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?

Taxable income of a marijuana business

Despite marijuana operations at the state level being legal at the state level since 1996 in California (and now many states), tax guidance has been sparse.  A recent, non-binding Chief Counsel Advice memo sheds some light on how the UNICAP rules apply (or don't apply), but more is needed.

I've got a short article in the AICPA Tax Insider today about the CCA and its meaning - here.

A few more observations beyond the article: While the CCA basically says that the UNICAP rules do not allow a seller of a controlled substance, such as marijuana, to treat more costs as inventoriable, there seems to still be some leeway for a producer. Producers have been subject to the Reg. 1.471-11 full absorption rules since before UNICAP. These rules require treating direct materials and labor as inventoriable and then specify how to deal with indirect costs, which the regulation separates into three categories:

1. Production - expenses that are clearly part of inventory.
2. Selling - expenses that are clearly not part of production
3. Other - treat the same as you treat for books.

So, it seems that if for books, the producer leans towards treating costs as production-related, if justified and clearly not a category 2 cost, it does the same for tax and gets a better result than would a producer who treats category 3 as mostly non-production costs.  Is this the intended application of the Section 280E rule? 

If you are not familiar with Section 280E, read the article - it also has links to the tax rules cited above.

What do you think?


Photo from http://www.nlm.nih.gov/medlineplus/marijuana.html.

What's missing from Camp's tax reform proposal?

In late February, Congressman Camp, chair of the House Ways and Means Committee, released his discussion draft of the Tax Reform Act of 2014.  It has at least 400 provisions in it and most notably, lowers the individual rates to 10% and 25% (with a 10% surtax for high income individuals) and a flat 25% for corporations.

The discussion draft has a lot of changes. Most of these changes would make the federal income tax simpler and in some places, more fair.  I think more can be done.  I've got a short article in the AICPA Tax Insider today with some suggestions for what is missing from the draft.  It's not intended as a complete list, but more as a reminder that while his bill is quite lengthy, there is still more needed to yield a simpler and more equitable tax system.

I hope you'll take a look at my list.  What do you think? What might you add (or remove) and why?

7th Anniversary of 21st Century Taxation Blog

Today - May 14, 2014 marks the 7th anniversary of this 21st Century Taxation Blog. I started this blog when I was a fellow with the New America Foundation.  I was charged with getting new ideas out into the mainstream, such as through op eds.  Given the times, I thought a blog might also be a helpful approach.  I think it has.  I aim to post at least weekly and now I also blog at SalesTaxSupport.com and Biowebspin and my blog entries are picked up by Proformative and Tax Connections.  I've met people I likely would not have met if I had not been blogging.  And, it's fun.

My initial aim hasn't changed.  I aim to critique proposals and existing rules as to whether they meet principles of good tax policy and help move our tax systems into the 21st century ways of living and doing business.  I also suggest some ideas of my own. And I've got a variety of websites related to tax reform at http://www.21stcenturytaxation.com/.

Here are two reforms I'll offer today:

1. As part of federal income tax reform, repeal Section 263A - the unicap rules.  These rules were not really needed when enacted as part of the Tax Reform Act of 1986.  Their main purpose was likely as a revenue raiser to help lower rates. These rules apply to large retailers (over $10 million of receipts) and producers of tangible property (whether for self-use of sale). We have other rules governing capitalization of benefits that provide long-term benefits (Section 263(a)). We have longstanding rules on what a producer of inventory needs to capitalize (similar to what is required for books). Also, today, companies likely employ more just-in-time inventory practices than in 1986.  Unicap requires calculations and recordkeeping beyond what is required for financial statements. It is only a timing difference. Let's really simplify the federal income tax law and repeal it.  [See 2008 post and link to a "trends" and tax reform table at the end.]

2. As part of eliminating the continued deficits in the Highway Trust Fund, let's explore a gas tax that is not based on how many gallons of gas you purchase. Instead, let's find a way to tie it to how many miles you drive.  With people driving more fuel efficient cars, including ones that don't even require purchase of gasoline, the current system is outdated. Oregon experimented with a vehicle miles traveled approach and there are studies out on alternatives. [See 2010 post and 2014 post.]

What do you suggest to move our tax system into the 21st century?

Thanks for reading this blog!