The Large Business & International division (LB&I) has issued a directive (LB&I-04-0814-007) to examiners that provides guidance in determining whether a taxpayer's method for allocating mixed service costs (MSC) to certain self-constructed tangible personal property is appropriate and should not be challenged. The directive applies to examination activity relating to electric utilities, natural gas utilities, and combined electric and natural gas utilities. It appears to build on Industry Director Directive No. 5.
The directive reminds utility industry taxpayers that they are not eligible to use the simplified service cost method to allocate MSC to self-constructed property that is not mass-produced or does not have a high degree of turnover. Therefore, utility industry taxpayers should allocate MSC based on a reasonable allocation method such as the "facts and circumstances" method.
The directive instructs examiners not to challenge the reasonableness of an MSC allocation used by a utility industry taxpayer if it follows the two-step method outlined in the directive. The first step involves identifying various categories of MSC departments and allocating the MSC within those departments based on appropriate headcount ratios, depending on how broadly the MSC departments provide support services throughout the company. Thus, for example, the taxpayer allocates the company-wide MSC between capitalizable MSC and noncapitalizable MSC within the various departments based on a company-wide headcount ratio. For MSC departments that provide support to specific departments rather than company-wide, the taxpayer should allocate such MSC between capitalizable and noncapitalizable activities based on a headcount ratio method that includes in the denominator only employees who actually benefited from the MSC being allocated.
In step two, the taxpayer allocates capitalizable MSC among capital activities according to a production cost ratio, which is provided in the directive. The production cost ratio has a limited reduction (50%) for purchased electricity and natural gas.
The directive also notes that it does not address whether a particular cost is a mixed service cost, or whether a department is a service department that generates both capitalizable service costs and deductible service costs.
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