Tax Controversy Alert
Treasury and the IRS have re-proposed regulations governing the application of section 263(a) to costs incurred to acquire, produce, or improve real or personal tangible property (the so-called "tangibles regulations"). Public comments raised a variety of concerns regarding the original version of the proposed regulations issued in 2006. In response, the government has withdrawn the 2006 proposed regulations, and re-proposed the tangibles regulations in whole. The re-proposed regulations retain substantial portions of the 2006 proposed regulations, but also include a number of significant changes responding to public concerns.
Materials and Supplies. The government responded to public concerns regarding the treatment of materials and supplies under the 2006 proposed regulations. The re-proposed regulations largely retain the traditional treatment of incidental and non-incidental materials and supplies, but provide new rules intended to clarify the interaction of these standards with the capitalization standards of the re-proposed regulations. For example, the re-proposed regulations provide a revised definition of "materials and supplies;" a new rule deferring the deductibility of costs for rotable or temporary materials and supplies; and a $100 de minimis rule under the definition of materials and supplies.
The re-proposed regulations remove the 12-month rule found in the 2006 proposed regulations. Instead, under the re-proposed regulations, any unit of property having a useful life of 12 months or less is subject to the rules applicable to materials and supplies and generally is deductible in the year it is used or consumed.
Acquisitive Transaction Costs. The re-proposed regulations largely retain the 2006 proposed standards applicable to costs incurred to acquire tangible property. Among the changes is a proposed rule permitting a deduction for costs incurred to investigate whether to acquire real property, and which parcel to acquire. This "whether and which" rule is inapplicable to investigative costs in connection with personal property, however. "Inherently facilitative" costs must be capitalized in all events. The re-proposed regulations also relax the standards governing the capitalization of inherently facilitative costs incurred in connection with multiple, alternative transactions where only one of the alternatives is ultimately pursued to conclusion. There, the costs may be allocated among each of the alternatives considered, regardless of whether the taxpayer intended to or could have completed only one of the alternatives.
De minimis Rule. The re-proposed regulations provide the de minimis rule for acquisition costs sought by many public commentators. Under the proposal, a taxpayer having written accounting procedures for the expensing of de minimis items for financial reporting purposes can use that same standard for tax purposes so long as doing so does not distort the taxpayer’s income. The re-proposed regulations provide a safe harbor for determining whether application of its de minimis rule distorts the taxpayer’s income. The preamble notes that this rule is not intended to affect any "current understanding" between the taxpayer and its exam team with respect to the size and character of transactions that will be the focus of examinations.
Unit of Property. The re-proposed regulations abandon the much-maligned "four categories" used by the 2006 proposed regulations to define a unit of property. Instead, as suggested by a number of commentators, the government has adopted the functional interdependence test of section 263A as the general definition for a unit of property for purposes of section 263(a). The re-proposed regulations require use of a smaller unit of property in certain situations. For example, "plant assets" such as an integrated assembly line or an electric generating facility must be further broken down into those components or groups of components that perform a discrete and major function or operation. A smaller unit of property also may be required depending on how the taxpayer has classified the unit of property and its components for financial and regulatory accounting purposes, or for purposes of tax depreciation. The preamble notes, however, that these two exceptions are intended to apply only in "unique circumstances."
The government again reserved on the definition of "network assets" such as electric transmission and distribution lines, pipelines, and railroad tracks. The government has decided that the unit of property rules for network assets should be determined on an industry by industry basis though the Industry Issue Resolution program. The government will accept applications for IIRs defining network assets once the tangibles regulations have been finalized.
Routine Maintenance Safe Harbor. Under a new "routine maintenance safe harbor," qualifying maintenance activities are deemed not to improve the unit of property. Routine maintenance activities include recurring activities that a taxpayer expects to perform more than once over the class life of the unit of property as a result of the taxpayer’s use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. Certain types of costs are specifically excluded from this safe harbor. Excluded costs include those for replacement components where the taxpayer has taken into account the basis of the component being replaced either through the recognition of gain or loss from the sale of the replaced component, through a retirement loss, or through a casualty loss. Where the safe harbor does not apply to a particular cost, the general rules governing improvements must be considered.
Capitalization Standard. Where costs are ineligible for the routine maintenance safe harbor, they must be capitalized if they result in either (i) a betterment, (ii) a restoration, or (iii) a new or different use.
Betterments. The re-proposed regulations replace the "material increase in value" standard with a "betterment" standard. This change in nomenclature appears to have little substantive effect, apart from minimizing the importance of changes in the fair market value of the unit of property. A betterment occurs only in one of three circumstances: (i) the amelioration of a preexisting defect; (ii) a material addition to the unit of property (including a physical enlargement, expansion, or extension); or (iii) a material increase in the capacity, productivity, efficiency, strength, or quality of either the unit of property or of its output.
Restorations. The government responded to the many public comments that the 2006 proposed regulations’ restoration standard was too broad and too complex. Eliminating some of the more controversial provisions of the 2006 proposal, the re-proposed regulations rely instead on a series of bright line rules determining when a restoration has occurred. For example, a restoration occurs where the taxpayer returns the unit of property to its ordinarily efficient operating condition; rebuilds a unit of property to a like-new condition; or replaces a major component or substantial structural part of a unit of property. The re-proposed regulations contain a number of helpful definitions and standards designed to make these rules more user friendly. Finally, the preamble to the re-proposed regulations notes that the government has again declined to include the "plan of rehabilitation" doctrine in the tangibles regulations, and notes instead that once the re-proposed regulations are finalized, the judicial plan of rehabilitation doctrine will be "obsolete." Instead, the government intends to rely on the "directly benefits or is incurred by reason of" standard applicable under section 263A to determine the scope of a restoration project.
The government has adhered to its controversial position that costs incurred to repair damage with respect to which the taxpayer has claimed a casualty loss deduction may not be deducted as repair costs. The government suggested, however, that it would consider whether events in some industries are so common that the costs arising from them are deductible as ordinary and necessary business expenses under section 162 rather than as casualty losses under section 165. The treatment of casualty events is likely to be one of the more controversial provisions of the re-proposed regulations, and eventually may well be litigated.
New or Different Use. The re-proposed regulations restore the traditional "adaptation to a new or different use" standard as an independent test for capitalization, but otherwise made relatively little change to the standard.
Regulatory Accounting Method. In response to public comments, the re-proposed regulations establish an elective "regulatory accounting method." Under this method, the tax treatment of costs to repair or improve tangible property subject to regulatory accounting rules of the Federal Energy Regulatory Commission, the Federal Communications Commission, or the Surface Transportation Board is governed by the costs’ treatment for regulatory accounting purposes. This essentially is a strict regulatory accounting conformity rule. If elected, the regulatory accounting method must be used for all of the taxpayer’s tangible property that is subject to regulatory accounting rules. Even under the regulatory accounting method, however, the taxpayer still must consider the potential application of section 263A. Because it effectively removes the taxpayer’s regulated assets from the scope of the tangibles regulations (eliminating potential disputes as to units of property, betterments, restorations, etc.), this safe harbor may prove extremely attractive to many taxpayers, particularly those with "network assets" and those having millions of individual units of property.
Repair Allowance. The re-proposed regulations do not contain the one-size-fits-all repair allowance method proposed in 2006. Instead, the re-proposed regulations provide authority for the development of repair allowances on an industry-by-industry basis, presumably through the IIR process.
Public Comments and Hearing
The government has scheduled a public hearing on the proposed regulations for June 24, 2008. Public comments on the proposed regulations must be received by June 9, 2008.
For further information, please contact any of the following lawyers:
Patricia Sweeney, firstname.lastname@example.org, 202-626-5926