Tier Issue: Mixed Services Costs IDD 5

September 15, 2009

LMSB-04-0809-033
Impacted IRM 4.51.2

Introduction
In the interest of ensuring consistent tax administration, this directive provides guidance to the field regarding the allocation of resources to examinations of mixed service costs (MSC) subject to the reasonableness requirement of the regulations.  See Treas. Reg. § 1.263A-1(e)(3)(i).  To that end, this directive classifies certain MSC allocation methods according to their relative significance to obtaining taxpayer compliance.  LMSB examiners are directed not to challenge methods of allocating MSC that are considered relatively less significant to compliance, subject to the approval of the Utility Technical Advisor. 

Background/Strategic Importance:
The allocation of MSC under section 263A became a Tier I issue after more than sixty taxpayers (mostly utilities) filed requests to change their method of accounting for MSC from a “facts and circumstances” method to the Simplified Service Cost Method (SSCM) beginning in 2001.  See Treas. Reg. § 1.263A-1(h).  In the typical case involving an electric utility, the main effect of applying the SSCM is a significant de-capitalization of costs previously capitalized to self-constructed assets (SCA).  For tax years ending before August 2, 2005 (Phase I), the primary dispute is whether the SCA qualify as eligible property for the SSCM.  See Rev. Rul. 2005-53, 2005-2 C.B. 425.  For tax years ending on or after August 2, 2005 (Phase II), regulations prospectively resolve the question of eligibility by clarifying when SCA are considered to be produced on a routine and repetitive basis.  See T.D. 9217, 2005-2 C.B. 498 (Aug. 3, 2005).  The regulations require taxpayers using SSCM to change their method of accounting for MSC allocable to ineligible SCA to a “facts and circumstances” method.  In Phase II, the primary issue is not whether the SCA qualify as eligible property but rather whether the taxpayer’s “facts and circumstances” method of allocating indirect costs among production, resale, and other activities is reasonable as required by the regulations.  See Treas. Reg. § 1.263A-1(e)(3)(i).  This directive relates to Phase II cases subject to that requirement. 

Issue Tracking:
Project Code 0511      Tracking Code 1511

UIL 263A.06-01; SAIN 707; Second Tier SAIN 191

Accuracy-related Penalty UIL 6662.00-00 SAIN 624-01; Second Tier SAIN 192
Planning and Examination Guidance:
In formulating this guidance, consideration was given to a variety of issues relating to compliance with the reasonableness requirement of the regulations.  Prior to the late 1990s, utilities were vertically integrated (i.e., they generated, transmitted, and distributed electricity within a certain geographical area).  Since that time, some utilities have disposed of their generation assets and now merely purchase electricity to resell.  Other utilities both generate electricity and purchase electricity for sale to their customers.  Some of the differences between utility operations that generate electricity and utility operations that purchase electricity are relevant to the determination of reasonableness.  By its nature, the “facts and circumstances” test for determining reasonableness calls for a broad-ranging inquiry into the taxpayer’s production and associated service activities.  Some MSC allocation methods are considered to pose a greater threat to compliance than others, although the amount of examination resources consumed is substantially the same regardless of the method’s significance to compliance.  Based on these and other considerations, this directive provides examples of MSC allocation methods classified as relatively more or less significant to compliance.  To best allocate limited examination resources, the field is directed not to challenge methods identified in this directive as being relatively less significant to compliance priorities. While the classification of these examples is intended to be consistent with the reasonableness requirement, that classification is not intended as a statement of position as to reasonableness.  Nor is the classification intended to serve as a substitute for a determination based on all the relevant facts and circumstances when that is warranted.  See ”Audit Techniques” below.

1.   Examples of MSC Allocation Methods Considered Relatively Less Significant to Compliance Priorities. 

a. A consistent headcount ratio.  The taxpayer allocates MSC between transmission and distribution (T&D) and other departments and between production and non-production activities within a T&D department based on a headcount ratio that is consistently applied across all service departments, re-determined annually, and in which the  denominator includes only those employee who actually benefit from the MSC.


b. A production cost ratio with a limited reduction for purchased power.  The taxpayer allocates the portion of MSC subject to allocation among production activities according to a production cost ratio that is computed as follows:

(i) Numerator.  The numerator equals the total section 263A costs of SCA, less the MSC, less the interest capitalized to SCA.


(ii) Denominator.  The denominator equals the total section 263A costs of SCA, plus the section 263A costs of electricity sold with additional adjustments for natural gas, steam, etc., less 50 percent of the cost of the taxpayer's purchased power, less the MSC, less the interest included in the above amounts.


(iii) Application.  This ratio is then multiplied by the total MSC allocated to production activities using the headcount cost driver to arrive at the amount of MSC to be allocated to SCA.


(iv) Reductions for temporary lines.  The use of the headcount ratio and the production cost ratio takes into consideration the amount of costs that may have been capitalized to temporary lines.  Therefore, further reductions in the amount capitalized for temporary lines should not be made.

2. Examples of MSC Allocation Methods Considered Relatively More Significant to Compliance Priorities. 

a. Generation departments in the MSC pool.  The taxpayer asserts that a department that exclusively supports a production activity qualifies as a MSC department merely because the department incurs a cost that is deductible under section 1.263A-1(e)(3)(iii) (e.g., the department acquires property qualifying for the deduction under section 174 or sustains a casualty or theft loss deductible under section 165).

b. Additional costs of working in an energized environment treated as costs of maintaining electric service.  The taxpayer asserts the additional costs of working more slowly in an energized environment are to be capitalized as costs of maintaining electric service instead of being capitalized to the cost of SCA.  The taxpayer argues that these costs are analogous to the cost of temporarily relocating lines in Rev. Rul. 73-203, 1973-1 C.B.  146.  See TAM 200811021(December 11, 2007).

c. Overly broad or other inappropriate cost drivers.  The taxpayer uses cost drivers that are overly broad or inappropriate, such as cost drivers that result in the allocation of MSC to departments that receive no benefit from the MSC.


d. Imputation of production costs based on hypothetical events.  The taxpayer uses a production ratio based on the estimated cost that would have been paid for generating power instead of purchasing power or an estimated headcount based on the number of employees that would have been required to generate the electricity instead of purchasing it.

Audit Techniques:
In Phase II cases, the allocation of MSC remains a Tier I issue.  In a given case, the decision to examine the taxpayer’s MSC allocation method should be made in accordance with this directive, subject to the concurrence of the Utility Technical Advisor.   Audit techniques for examining the MSC issue in Phase II cases include the review of the new accounting method to determine if the method is reasonable based on the facts and circumstances. The facts and circumstances should be fully developed and the determination of reasonableness should be well documented due to the possibility of litigation.  In addition, the adequacy of the taxpayer’s substantiation should be evaluated.  In the absence of written records, the taxpayer may attempt to rely on estimates derived from responses to employee interviews.  Although interview data should not be dismissed out of hand, the method used to obtain the interview data should be carefully analyzed due to the potential unreliability of uncorroborated oral testimony.  In addition, the taxpayer’s substantiation should be subjected to critical analysis under the so-called “Cohan Doctrine,” that is, whether the taxpayer’s evidence satisfies the threshold showing that the costs in question were actually incurred for the tax year, even though the exact amount cannot be determined.  Pro forma Information Document Requests (F4564) and a pro forma Notice of Proposed Adjustment (F5701) are available on the Pre-filing and Technical Guidance Utility Technical Advisor website.  Members of the Issue Specialization Team (IST) will visit audit sites as needed to assist with the issue development. All F5701 must be approved by the Utility Technical Advisor prior to issuance.

Risk Analysis:
The appropriate industry IST member will perform the risk analysis of the MSC issue.  Upon identifying an MSC issue in a Phase II case, agents in all industries must contact their respective ISTs for instructions to ensure proper and consistent application of MSC IDD #1, dated June 8, 2006, IDD #2, dated May 1, 2007, IDD #3, dated May 2, 2007, and IDD #4, dated June 19, 2009, in conjunction with this directive. 

Contacts:
Please mail or fax any relevant Forms 3115 filed to the Utility Technical Advisor listed on the website.  Also, contact the IST for your respective industry listed on the website.  If you have any questions, contact the Utility Technical Advisor.

This Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.

cc:  Commissioner, LMSB
       Deputy Commissioner, Operations, LMSB
       Deputy Commissioner, International, LMSB
       Director, Planning, Quality, Analysis & Support, LMSB
       Director, Research & Workload Identification, LMSB
       Division Counsel, LMSB
       Chief, Appeals
       Commissioner, SBSE
       www.irs.gov