Narrow exemptions cause inefficiency, inequity and complexity - HR 867 and S. 1179

H.R. 867 and S. 1179 (114th Congress) propose to modify IRC Section 263A(f) on interest capitalization to add an exemption to the rule. It would read:

“(5) EXEMPTION OF NATURAL AGING PROCESS IN DETERMINATION OF PRODUCTION PERIOD FOR DISTILLED SPIRITS.—For purposes of this subsection, the production period for distilled spirits shall be determined without regard to any period allocated to the natural aging process.”

The current interest capitalization rule was added as part of the Tax Reform Act of 1986. The logic is that if a taxpayer is producing a tangible item, such as inventory or a building, it must identify all of the costs incurred that relate to that item. Those costs are to be capitalized rather than currently expensed. These costs include direct materials and labor and many types of indirect costs. If the producer borrowed money to aid the production process, the interest expense incurred during the production time period is yet one more indirect cost to capitalize. The rules to compute the interest are complex because the producer must identify both traced debt and avoided cost debt.

The rule at Section 263A(f) does not apply to all production though. The rule only applies to property produced that has:

1. a long useful life, or
2. an estimated production period exceeding 2 years, or
3. an estimated production period exceeding 1 year and a cost exceeding $1,000,000.

In TAM 9327007, the IRS ruled that the time that wine was aging in the bottle was considered part of the production period such that if it took over two years, interest capitalization was required. 

S. 1179 is sponsored by Kentucky Senator Mitch McConnell. In a 5/4/15 press release, he notes some interesting statistics about bourbon production and his state:

“Kentucky produces 95 percent of the world’s Bourbon supply. Over 15,000 jobs in Kentucky are attributed to the Bourbon industry and it brings in billions of dollars to our state’s economy. This legislation will not only put Kentucky’s Bourbon industry on a level playing field with its competitors, but it is a pro-growth measure that will also help provide a boost to our economy and help create jobs in Kentucky.”

If interest capitalization has such an adverse affect on the bourbon production industry, it would seem that it has a worse affect on the much larger U.S. wine production industry (particularly red wine that requires longer aging).

So, why only pull bourbon from the interest capitalization rule?  Why not just repeal the rule if it is that burdensome?

When one item is singled out for different treatment, problems result:

1. Inefficiencies - one industry is favored over others; the law violates the principle of neutrality and support of economic growth.
2. Inequity - why should a bourbon producer not have to capitalize interest expense but a red wine producer (and likely other producers of alcoholic beverages) have to, even if they are the same size business?
3. Complexity - it can be difficult and take many words and sometimes litigation to determine exactly what falls under the exemption. When a rule applies to all transactions, it is easier to apply.  If the rule itself is complex for everyone, it should be redesigned or repealed.

No doubt, our Senator Majority Leader is well-intentioned in his effort to help a key industry in his state. But why be so narrow and violate principles of good tax policy?  While his proposed change will score as a revenue loser over ten years, it is really just about timing - when is the interest expense deducted (when incurred or only when the bourbon is sold).  And, the rest of Section 263A should be reviewed as part of comprehensive tax reform, particularly regarding its application to inventory. Inventory practices have changed since 1986 and the provision likely isn't needed today as companies use just-in-time inventory practices.

What do you think?