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of the amount of indirect costs that must be capitalized under
section 263A and the amount of costs that must be recovered under
the percentage of completion method of section 460.22 However, a
careful reading of the regulations shows that the rule for the
first level allocation is identical under both regimes, and thus
the order in which they are applied is irrelevant. The Code
sections and regulations work in tandem to provide for a single,
comprehensive set of cost allocation rules.
First, we must clarify what costs and which level of cost
allocation are at issue in the instant case. Both parties agree
that Qwest’s first level allocation of indirect costs is at
issue; i.e., how Qwest allocates indirect costs between its long-
term customer contracts and its self-produced retained assets.
Thus, our focus will remain on the first level allocation of
indirect costs.
Sections 1.263A-1(e)(3)(i) and 1.451-3(d)(6)(ii), Income Tax
Regs., provide the rules for the first level allocations. Both
sections require the taxpayer to make a “reasonable allocation”
22 Respondent then argues that sec. 263A should be applied
first. However, respondent ignores the language of sec.
263A(c)(4), which provides that sec. 263A does not apply to any
property produced by the taxpayer pursuant to a long-term
contract as defined by sec. 460. Given this language, the
argument could be made that, in situations such as the present
case, sec. 460 would apply first. Petitioner does not raise this
argument. In our analysis, infra, we find that the order of
application of the sections is not determinative of the outcome,
and thus we do not discuss this argument further.
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