Sect. 263a Cost Capitalization Regulations Sharpening Tax Planning and Compliance Under the Latest IRS Guidance

Transcription

1 presents Sect. 263a Cost Capitalization Regulations Sharpening Tax Planning and Compliance Under the Latest IRS Guidance A Live 110-Minute Teleconference/Webinar with Interactive Q&A Today's panel features: James Atkinson, Of Counsel, Miller Chevalier, Washington, D.C. Natalie Tucker, Director, National Tax Accounting Methods and Periods Group, RSM McGladrey, Jacksonville, Fla. James Liechty, Director, Federal Tax Services Group, PricewaterhouseCoopers, Washington, D.C. Tuesday, November 24, 2009 The conference begins at: 1 pm Eastern 12 pm Central 11 am Mountain 10 am Pacific You can access the audio portion of the conference on the telephone or by using your computer's speakers. Please refer to the dial in/ log in instructions ed to registrations. CLICK ON EACH FILE IN THE LEFT HAND COLUMN TO SEE INDIVIDUAL PRESENTATIONS. If no column is present: click Bookmarks or Pages on the left side of the window. If no icons are present: Click View, select Navigational Panels, and chose either Bookmarks or Pages. If you need assistance or to register for the audio portion, please call Strafford customer service at ext. 10

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3 Sect. 263(a) Cost Capitalization Regulations Webinar Nov. 24, 2009 James Atkinson Miller & Chevalier Natalie Tucker RSM McGladrey James Liechty PricewaterhouseCoopers LLP

4 Today s Program Recent Background, slides 3 and 4 (James Atkinson) Issues With Intangibles, slides 5 through 22 (James Atkinson, Natalie Tucker) Issues With Tangibles, slides 23 through 40 (James Liechty) Tax Planning And Controversy Issues, slides 41 through 55 (Natalie Tucker, James Atkinson, James Liechty) This document was not intended or written to be used, and it cannot be used, for the purpose of avoiding tax penalties that may be imposed on the taxpayer. 2

5 Recent Background 3

6 Capitalization: Recent History Commissioner v. Lincoln Savings & Loan Assoc., 403 U.S. 345 (1971) Separate and distinct asset INDOPCO v. Commissioner, 503 U.S. 79 (1992) Significant future benefit Significant future benefit : Audits and angst Overhaul of applicable regulations Intangibles M&A costs Tangibles 4

7 Issues With Intangibles 5

8 Intangibles Overhauling the treatment of costs incurred to acquire or create intangible assets became the first step in the process Once the decision was made to proceed, Treasury and the IRS moved relatively quickly and with significant taxpayer input ANPRM: 67 Fed. Reg (Jan. 24, 2002) NPRM: 67 Fed. Reg ( Dec. 19, 2002) T.D. 9107: 69 Fed. Reg. 436 (Jan. 5, 2004) 6

9 INDOPCO Regs: Highlights Sect (a)-4: Capitalization required for: Amounts paid to acquire any intangible Amounts paid to create certain, but not all, intangibles Amounts paid to create or enhance a separate and distinct intangible asset Amounts paid to create or enhance a future benefit, but only under certain circumstances 7

10 Intangibles (Cont.) Regulations establish standards governing capitalization of the consideration paid for costs to acquire intangibles or to create intangibles They also establish standards for capitalizing transaction costs Facilitative costs incurred in the process of investigating or pursuing the transaction Excludes internal costs and most de minimis costs Significantly, they created bright lines and safe harbors 12-month rule $5,000 de minimis rule for certain transactions 8

11 Intangibles: The Impact National Office took control Narrowed definition of separate and distinct intangible asset and made this a fixed rule rather than a set of factors Constricted the application of the substantial future benefit standard, and took control of when it could be applied Reversed the paradigm for costs incurred to create intangible assets Eight categories of created intangibles, the costs of which must be capitalized Anything not specifically listed is deductible (subject to Sect. 263A) Costs incurred to acquire intangibles is not exclusive, and may be interpreted more expansively by the IRS 9

12 M&A Transaction Costs Originally, these costs were subject to the general rules of Sect (a)-4 A separate regulation applicable to these costs, Sect (a)-5, was included in the final regulations This provision requires the capitalization of transaction costs incurred to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions The regulation applies only to transaction costs, not to the purchase price of the acquired property (those remain potentially subject to Sect (a)-4) 10

13 M&A Transaction Costs (Cont.) Broad, but exclusive, list of 10 transactions subject to the capitalization requirement An acquisition of assets constituting a trade or business (whether the taxpayer is the acquirer or the target) An acquisition by the taxpayer of an ownership interest in a business entity, if immediately after the acquisition the taxpayer and the target are related An acquisition of an ownership interest in the taxpayer A restructuring, recapitalization or reorganization of the capital structure of a business entity A section 351 or 721 transaction 11

14 M&A Transaction Costs (Cont.) The 10 transactions (Cont.) Formation or organization of a disregarded entity An acquisition of capital A stock issuance A borrowing Writing an option 12

15 M&A Transaction Costs (Cont.) Because the list is exclusive (like the costs incurred to create intangibles), the transaction costs must be capitalized only if the transaction falls within one of these 10 categories; otherwise the costs are deductible (subject as always to Sect. 263A) This structure generally is beneficial to taxpayers, because the default rule favors a current deduction rather than capitalization. But, the breadth of the categories blunts this advantage somewhat 13

16 M&A Transaction Costs (Cont.) Capitalization is required if the transaction cost facilitates the transaction, meaning it is paid in the process of investigating or otherwise pursing the transaction That is a factual determination Certain costs will always be capitalized under this standard Amounts paid to determine the value or price of a transaction Other costs will never be capitalized under these rules Business integration costs Costs incurred in connection with stock distributions required by law, regulatory mandate or court order Costs incurred to oppose an involuntary bankruptcy Certain stock issuance costs incurred by regulated investment companies 14

17 M&A Transaction Costs (Cont.) Special rule for covered transactions, such as taxable acquisitions of businesses through asset purchases, or A, B, C and certain D reorganizations Amounts facilitate these transactions only if they relate to activities performed on or after the earlier of: The date on which a letter of intent, exclusivity agreement or similar written communication is executed by both parties; or The date on which the material terms of the transaction are approved by the taxpayer s board of directors (or appropriate officials) Any inherently facilitative costs must be capitalized, regardless of when they are incurred The regulations list six categories, which appear to be an exclusive list of inherently facilitative costs 15

18 M&A Transaction Costs (Cont.) Success-based fees are capitalized, unless the taxpayer retains sufficient documentation to show that a portion of the fee is allocable to activities that do not facilitate the transaction The nature and extent of the required documentation is a continuing source of disagreement between taxpayers and the IRS. Investment banking fees are particularly problematic Presumably, this standard will be clarified in forthcoming guidance 16

19 M&A Transaction Costs (Cont.) Sect (a)-5 provides safe harbors similar to those available under Sect (a)-4 Safe harbor for internal costs such as employee compensation (including salary, bonuses, and commissions) This includes guaranteed payments to partners as well as annual compensation paid to directors $5,000 per transaction de minimis rule The de minimis rule is inapplicable to commissions paid to facilitate one of the 10 transactions This creates different tax treatment for internal commissions and those paid to non-employees Taxpayers can elect to capitalize otherwise deductible payments 17

20 Sect (a)-5(g)(2) Recovery Of Capitalized Transaction Costs Acquirer s costs in taxable asset acquisition Allocated to basis of acquired assets under Sect Recovered through sale, depreciation or amortization Acquirer s costs in taxable stock acquisition Capitalized to basis of acquired stock Recovered upon subsequent taxable sale of stock May not be recovered if company liquidates under Sect. 332 Target s costs in taxable asset sale Reduce amount realized on disposition 18

21 Recovery Of Capitalized Transaction Costs (Cont.) Sect (a)-5(g)(2) does not address: Tax-free transactions Target in taxable stock acquisition Stock issuance costs Future guidance Preamble to regulations states intent to provide guidance Notice Request for comments Treasury has indicated guidance on recovery of capitalized transaction costs and documentation requirement for success-based fees should be out by Spring

22 Recovery Of Capitalized Transaction Costs (Cont.) Permanent capitalization Recovery as start-up expenditures Current deduction FASB ASC 805, Business Combinations (previously SFAS No. 141R) Effective for acquisition dates on or after beginning of first annual reporting period beginning on or after Dec. 15, 2008 Business expansion Private equity groups Escrowed hold-backs for benefit of tax deduction Indemnification provisions included in tax deductions disallowed upon exam 20

23 Recovery Of Capitalized Transaction Costs (Cont.) PLR Investigatory due diligence costs Target - Deductible under Sect. 162 New subsidiary - Amortizable under Sect. 195 Financing costs Amortizable under Sect If failed financing approach, deductible abandonment loss under Sect

24 Intangibles: Other Developments Santa Fe Pacific Gold Co., 132 T.C. No. 12 (April 2009): Current deduction allowed for break-up fee paid to white knight TAM (Aug. 14, 2007): Costs to investigate and pursue mutually exclusive potential business restructurings are required to be capitalized, but loss deductions allowed for non-mutually exclusive alternatives when abandoned TAM (Feb. 11, 2005): Termination expenses paid to terminate merger agreement must be capitalized PLR (May 1, 2007): Payments made by natural gas company to terminate gas sales contract not required to be capitalized TAM (Dec. 7, 2007): Denying audit protection for accounting method change made under Sect (a)-5 by taxpayer under audit 22

25 Issues With Tangibles 23

26 Tangible Assets: Overview For federal income tax purposes, taxpayers are required to capitalize expenditures that: Appreciably prolong the useful life of a unit of property (UOP) Materially increase the value of a UOP, or Adapt the UOP to a new or different use These expenditures put property into useful condition Taxpayers may deduct expenditures for repairs These expenditures keep property in useful condition Treatment of retired property Is a complete unit of property (UOP) retired? Deduct? Continue to depreciate? 24

27 Key issue in analysis: Tangible Assets: Overview (Cont.) What is the UOP for determining whether amount is a deductible repair or a capital expenditure? Functional interdependence test Hawaiian Independent Refinery, Inc. v. U.S., 697 F 2d (Fed. Cir. 1983) Armstrong World Industries, Inc. & Affiliated Cos., 974 F.2d 422 (3rd Cir. 1992) Public Service Co. of New Mexico v. U.S., 431 F.2d 980 (10th Cir. 1970) FedEx Corp. v. U.S., 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff d 412 F.3d 617 (6 th Cir. Tenn. 2005) Multiple tests 25

28 Tangible Assets: Overview (Cont.) Who can benefit? Capital-intensive taxpayers that regularly incur a significant amount of routine and incidental repairs and maintenance expenses Significant impact for taxpayers with longer-lived MACRS assets Taxpayers across all industries: Retail Banking Manufacturing Hospitality Construction Utilities (e.g., electricity generation, water) Telecommunications Pipeline transportation Oil and gas exploration and production 26

29 Tangible Assets: Overview (Cont.) Routine repairs and maintenance expenses may include: HVAC Repainting Mending leaks Plastering Replacing windows, tiles Replacement parts Repairing and replacing roofing materials Rebranding Sidewalks, parking lots and pavement Storm drainage, sanitary sewage and water service 27

30 Tangible Assets: Overview (Cont.) Taxpayers often follow their financial statement treatment of incidental repairs and maintenance expenditures ( repairs ) Conservatism Dollar thresholds Earnings per share Often results in capitalization of costs for financial statement purposes Tax method usually follows financial statement method Application of federal income tax principles often results in many expenditures being deductible Opportunity to determine whether otherwise deductible repair costs have been improperly capitalized and depreciated 28

31 Example 1 Tax Repairs: Overview (Cont.) The owner of a retail store replaces displaced wooden shingles on a damaged roof with new shingles of a similar grade and quality The taxpayer classifies the building as the UOP The expenditures do not: Materially add value to the UOP (i.e., building) Appreciably prolong the useful life of the building, or Adapt the building to a new or different use For tax purposes, the expenditures are deductible repairs 29

32 Tax Repairs: Overview (Cont.) Example 2 Taxpayer historically treats an automobile and the tires as two separate UOPs Taxpayer replaces the tires and appropriately deducts as a retirement loss the old tires and capitalizes and depreciates the new tires Taxpayer later determines that the appropriate treatment of the assets is to treat the automobile and tires as one UOP 30

33 Tax Repairs: Overview (Cont.) Example 2 (Cont.) Taxpayer must file a method change to recharacterize the UOP Cost of the replacement tires is a deductible repair favorable Sect. 481(a) Retirement loss must be disallowed unfavorable Sect. 481(a) See Rev. Proc

34 Tangible Regulations Proposed August 2006 Re-Proposed March

35 Re-Proposed Tangible Regulations Overview (Sect (a)-1 through 1.263(a)-3) The IRS issued re-proposed regulations March 7, 2008 for amounts paid to acquire, produce or repair tangible property. Materials and supplies interface De minimis rule UOP rules Material increase in value (betterment, etc.) Repair allowance When finalized, the re-proposed regulations are expected to be effective prospectively 33

36 Re-Proposed Tangible Regulations (Cont.) UOP No UOP definitions provided for network assets (pipelines, telephone/cable lines, electrical lines, railroad track) Industry Issue Resolution (IIR) Taxpayers invited to participate in the IIR process to define UOP for network assets after regulations are finalized Leasehold improvements Sect property Sect property 34

37 Re-Proposed Tangible Regulations Changes in landscape (Cont.) Plan of rehabilitation eliminated More liberal view of repairs via proposed regulation examples Asbestos removal and replacement with similar insulation Retail store re-branding and periodic layout construction (Sect property) Roof replacement (as long as not a betterment ) Turbine blade replacements within a steam turbine 35

38 Re-Proposed Tangible Regulations (Cont.) Casualty losses Sect. 198A qualified disaster expenses Evaluate expenditure on its own merits Joint Committee on Taxation: Noted» 2006 proposed repairs regulations per se capitalization rule, and» IRS internal legal memorandum No inference Under proposed regulations Deduct casualty Per se capitalization of replacement property Possibility of removing per se capitalization rule and replacing with a rule similar to Sect. 198A? 36

39 Re-Proposed Tangible Regulations (Cont.) Final regulations Likely sometime in 2010? Additional proposed regulations? UOP Repair allowance Remainder final? Reserved regulations and/or future IIRs? UOP network assets Repair allowance safe harbor 37

40 Re-Proposed Tangible Regulations (Cont.) Implementation of final regulations Transition to final regulations Effective prospectively Automatic method change? Sect. 481(a) adjustment/cut-off/modified cut-off? Analogy to intangible regulations transition rule? 38

41 Re-Proposed Tangible Regulations (Cont.) Impact to pre-final regulation years? Will current law remain applicable? Automatic method changes to continue? Sect. 481(a) adjustments to continue? 39

42 Likelihood Of Examination LMSB emerging issues alert Issued to LMSB examiners in May 2009, publicly September 2009 Reminder that regulations have not be finalized Potential tiering of repairs? IRS compliance assurance process (CAP) Repairs change does not prevent a taxpayer from participating in CAP Likely not going to reach settlements in the field Looking to develop consistent settlement positions among all industries 40

43 Tax Planning And Controversy Issues 41

44 Method Changes - General 42

45 Method Changes General (Cont.) Rev. Proc Provides additional guidance on the requirements for requesting automatic and non-automatic accounting method changes Added additional accounting method changes that are now automatic Revised some existing automatic changes Effective for automatic Form 3115s filed on or after Aug. 27, 2009 for years ending on or after Dec. 31, 2008 Effective for non-automatic Form 3115s filed on or after Aug. 27, 2009 for years ending on or after Aug. 27,

46 Method Changes General (Cont.) Rev. Proc (Cont.) Clarifications Sect. 481(a) adjustment must consider all relevant accounts Changes definition of under examination Changes definition of issue under consideration 44

47 Method Changes - Intangibles Change to method permitted by Sect (a)-4, 1.263(a)-5, and 1.167(a)-3(b) Generally automatic under App. Sec of Rev. Proc Examples Deduct pre-paids under 12-month rule Deduct package design costs Account for transaction costs consistent with Sect (a)-5 45

48 Method Changes - Repairs Automatic method change from capitalization to expense of repair and maintenance costs New App. Sect of Rev. Proc (as modified by Rev. Proc ) Determination of deductible repair based on present law Identify unit of property Does expenditure prolong useful life, increase value, adapt to new or different use? Plan of rehabilitation IRS will not rule on unit of property Issuance of final regulations may require additional method change 46

49 Method Changes Repairs (Cont.) Taxpayers required to represent that repair and maintenance costs: Are incurred to keep property in ordinarily efficient operating condition Do not materially increase the value or substantially prolong the useful life of any unit of property Do not adapt any unit of property to a new or different use Do not include costs to replace any unit of property, or any major components or substantial structural parts of any unit of property Are not incurred as part of a plan of rehabilitation, modernization or improvement to any unit of property; and Do not result from any prior owner s use of any unit of property 47

50 Method Changes Repairs (Cont.) Exam will look at the unit of property and Sect. 481(a) adjustment in the field Additional filing requirement Third copy filed with Ogden, Utah Service Center Repairs will likely become a Tier issue LMSB memo 48

51 Method Changes Repairs (Cont.) Automatic method changes for disposition of structural components of buildings and other tangible property and land improvements New App. Sect and 6.25 of Rev. Proc (as modified by Rev. Proc ) Must provide detailed descriptions of property, determination of unit of property for acquisitions and dispositions, and legal authority if unit of property is inconsistent No ruling on unit of property Additional filing requirement Third copy filed with Ogden, Utah Service Center 49

52 Repair Cost Method Changes IRS appears to be getting nervous about repair CAMs Many cookie cutter method change requests New, special procedure for automatic method changes involving repair costs is a red flag LMSB memo suggests potential designation as a tiered issue (LMSB ) Consider preparing for potential audit in advance Make sure you have thoroughly documented your positions Ensure consistency with any recent cost segregation studies Consider a cold read of supporting memos to probe areas of likely IRS scrutiny 50

53 Environmental Clean-Up Costs Sect. 198 expensing of environmental remediation costs has been designated a Tier III issue The IRS is concerned about taxpayers awareness of and compliance with the procedural requirements under Sect. 198, Rev. Proc and the M-3 reporting requirements The IRS also is exploring the relationship between the capitalization requirements of environmental remediation and the expensing of such costs Rev. Rul and Rev. Rul tightened the previous standard for deducting environmental cleanup costs provided by Rev. Rul

54 Environmental Cleanup Costs (Cont.) Note that the proposed tangibles regulations also change the treatment of environmental cleanup costs where there has been a break in ownership Previously, the IRS took the position that a break in ownership is not relevant, so long as the taxpayer was responsible for having contaminated the land Query whether IRS views the proposed standard as reflecting current law or as a change in current law The answer to that question will determine the extent to which it may take this position for years prior to the effective date of the proposed tangibles regulations 52

55 Tangible Assets: Why Make A Repairs Accounting Method Change Now? A change in method of accounting for repairs continues to be an area of opportunity Taxpayers looking to accelerate cash-flow Automatic consent as provided in Rev. Proc Sect. 199 change from 6% to 9% per year Possibility that final regulations may require that repairs changes be made with a cut-off or modified cut-off 53

56 Tangible Assets: Why Make A Repairs Accounting Method Change Now? (Cont.) Action items Consider filing a Form 3115 Due by the time return is timely filed, including extensions Procedural considerations Retirements generally a positive Sect. 481(a) adjustment Repairs generally a negative Sect. 481(a) adjustment Copy to IRS exam team and Ogden, Utah Must both the repairs and retirements 3115s be filed at the same time? File in a window period or under director consent Computation of Sect. 481(a) adjustment Quality of records 54

57 Tangible Assets: Why Make A Repairs Accounting Action items Method Change Now? (Cont.) Consider statistical sampling when many expenditures require review IRS guidance provides statistical sampling safe harbor when specified methodologies are followed Key safe harbor considerations include: The time required to analyze large volumes of data The cost of analyzing data, and Whether other books and records may independently exist or have greater probative value. Note that IRS guidance does not support: Sampling expenditures for one period and applying results to other periods, or Use of judgment sampling 55