 I.R.B. 10) and Sec. 601.601(d)(2) of this chapter.
    (2) Special rules--(i) Ordering rules when multiple changes in 
method of accounting occur in the year of change.
    (A) In general. A change in method of accounting for costs subject 
to section 263A is generally deemed to occur (including the computation 
of the adjustment under section 481(a)) before any other change in 
method of accounting is deemed to occur for that same taxable year.
    (B) Exceptions to the general ordering rule--(1) Change from the 
LIFO inventory method. In the case of a taxpayer that is discontinuing 
its use of the LIFO inventory method in the same taxable year it is 
changing its method of accounting for costs subject to section 263A, 
the change from the LIFO method may be made before the change in method 
of accounting (and the computation of the corresponding adjustment 
under section 481 (a)) under section 263A is made.
    (2) Change from the specific goods LIFO inventory method. In the 
case of a taxpayer that is changing from the specific goods LIFO 
inventory method to the dollar-value LIFO inventory method in the same 
taxable year it is changing its method of accounting for costs subject 
to section 263A, the change from the specific goods LIFO inventory 
method may be made before the change in method of accounting under 
section 263A is made.
    (3) Change in overall method of accounting. In the case of a 
taxpayer that is changing its overall method of accounting from the 
cash receipts and disbursements method to an accrual method in the same 
taxable year it is changing its method of accounting for costs subject 
to section 263A, the taxpayer must change to an accrual method for 
capitalizable costs (see Sec. 1.263A-1(c)(2)(ii)) before the change in 
method of accounting (and the computation of the corresponding 
adjustment under section 481(a)) under section 263A is made.
    (4) Change in method of accounting for depreciation. In the case of 
a

[[Page 42056]]

taxpayer that is changing its method of accounting for depreciation in 
the same taxable year it is changing its method of accounting for costs 
subject to section 263A and any portion of the depreciation is subject 
to section 263A, the change in method of accounting for depreciation 
must be made before the change in method of accounting (and the 
computation of the corresponding adjustment under section 481(a)) under 
section 263A is made.
    (ii) Adjustment required by section 481(a). In the case of any 
taxpayer required or permitted to change its method of accounting for 
any taxable year under section 263A and the regulations thereunder, the 
change will be treated as initiated by the taxpayer for purposes of the 
adjustment required by section 481(a). The adjustment required by 
section 481(a) is to be taken into account in computing taxable income 
over a period not to exceed 4 taxable years.
    (iii) Base year--(A) Need for a new base year. Certain dollar-value 
LIFO taxpayers (whether using double extension or link-chain) must 
establish a new base year when they revalue their inventories under 
section 263A.
    (1) Facts and circumstances revaluation method used. A dollar-value 
LIFO taxpayer that uses the facts and circumstances revaluation method 
is permitted, but not required, to establish a new base year.
    (2) 3-year average method used--(i) Simplified method not used. A 
dollar-value LIFO taxpayer using the 3-year average method but not the 
simplified production method or the simplified resale method to revalue 
its inventory is required to establish a new base year.
    (ii) Simplified method used. A dollar-value LIFO taxpayer using the 
3-year average method and either the simplified production method or 
the simplified resale method to revalue its inventory is permitted, but 
not required, to establish a new base year.
    (B) Computing a new base year. For purposes of determining future 
indexes, the year of change becomes the new base year (that is, the 
index at the beginning of the year of change generally must be 1.00) 
and all costs are restated in new base year costs for purposes of 
extending such costs in future years. However, when a new base year is 
established, costs associated with old layers retain their separate 
identity within the base year, with such layers being restated in terms 
of the new base year index. For example, for purposes of determining 
whether a particular layer has been invaded, each layer must retain its 
separate identity. Thus, if a decrement in an inventory pool occurs, 
layers accumulated in more recent years must be viewed as invaded 
first, in order of priority.
    (c) Inventory--(1) Need for adjustments. When a taxpayer changes 
its method of accounting for costs subject to section 263A, the 
taxpayer generally must, in computing its taxable income for the year 
of change, take into account the adjustments required by section 
481(a). The adjustments required by section 481(a) relate to 
revaluations of inventory property, whether the taxpayer produces the 
inventory or acquires it for resale. See paragraph (d) of this section 
in regard to the adjustments required by section 481(a) that relate to 
non-inventory property.
    (2) Revaluing beginning inventory--(i) In general. If a taxpayer 
changes its method of accounting for costs subject to section 263A, the 
taxpayer must revalue the items or costs included in its beginning 
inventory in the year of change as if the new method (that is, the 
method to which the taxpayer is changing) had been in effect during all 
prior years. In revaluing inventory costs under this procedure, all of 
the capitalization provisions of section 263A and the regulations 
thereunder apply to all inventory costs accumulated in prior years. The 
necessity to revalue beginning inventory as if these capitalization 
rules had been in effect for all prior years includes, for example, the 
revaluation of costs or layers incurred in taxable years preceding the 
transition period to the full absorption method of inventory costing as 
described in Sec. 1.471-11(e), regardless of whether a taxpayer 
employed a cut-off method under those regulations. The difference 
between the inventory as originally valued using the former method 
(that is, the method from which the taxpayer is changing) and the 
inventory as revalued using the new method is equal to the amount of 
the adjustment required under section 481(a).
    (ii) Methods to revalue inventory. There are three methods 
available to revalue inventory. The first method, the facts and 
circumstances revaluation method, may be used by all taxpayers. Under 
this method, a taxpayer determines the direct and indirect costs that 
must be assigned to each item of inventory based on all the facts and 
circumstances. This method is described in paragraph (c)(2)(iii) of 
this section. The second method, the weighted average method, is 
available only in certain situations to taxpayers using the FIFO 
inventory method or the specific goods LIFO inventory method. This 
method is described in paragraph (c)(2)(iv) of this section. The third 
method, the 3-year average method, is available to all taxpayers using 
the dollar-value LIFO inventory method of accounting. This method is 
described in paragraph (c)(2)(v) of this section. The weighted average 
method and the 3-year average method revalue inventory through 
processes of estimation and extrapolation, rather than based on the 
facts and circumstances of a particular year's data. All three methods 
are available regardless of whether the taxpayer elects to use a 
simplified method to capitalize costs under section 263A.
    (iii) Facts and circumstances revaluation method--(A) In general. 
Under the facts and circumstances revaluation method, a taxpayer 
generally is required to revalue inventories by applying the 
capitalization rules of section 263A and the regulations thereunder to 
the production and resale activities of the taxpayer, with the same 
degree of specificity as required of inventory manufacturers under the 
law immediately prior to the effective date of the Tax Reform Act of 
1986 (Pub. L. 99-514, 100 Stat. 2085, 1986-3 C.B. (Vol. 1)). Thus, for 
example, with respect to any prior year that is relevant in determining 
the total amount of the revalued balance as of the beginning of the 
year of change, the taxpayer must analyze the production and resale 
data for that particular year and apply the rules and principles of 
section 263A and the regulations thereunder to determine the 
appropriate revalued inventory costs. However, under the facts and 
circumstances revaluation method, a taxpayer may utilize reasonable 
estimates and procedures in valuing inventory costs if--
    (1) The taxpayer lacks, and is not able to reconstruct from its 
books and records, actual financial and accounting data which is 
required to apply the capitalization rules of section 263A and the 
regulations thereunder to the relevant facts and circumstances 
surrounding a particular item of inventory or cost; and
    (2) The total amounts of costs for which reasonable estimates and 
procedures are employed are not significant in comparison to the total 
restated value (including costs previously capitalized under the 
taxpayer's former method) of the items or costs for the period in 
question.
    (B) Exception. A taxpayer that is not able to comply with the 
requirement of paragraph (c)(2)(iii)(A)(2) of this section because of 
the existence of a significant amount of costs that would require the 
use of estimates and procedures must

[[Page 42057]]

revalue its inventories under the procedures provided in paragraph 
(c)(2)(iv) or (v) of this section.
    (C) Estimates and procedures allowed. The estimates and procedures 
of this paragraph (c)(2)(iii) include--
    (1) The use of available information from more recent years to 
estimate the amount and nature of inventory costs applicable to earlier 
years; and
    (2) The use of available information with respect to comparable 
items of inventory produced or acquired during the same year in order 
to estimate the costs associated with other items of inventory.
    (D) Use by dollar-value LIFO taxpayers. Generally, a dollar-value 
LIFO taxpayer must recompute its LIFO inventory for each taxable year 
that the LIFO inventory method was used.
    (E) Examples. The provisions of this paragraph (c)(2)(iii) are 
illustrated by the following three examples. The principles set forth 
in these examples are applicable both to production and resale 
activities and the year of change in all three examples is 1997. The 
examples read as follows:

    Example 1. Taxpayer X lacks information for the years 1993 and 
earlier, regarding the amount of costs incurred in transporting 
finished goods from X's factory to X's warehouse and in storing 
those goods at the warehouse until their sale to customers. X 
determines that, for 1994 and subsequent years, these transportation 
and storage costs constitute 4 percent of the total costs of 
comparable goods under X's method of accounting for such years. 
Under this paragraph (c)(2)(iii), X may assume that transportation 
and storage costs for the years 1993 and earlier constitute 4 
percent of the total costs of such goods.
    Example 2. Assume the same facts as in Example 1, except that 
for the year 1993 and earlier, X used a different method of 
accounting for inventory costs whereunder significantly fewer costs 
were capitalized than amounts capitalized in later years. Thus, the 
application of transportation and storage based on a percentage of 
costs for 1994 and later years would not constitute a reasonable 
estimate for use in earlier years. X may use the information from 
1994 and later years, if appropriate adjustments are made to reflect 
the differences in inventory costs for the applicable years, 
including, for example--
    (i) Increasing the percentage of costs that are intended to 
represent transportation and storage costs to reflect the aggregate 
differences in capitalized amounts under the two methods of 
accounting; or
    (ii) Taking the absolute dollar amount of transportation and 
storage costs for comparable goods in inventory and applying that 
amount (adjusted for changes in general price levels, where 
appropriate) to goods associated with 1993 and prior periods.
    Example 3. Taxpayer Z lacks information for certain years with 
respect to factory administrative costs, subject to capitalization 
under section 263A and the regulations thereunder, incurred in the 
production of inventory in factory A. Z does have sufficient 
information to determine factory administrative costs with respect 
to production of inventory in factory B, wherein inventory items 
were produced during the same years as factory A. Z may use the 
information from factory B to determine the appropriate amount of 
factory administrative costs to capitalize as inventory costs for 
comparable items produced in factory A during the same years.

    (iv) Weighted average method--(A) In general. A taxpayer using the 
FIFO method or the specific goods LIFO method of accounting for 
inventories may use the weighted average method as provided in this 
paragraph (c)(2)(iv) to estimate the change in the amount of costs that 
must be allocated to inventories for prior years. The weighted average 
method under this paragraph (c)(2)(iv) is only available to a taxpayer 
that lacks sufficient data to revalue its inventory costs under the 
facts and circumstances revaluation method provided for in paragraph 
(c)(2)(iii) of this section. Moreover, a taxpayer that qualifies for 
the use of the weighted average method under this paragraph (c)(2)(iv) 
must utilize such method only with respect to items or costs for which 
it lacks sufficient information to revalue under the facts and 
circumstances revaluation method. Particular items or costs must be 
revalued under the facts and circumstances revaluation method if 
sufficient information exists to make such a revaluation. If a taxpayer 
lacks sufficient information to otherwise apply the weighted average 
method under this paragraph (c)(2)(iv) (for example, the taxpayer is 
unable to revalue the costs of any of its items in inventory due to a 
lack of information), then the taxpayer must use reasonable estimates 
and procedures, as described in the facts and circumstances revaluation 
method, to whatever extent is necessary to allow the taxpayer to apply 
the weighted average method.
    (B) Weighted average method for FIFO taxpayers--(1) In general. 
This paragraph (c)(2)(iv)(B) sets forth the mechanics of the weighted 
average method as applicable to FIFO taxpayers. Under the weighted 
average method, an item in ending inventory for which sufficient data 
is not available for revaluation under section 263A and the regulations 
thereunder must be revalued by using the weighted average percentage 
increase or decrease with respect to such item for the earliest 
subsequent taxable year for which sufficient data is available. With 
respect to an item for which no subsequent data exists, such item must 
be revalued by using the weighted average percentage increase or 
decrease with respect to all reasonably comparable items in the 
taxpayer's inventory for the same year or the earliest subsequent 
taxable year for which sufficient data is available.
    (2) Example. The provisions of this paragraph (c)(2)(iv)(B) are 
illustrated by the following example. The principles set forth in this 
example are applicable both to production and resale activities and the 
year of change in the example is 1997. The example reads as follows:

    Example. Taxpayer A manufactures bolts and uses the FIFO method 
to identify inventories. Under A's former method, A did not 
capitalize all of the costs required to be capitalized under section 
263A. A maintains inventories of bolts, two types of which it no 
longer produces. Bolt A was last produced in 1994. The revaluation 
of the costs of Bolt A under this section for bolts produced in 1994 
results in a 20 percent increase of the costs of Bolt A. A portion 
of the inventory of Bolt A, however, is attributable to 1993. A does 
not have sufficient data for revaluation of the 1993 cost for Bolt 
A. With respect to Bolt A, A may apply the 20 percent increase 
determined for 1994 to the 1993 production as an acceptable 
estimate. Bolt B was last produced in 1992 and no data exists that 
would allow revaluation of the inventory cost of Bolt B. The 
inventories of all other bolts for which information is available 
are attributable to 1994 and 1995. Revaluation of the costs of these 
other bolts using available data results in an average increase in 
inventory costs of 15 percent for 1994 production. With respect to 
Bolt B, the overall 15 percent increase for A's inventory for 1994 
may be used in revaluing the cost of Bolt B.

    (C) Weighted average method for specific goods LIFO taxpayers--(1) 
In general. This paragraph (c)(2)(iv)(C) sets forth the mechanics of 
the weighted average method as applicable to LIFO taxpayers using the 
specific goods method of valuing inventories. Under the weighted 
average method, the inventory layers with respect to an item for which 
data is available are revalued under this section and the increase or 
decrease in amount for each layer is expressed as a percentage of 
change from the cost in the layer as originally valued. A weighted 
average of the percentage of change for all layers for each type of 
good is computed and applied to all earlier layers for each type of 
good that lack sufficient data to allow for revaluation. In the case of 
earlier layers for which sufficient data exists, such layers are to be 
revalued using actual data. In cases where sufficient data is not 
available to make a weighted average estimate with respect to a 
particular item of inventory, a weighted average increase or decrease 
is to be determined using all other inventory items revalued by the 
taxpayer in the

[[Page 42058]]

same specific goods grouping. This percentage increase or decrease is 
then used to revalue the cost of the item for which data is lacking. If 
the taxpayer lacks sufficient data to revalue any of the inventory 
items contained in a specific goods grouping, then the weighted average 
increase or decrease of substantially similar items (as determined by 
principles similar to the rules applicable to dollar-value LIFO 
taxpayers in Sec. 1.472-8(b)(3)) must be applied in the revaluation of 
the items in such grouping. If insufficient data exists with respect to 
all the items in a specific goods grouping and to all items that are 
substantially similar (or such items do not exist), then the weighted 
average for all revalued items in the taxpayer's inventory must be 
applied in revaluing items for which data is lacking.
    (2) Example. The provisions of this paragraph (c)(2)(iv)(C) are 
illustrated by the following example. The principles set forth in this 
example are applicable both to production and resale activities and the 
year of change in the example is 1997. The example reads as follows:

    Example. (i) Taxpayer M is a manufacturer that produces two 
different parts. Under M's former method, M did not capitalize all 
of the costs required to be capitalized under section 263A. Work-in-
process inventory is recorded in terms of equivalent units of 
finished goods. M's records show the following at the end of 1996 
under the specific goods LIFO inventory method:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Carrying   
                     LIFO Product and layer                           Number           Cost           values    
----------------------------------------------------------------------------------------------------------------
Product #1:                                                                                                     
    1993........................................................             150           $5.00            $750
    1994........................................................             100            6.00             600
    1995........................................................             100            6.50             650
    1996........................................................              50            7.00             350
                                                                 -----------------------------------------------
                                                                                                          $2,350
Product #2:                                                                                                     
    1993........................................................             200           $4.00            $800
    1994........................................................             200            4.50             900
    1995........................................................             100            5.00             500
    1996........................................................             100            6.00             600
                                                                 -----------------------------------------------
                                                                                                           2,800
                                                                 ===============================================
        Total carrying value of Products #1 and #2 under M's                                                    
         former method..........................................  ..............  ..............           5,150
----------------------------------------------------------------------------------------------------------------

    (ii) M has sufficient data to revalue the unit costs of Product 
#1 using its new method for 1994, 1995 and 1996. These costs are: 
$7.00 in 1994, $7.75 in 1995, and $9.00 in 1996. This data for 
Product #1 results in a weighted average percentage change of 20.31 
percent 
((100 x ($7.00-$6.00))+(100 x ($7.75-$6.50))+(50 x ($9.00-$7.00)) 
divided by (100 x $6.00) + (100 x $6.50) + (50 x $7.00)]. M has 
sufficient data to revalue the unit costs of Product #2 only in 1995 
and 1996. These costs are: $6.00 in 1995 and $7.00 in 1996. This 
data for Product #2 results in a weighted average percentage change 
of 18.18 percent [(100 x ($6.00-$5.00))+(100 x ($7.00-$6.00)) 
divided by (100 x $5.00)+(100 x $6.00)].
    (iii) M can estimate its revalued costs for Product #1 for 1993 
by applying the weighted average increase computed for Product #1 
(20.31 percent) to the unit costs originally carried on M's records 
for 1993 under M's former method. The estimated revalued unit cost 
of Product #1 would be $6.02 ($5.00 x 1.2031). M estimates its 
revalued costs for Product #2 for 1993 and 1994 in a similar 
fashion. M applies the weighted average increase determined for 
Product #2 (18.18 percent) to the unit costs of $4.00 and $4.50 for 
1993 and 1994 respectively. The revalued unit costs of Product #2 
are $4.73 for 1993 ($4.00 x 1.1818) and $5.32 for 1994 
($4.50 x 1.1818).
    (iv) M's inventory would be revalued as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                                     Carrying   
                     LIFO product and layer                           Number           Cost           values    
----------------------------------------------------------------------------------------------------------------
Product #1:                                                                                                     
    1993........................................................             150           $6.02            $903
    1994........................................................             100            7.00             700
    1995........................................................             100            7.75             775
    1996........................................................              50            9.00             450
                                                                 -----------------------------------------------
                                                                                                          $2,828
Product #2:                                                                                                     
    1993........................................................             200            4.73             946
    1994........................................................             200            5.32           1,064
    1995........................................................             100            6.00             600
    1996........................................................             100            7.00             700
                                                                 -----------------------------------------------
                                                                                                           3,310
        Total value of Products #1 and #2 as revalued under M's                                                 
         new method.............................................  ..............  ..............           6,138
                                                                                                 ===============
        Total amount of adjustment required under section 481(a)                                                
         [$6,138-$5,150]........................................  ..............  ..............             988
----------------------------------------------------------------------------------------------------------------

    (D) Adjustments to inventory costs from prior years. For special 
rules applicable when a revaluation using the weighted average method 
includes costs not incurred in prior years, see paragraph (c)(2)(v)(E) 
of this section.
    (v) 3-year average method--(A) In general. A taxpayer using the 
dollar-value LIFO method of accounting for inventories may revalue all 
existing LIFO layers of a trade or business based on the 3-year average 
method as

[[Page 42059]]

provided in this paragraph (c)(2)(v). The 3-year average method is 
based on the average percentage change (the 3-year revaluation factor) 
in the current costs of inventory for each LIFO pool based on the three 
most recent taxable years for which the taxpayer has sufficient 
information (typically, the three most recent taxable years of such 
trade or business). The 3-year revaluation factor is applied to all 
layers for each pool in beginning inventory in the year of change. The 
3-year average method is available to any dollar-value taxpayer that 
complies with the requirements of this paragraph (c)(2)(v) regardless 
of whether such taxpayer lacks sufficient data to revalue its inventory 
costs under the facts and circumstances revaluation method prescribed 
in paragraph (c)(2)(iii) of this section. The 3-year average method 
must be applied with respect to all inventory in a taxpayer's trade or 
business. A taxpayer is not permitted to apply the method for the 
revaluation of some, but not all, inventory costs on the basis of 
pools, business units, or other measures of inventory amounts that do 
not constitute a separate trade or business. Generally, a taxpayer 
revaluing its inventory using the 3-year average method must establish 
a new base year. See, paragraph (b)(2)(iii)(A)(2)(i) of this section. 
However, a dollar-value LIFO taxpayer using the 3-year average method 
and either the simplified production method or the simplified resale 
method to revalue its inventory is permitted, but not required, to 
establish a new base year. See, paragraph (b)(2)(iii)(A)(2)(ii) of this 
section. If a taxpayer lacks sufficient information to otherwise apply 
the 3-year average method under this paragraph (c)(2)(v) (for example, 
the taxpayer is unable to revalue the costs of any of its LIFO pools 
for three years due to a lack of information), then the taxpayer must 
use reasonable estimates and procedures, as described in the facts and 
circumstances revaluation method under paragraph (c)(2)(iii) of this 
section, to whatever extent is necessary to allow the taxpayer to apply 
the 3-year average method.
    (B) Consecutive year requirement. Under the 3-year average method, 
if sufficient data is available to calculate the revaluation factor for 
more than three years, the taxpayer may use data from such additional 
years in determining the average percentage increase or decrease only 
if the additional years are consecutive to and prior to the year of 
change. The requirement under the preceding sentence to use consecutive 
years is applicable under this method regardless of whether any 
inventory costs in beginning inventory as of the year of change are 
viewed as incurred in, or attributable to, those consecutive years 
under the LIFO inventory method. Thus, the requirement to use data from 
consecutive years may result in using information from a year in which 
no LIFO increment occurred. For example, if a taxpayer is changing its 
method of accounting in 1997 and has sufficient data to revalue its 
inventory for the years 1991 through 1996, the taxpayer may calculate 
the revaluation factor using all six years. If, however, the taxpayer 
has sufficient data to revalue its inventory for the years 1990 through 
1992, and 1994 through 1996, only the three years consecutive to the 
year of change, that is, 1994 through 1996, may be used in determining 
the revaluation factor. Similarly, for example, a taxpayer with LIFO 
increments in 1995, 1993, and 1992 may not calculate the revaluation 
factor based on the data from those years alone, but instead must use 
the data from consecutive years for which the taxpayer has information.
    (C) Example. The provisions of this paragraph (c)(2)(v) are 
illustrated by the following example. The principles set forth in this 
example are applicable both to production and resale activities and the 
year of change in the example is 1997. The example reads as follows:

    Example. (i) Taxpayer G, a calendar year taxpayer, is a reseller 
that is required to change its method of accounting under section 
263A. G will not use either the simplified production method or the 
simplified resale method. G adopted the dollar-value LIFO inventory 
method in 1991, using a single pool and the double extension method. 
G's beginning LIFO inventory as of January 1, 1997, computed using 
its former method, for the year of change is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                     Base year                     LIFO carrying
                                                                       costs           Index           value    
----------------------------------------------------------------------------------------------------------------
Base layer                                                               $14,000            1.00         $14,000
1991 layer......................................................           4,000            1.20           4,800
1992 layer......................................................           5,000            1.30           6,500
1993 layer......................................................           2,000            1.35           2,700
1994 layer......................................................               0            1.40               0
1995 layer......................................................           4,000            1.50           6,000
1996 layer......................................................           5,000            1.60           8,000
                                                                 -----------------------------------------------
    Total.......................................................          34,000  ..............          42,000
----------------------------------------------------------------------------------------------------------------

    (ii) G is able to recompute total inventoriable costs incurred 
under its new method for the three preceding taxable years as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                   Current cost                                 
                                                                    as recorded    Current cost     Percentage  
                                                                      (former       as adjusted       change    
                                                                      method)      (new method)                 
----------------------------------------------------------------------------------------------------------------
1994............................................................         $35,000         $45,150             .29
1995............................................................          43,500          54,375             .25
1996............................................................          54,400          70,720             .30
                                                                 -----------------------------------------------
    Total.......................................................         132,900         170,245             .28
----------------------------------------------------------------------------------------------------------------

    (iii) Applying the average revaluation factor of .28 to each 
layer, G's inventory is restated as follows:

----------------------------------------------------------------------------------------------------------------
                                                                   Restated base                   Restated LIFO
                                                                    year costs         Index      carrying value
----------------------------------------------------------------------------------------------------------------
Base layer......................................................         $17,920            1.00         $17,920

[[Page 42060]]

                                                                                                                
1991 layer......................................................           5,120            1.20           6,144
1992 layer......................................................           6,400            1.30           8,320
1993 layer......................................................           2,560            1.35           3,456
1994 layer......................................................               0            1.40               0
1995 layer......................................................           5,120            1.50           7,680
1996 layer......................................................           6,400            1.60          10,240
                                                                 -----------------------------------------------
    Total.......................................................          43,520  ..............          53,760
----------------------------------------------------------------------------------------------------------------

    (iv) The adjustment required by section 481(a) is $11,760. This 
amount may be computed by multiplying the average percentage of .28 
by the LIFO carrying value of G's inventory valued using its former 
method ($42,000). Alternatively, the adjustment required by section 
481(a) may be computed by the difference between--
    (A) The revalued costs of the taxpayer's inventory under its new 
method ($53,760), and
    (B) The costs of the taxpayer's inventory using its former 
method ($42,000).
    (v) In addition, the inventory as of the first day of the year 
of change (January 1, 1997) becomes the new base year cost for 
purposes of determining the LIFO index in future years. See, 
paragraphs (b)(2)(iii)(A)(2)(i) and (b)(2)(iii)(B) of this section. 
This requires that layers in years prior to the base year be 
restated in terms of the new base year index. The current year cost 
of G's inventory, as adjusted, is $70,720. Such cost must be 
apportioned to each layer in proportion to the restated base year 
cost of that layer to total restated base year costs ($43,520), as 
follows:

----------------------------------------------------------------------------------------------------------------
                                                                   Restated base                   Restated LIFO
                                                                    year costs    Restated index  carrying value
----------------------------------------------------------------------------------------------------------------
Old base layer..................................................         $29,120            .615         $17,920
1991 layer......................................................           8,320            .738           6,144
1992 layer......................................................          10,400             .80           8,320
1993 layer......................................................           4,160            .831           3,456
1994 layer......................................................               0  ..............               0
1995 layer......................................................           8,320            .923           7,680
1996 layer......................................................          10,400            .985          10,240
                                                                 -----------------------------------------------
        Total...................................................          70,720  ..............          53,760
----------------------------------------------------------------------------------------------------------------

    (D) Short taxable years. A short taxable year is treated as a full 
12 months.
    (E) Adjustments to inventory costs from prior years--(1) General 
rule--(i) The use of the revaluation factor, based on current costs, to 
estimate the revaluation of prior inventory layers under the 3-year 
average method, as described in paragraph (c)(2)(v) of this section, 
may result in an allocation of costs that include amounts attributable 
to costs not incurred during the year in which the layer arose. To the 
extent a taxpayer can demonstrate that costs that contributed to the 
determination of the revaluation factor could not have affected a prior 
year, the revaluation factor as applied to that year may be adjusted 
under the restatement adjustment procedure, as described in paragraph 
(c)(2)(v)(F) of this section. The determination that a cost could not 
have affected a prior year must be made by a taxpayer only upon showing 
that the type of cost incurred during the years used to calculate the 
revaluation factor (revaluation years) was not present during such 
prior year. An item of cost will not be eligible for the restatement 
adjustment procedure simply because the cost varies in amount from year 
to year or the same type of cost is described or referred to by a 
different name from year to year. Thus, the restatement adjustment 
procedure allowed under paragraph (c)(2)(v)(F) of this section is not 
available in a prior year with respect to a particular cost if the same 
type of cost was incurred both in the revaluation years and in such 
prior year, although the amount of such cost and the name or 
description thereof may vary.
    (ii) The provisions of this paragraph (c)(2)(v)(E) are also 
applicable to taxpayers using the weighted average method in revaluing 
inventories under paragraph (c)(2)(iv) of this section. Thus, to the 
extent a taxpayer can demonstrate that costs that contributed to the 
determination of the restatement of a particular year or item could not 
have affected a prior year or item, the taxpayer may adjust the 
revaluation of that prior year or item accordingly under the weighted 
average method. All the requirements and definitions, however, 
applicable to the restatement adjustment procedure under this paragraph 
(c)(2)(v)(E) fully apply to a taxpayer using the weighted average 
method to revalue inventories.
    (2) Examples of costs eligible for restatement adjustment 
procedure. The provisions of this paragraph (c)(2)(v)(E) are 
illustrated by the following four examples. The principles set forth in 
these examples are applicable both to production and resale activities 
and the year of change in the four examples is 1997. The examples read 
as follows:

    Example 1. Taxpayer A is a reseller that introduced a defined 
benefit pension plan in 1994, and made the plan available to 
personnel whose labor costs were (directly or indirectly) properly 
allocable to resale activities. A determines the revaluation factor 
based on data available for the years 1994 through 1996, for which 
the pension plan was in existence. Based on these facts, the costs 
of the pension plan in the revaluation years are eligible for the 
restatement adjustment procedure for years prior to 1994.
    Example 2. Assume the same facts as in Example 1, except that a 
defined contribution plan was available, during prior years, to 
personnel whose labor costs were properly allocable to resale 
activities. The defined contribution plan was terminated before the 
introduction of the defined benefit plan in 1994. Based on these 
facts, the costs of the defined benefit pension plan in the 
revaluation years are not eligible for the restatement adjustment 
procedure with respect to years for which the defined contribution 
plan existed.
    Example 3. Taxpayer C is a manufacturer that established a 
security department in 1995 to patrol and safeguard its production 
and warehouse areas used in C's trade or business. Prior to 1995, C 
had not been required to utilize security personnel in its trade or 
business; C established the security department in 1995 in response 
to increasing vandalism and theft at its plant locations. Based on 
these facts, the costs of the security

[[Page 42061]]

department are eligible for the restatement adjustment procedure for 
years prior to 1995.
    Example 4. Taxpayer D is a reseller that established a payroll 
department in 1995 to process the company's weekly payroll. In the 
years 1991 through 1994, D engaged the services of an outside vendor 
to process the company's payroll. Prior to 1991, D's payroll 
processing was done by D's accounting department, which was 
responsible for payroll processing as well as for other accounting 
functions. Based on these facts, the costs of the payroll department 
are not eligible for the restatement adjustment procedure. D was 
incurring the same type of costs in earlier years as D was incurring 
in the payroll department in 1995 and subsequent years, although 
these costs were designated by a different name or description.

    (F) Restatement adjustment procedure--(1) In general--(i) This 
paragraph (c)(2)(v)(F) provides a restatement adjustment procedure 
whereunder a taxpayer may adjust the restatement of inventory costs in 
prior taxable years in order to produce a different restated value than 
the value that would otherwise occur through application of the 
revaluation factor to such prior taxable years.
    (ii) Under the restatement adjustment procedure as applied to a 
particular prior year, a taxpayer must determine the particular items 
of cost that are eligible for the restatement adjustment with respect 
to such prior year. The taxpayer must then recompute, using reasonable 
estimates and procedures, the total inventoriable costs that would have 
been incurred for each revaluation year under the taxpayer's former 
method and the taxpayer's new method by making appropriate adjustments 
in the data for such revaluation year to reflect the particular costs 
eligible for adjustment.
    (iii) The taxpayer must then compute the total percentage change 
with respect to each revaluation year, using the revised estimates of 
total inventoriable costs for such year as described in paragraph 
(c)(2)(v)(F)(1)(ii) of this section. The percentage change must be 
determined by calculating the ratio of the revised total of the 
inventoriable costs for such revaluation year under the taxpayer's new 
method to the revised total of the inventoriable costs for such 
revaluation year under the taxpayer's former method.
    (iv) An average of the resulting percentage change for all 
revaluation years is then calculated, and the resulting average is 
applied to the prior year in issue.
    (2) Examples of restatement adjustment procedure. The provisions of 
this paragraph (c)(2)(v)(F) are illustrated by the following two 
examples. The principles set forth in these examples are applicable 
both to production and resale activities and the year of change in the 
two examples is 1997. The examples read as follows:

    Example 1. Taxpayer A is a reseller that is eligible to make a 
restatement adjustment by reason of the costs of a defined benefit 
pension plan that was introduced in 1994, during the revaluation 
period. The revaluation factor, before adjustment of data to reflect 
the pension costs, is as provided in the example in paragraph 
(c)(2)(v)(C) of this section. Thus, for example, with respect to the 
year 1994, the total inventoriable costs under A's former method is 
$35,000, the total inventoriable costs under A's new method is 
$45,150, and the percentage change is .29. Under the method of 
accounting used by A during 1994 (the former method), none of the 
pension costs were included as inventoriable costs. Thus, under the 
restatement adjustment procedure, the total inventoriable cost under 
A's former method would remain at $35,000 if the pension plan had 
not been in existence. Similarly, A determines that the total 
inventoriable costs for 1994 under A's new method, if the pension 
plan had not been in existence, would have been $42,000. The 
restatement adjustment for 1994 determined under this paragraph 
(c)(2)(v)(F) would then be equal to .20 ([$42,000-$35,000]/$35,000). 
A would make similar calculations with respect to 1995 and 1996. The 
average of such amounts for each of the three years in the 
revaluation period would then be determined as in the example in 
paragraph (c)(2)(v)(C) of this section. Such average would be used 
to revalue cost layers for years for which the pension plan was not 
in existence. Such revalued layers would then be viewed as restated 
in compliance with the requirements of this paragraph. With respect 
to cost layers incurred during years for which the pension plan was 
in existence, no adjustment of the revaluation factor would occur.
    Example 2. Assume the same facts as in Example 1, except that a 
portion of the pension costs were included as inventoriable costs 
under the method used by A during 1994 (the former method). Under 
the restatement adjustment procedure, A determines that the total 
inventoriable costs for 1994 under the former method, if the pension 
plan had not been in existence, would have been $34,000. Similarly, 
A determines that the total inventoriable costs for 1994 under A's 
new method, if the pension plan had not been in existence, would 
have been $42,000. The restatement adjustment for 1994 determined 
under this paragraph (c)(2)(v)(F) would then be equal to .24 
([$42,000-$34,000]/$34,000). A would make similar calculations with 
respect to 1995 and 1996. The average of such amounts for each of 
the three years in the revaluation period would then be determined 
as in the example in paragraph (c)(2)(v)(C) of this section. Such 
average would be used to revalue cost layers for years for which the 
pension plan was not in existence.

    (3) Intercompany items--(i) Revaluing intercompany transactions. 
Pursuant to any change in method of accounting for costs subject to 
section 263A, taxpayers are required to revalue the amount of any 
intercompany item resulting from the sale or exchange of inventory 
property in an intercompany transaction to an amount equal to the 
intercompany item that would have resulted, had the cost of goods sold 
for that inventory property been determined under the taxpayer's new 
method. The requirement of the preceding sentence applies with respect 
to both inventory produced by a taxpayer and inventory acquired by the 
taxpayer for resale. In addition, the requirements of this paragraph 
(c)(3) apply only to any intercompany item of the taxpayer as of the 
beginning of the year of change in method of accounting. See 
Sec. 1.1502-13(b)(2)(ii). A taxpayer must revalue the amount of any 
intercompany item only if the inventory property sold in the 
intercompany transaction is held as inventory by a buying member as of 
the date the taxpayer changes its method of accounting under section 
263A. Corresponding changes to the adjustment required under section 
481(a) must be made with respect to any adjustment of the intercompany 
item required under this paragraph (c)(3). Moreover, the requirements 
of this paragraph (c)(3) apply regardless of whether the taxpayer has 
any items in beginning inventory as of the year of change in method of 
accounting. See Sec. 1.1502-13 for the definition of intercompany 
transaction.
    (ii) Example. The provisions of this paragraph (c)(3) are 
illustrated by the following example. The principles set forth in this 
example are applicable both to production and resale activities and the 
year of change in the example is 1997. The example reads as follows:

    Example. (i) Assume that S, a member of a consolidated group 
filing its federal income tax return on a calendar year, 
manufactures and sells inventory property to B, a member of the same 
consolidated group, in 1996. The sale between S and B is an 
intercompany transaction as defined under Sec. 1.1502-13(b)(1). The 
gain from the intercompany transaction is an intercompany item to S 
under Sec. 1.1502-13(b)(2). As of the beginning of the year of 
change in method of accounting (January 1, 1997), the inventory 
property is still held by B based on the particular inventory method 
of accounting used by B for federal income tax purposes (for 
example, the LIFO or FIFO inventory method). The property was sold 
by S to B in 1996 for $150; the cost of goods sold with respect to 
the property under the method in effect at the time the inventory 
was produced was $100, resulting in an intercompany item of $50 to S 
under Sec. 1.1502-13. As of January 1, 1997, S still has an 
intercompany item of $50.
    (ii) S is required to revalue the amount of its intercompany 
item to an amount equal to what the intercompany item would have

[[Page 42062]]

been had the cost of goods sold for that inventory property been 
determined under S's new method. Assume that the cost of the 
inventory under this method would have been $110, had the method 
applied to S's manufacture of the property in 1996. Thus, S is 
required to revalue the amount of its intercompany item to $40 (that 
is, $150 less $110), necessitating a negative adjustment to the 
intercompany item of $10. Moreover, S is required to increase its 
adjustment under section 481(a) by $10 in order to prevent the 
omission of such amount by virtue of the decrease in the 
intercompany item.
    (iii) Availability of revaluation methods. In revaluing the amount 
of any intercompany item resulting from the sale or exchange of 
inventory property in an intercompany transaction to an amount equal to 
the intercompany item that would have resulted had the cost of goods 
sold for that inventory property been determined under the taxpayer's 
new method, a taxpayer may use the other methods and procedures 
otherwise properly available to that particular taxpayer in revaluing 
inventory under section 263A and the regulations thereunder, including, 
if appropriate, the various simplified methods provided in section 263A 
and the regulations thereunder and the various procedures described in 
this paragraph (c).
    (4) Anti-abuse rule--(i) In general. Section 263A(i)(1) provides 
that the Secretary shall prescribe such regulations as may be necessary 
or appropriate to carry out the purposes of section 263A, including 
regulations to prevent the use of related parties, pass-thru entities, 
or intermediaries to avoid the application of section 263A and the 
regulations thereunder. One way in which the application of section 
263A and the regulations thereunder would be otherwise avoided is 
through the use of entities described in the preceding sentence in such 
a manner as to effectively avoid the necessity to restate beginning 
inventory balances under the change in method of accounting required or 
permitted under section 263A and the regulations thereunder.
    (ii) Deemed avoidance of this section--(A) Scope. For purposes of 
this paragraph (c), the avoidance of the application of section 263A 
and the regulations thereunder will be deemed to occur if a taxpayer 
using the LIFO method of accounting for inventories, transfers 
inventory property to a related corporation in a transaction described 
in section 351, and such transfer occurs:
    (1) On or before the beginning of the transferor's taxable year 
beginning in 1987; and
    (2) After September 18, 1986.
    (B) General rule. Any transaction described in paragraph 
(c)(4)(ii)(A) of this section will be treated in the following manner:
    (1) Notwithstanding any provision to the contrary (for example, 
section 381), the transferee corporation is required to revalue the 
inventories acquired from the transferor under the provisions of this 
paragraph (c) relating to the change in method of accounting and the 
adjustment required by section 481(a), as if the inventories had never 
been transferred and were still in the hands of the transferor; and
    (2) Absent an election as described in paragraph (c)(4)(iii) of 
this section, the transferee must account for the inventories acquired 
from the transferor by treating such inventories as if they were 
contained in the transferee's LIFO layer(s).
    (iii) Election to use transferor's LIFO layers. If a transferee 
described in paragraph (c)(4)(ii) of this section so elects, the 
transferee may account for the inventories acquired from the transferor 
by allocating such inventories to LIFO layers corresponding to the 
layers to which such properties were properly allocated by the 
transferor, prior to their transfer. The transferee must account for 
such inventories for all subsequent periods with reference to such 
layers to which the LIFO costs were allocated. Any such election is to 
be made on a statement attached to the timely filed federal income tax 
return of the transferee for the first taxable year for which section 
263A and the regulations thereunder applies to the transferee.
    (iv) Tax avoidance intent not required. The provisions of paragraph 
(c)(4)(ii) of this section will apply to any transaction described 
therein, without regard to whether such transaction was consummated 
with an intention to avoid federal income taxes.
    (v) Related corporation. For purposes of this paragraph (c)(4), a 
taxpayer is related to a corporation if--
    (A) the relationship between such persons is described in section 
267(b)(1), or
    (B) such persons are engaged in trades or businesses under common 
control (within the meaning of paragraphs (a) and (b) of section 52).
    (d) Non-inventory property--(1) Need for adjustments. A taxpayer 
that changes its method of accounting for costs subject to section 263A 
with respect to non-inventory property must revalue the non-inventory 
property on hand at the beginning of the year of change as set forth in 
paragraph (d)(2) of this section, and compute an adjustment under 
section 481(a). The adjustment under section 481(a) will equal the 
difference between the adjusted basis of the property as revalued using 
the taxpayer's new method and the adjusted basis of the property as 
originally valued using the taxpayer's former method.
    (2) Revaluing property. A taxpayer must revalue its non-inventory 
property as of the beginning of the year of change in method of 
accounting. The facts and circumstances revaluation method of paragraph 
(c)(2)(iii) of this section must be used to revalue this property. In 
revaluing non-inventory property, however, the only additional section 
263A costs that must be taken into account are those additional section 
263A costs incurred after the later of December 31, 1986, or the date 
the taxpayer first becomes subject to section 263A, in taxable years 
ending after that date. See Sec. 1.263A-1(d)(3) for the definition of 
additional section 263A costs.


Sec. 1.263A-7T   [Removed]

    Par. 5. Section 1.263A-7T is removed.


Sec. 1.263A-15   [Amended]

    Par. 6. Section 1.263A-15 is amended by removing ``1.263A-7T (e) 
generally'' from the last sentence in paragraph (a)(1) and replacing it 
with ``1.263A-7''.

    Dated: July 28, 1997.
Michael P. Dolan,
Acting Commissioner of Internal Revenue.
Donald C. Lubick,
Acting Assistant Secretary of the Treasury.
[FR Doc. 97-20530 Filed 8-4-97; 8:45 am]
BILLING CODE 4830-01-U