Sect. 263(a) Cost Capitalization Regulations

Transcription

1 Presenting a live 110-minute teleconference with interactive Q&A Sect. 263(a) Cost Capitalization Regulations Preparing Compliant Financials: Challenges for Mid-Sized and Smaller Accounting Firms THURSDAY, NOVEMBER 10, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: James Liechty, Director, Federal Tax Services Group, PricewaterhouseCoopers, Washington, D.C. Marla Miller, Senior Manager, Fixed Asset Advisory Services Group, BDO USA, Philadelphia Anthony J. Balden, Pepper Hamilton, Washington, D.C. For this program, attendees must listen to the audio over the telephone. Please refer to the instructions ed to the registrant for the dial-in information. Attendees can still view the presentation slides online. If you have any questions, please contact Customer Service at ext. 10.

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5 Sect. 263(a) Cost Capitalization Regulations Seminar Nov. 10, 2011 Marla Miller, BDO USA James Liechty, PricewaterhouseCoopers Anthony J. Balden, Pepper Hamilton

6 Today s Program Latest IRS Notices And Guidance On Sect. 263(a) [Anthony J. Balden] Slide 7 Slide 33 Pending Revisions To Sect. 263(a) Regs: Material Terms [Marla Miller and James Liechty] Slide 34 Slide 59 Compliance Challenges In Sect. 263(a)-Related Capitalization [James Liechty] Slide 60 Slide 67 Recent Experiences With IRS Audits On Sect. 263(a) [Marla Miller and Anthony J. Balden] Slide 68 Slide 72

7 Anthony J. Balden, Pepper Hamilton LATEST IRS NOTICES AND GUIDANCE ON SECT. 263(a)

8 Sect. 263(a): Capital Expenditures General rule No deduction shall be allowed for: (1) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate (with certain listed exceptions), or (2) Any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. 8

9 Sect. 263(a): Capital Expenditures (Cont.) Depending on the type of property, practitioners ask different questions and look to different guidance. What assets were improved or acquired? Tangible or intangible? Was the amount paid to put property into a useful condition? Appreciably prolong the useful life of a unit of property ("UOP )? Materially increase the value of a UOP? Adapt the UOP to a new or different use? Was the amount paid to make a repair or keep property in a useful condition? 9

10 Sect. 263(a): Final And Proposed Regulations Treas. Reg (a)-1: Capital expenditures, in general Prop. Reg (a)-1: Capital expenditures, in general Treas. Reg (a)-2: Examples of capital expenditures Prop. Reg (a)-2: Amounts paid to acquire or produce tangible property Treas. Reg (a)-3: Election to deduct or capitalize certain expenditures Prop. Reg (a)-3: Amounts paid to improve tangible property These final and proposed regulations help to answer certain questions. What is the UOP? What is an improvement/betterment? What is a repair? 10

11 Sect. 263(a): Final Regulations Treas. Reg (a)-4: Amounts paid to acquire or create intangibles Treas. Reg (a)-5: Amounts paid or incurred to facilitate an acquisition of a trade or business, a change in the capital structure of a business entity, and certain other transactions These regulations help to answer other questions. Was there a capital transaction? Was a capitalized intangible acquired? What amounts are capitalized? 11

12 Treas. Reg (a)-5: In General Treas. Reg (a)-5(a) generally applies to: Asset acquisitions Stock acquisitions Restructurings Formations (including disregarded entities) Stock issuances Borrowings Amounts paid to facilitate one of these transactions must be capitalized. 12

13 Treas. Reg (a)-5: Facilitative Items What does it mean to facilitate? 1.263(a)-5(b): Amounts are paid to facilitate if paid in the process of investigating or otherwise pursuing a transaction. Based on all the facts and circumstances The purchase price itself does not facilitate the transaction. Simplifying conventions: 1.263(a)-5(d) Employee compensation generally does not facilitate a transaction. Includes salary, bonuses, and commissions De minimis costs May elect to capitalize employee compensation, de minimis costs 13

14 Treas. Reg (a)-5(e) There are special rules for certain acquisitive transactions in Treas. Reg (a)-5(e), and many battles are fought under these provisions. Except for inherently facilitative amounts, amounts paid to investigate or pursue a covered transaction facilitate that transaction only if the activities are performed on or after a certain date (the bright-line date ). 14

15 Treas. Reg (a)-5(e): Covered Transaction First, what is a covered transaction? Taxable asset acquisition Taxable stock/ownership acquisition resulting in more than 50% control Type A, Type B, Type C and non-divisive Type D reorganizations Other transactions are not subject to these rules no borrowings, restructurings or stock issuances 15

16 Treas. Reg (a)-5(e): Inherently Facilitative Second, what activities are inherently facilitative? Appraisal or valuation Structuring, negotiation (including tax structuring) Preparing and reviewing documentation Obtaining regulatory approval (e.g., Hart-Scott-Rodino) Obtaining shareholder approval Conveying property (e.g., transfer taxes) Costs associated with these activities are always capitalized. 16

17 Treas. Reg (a)-5(e): Bright-Line Date Finally, what is the bright-line date? It is the earlier of: The date a letter of intent, exclusivity agreement or similar written communication (other than a confidentiality agreement) is executed by the acquirer and target; or The date the material terms of the transaction are approved by the board of directors, a committee or governing official. 17

18 Treas. Reg (a)-5(f): Success-Based Fees So, how do you treat a success-based fee? An amount paid that is contingent on the successful closing of a transaction is an amount paid to facilitate that transaction, except to the extent the taxpayer maintains sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. Treas. Reg (a)-5(f) Supporting records are required that identify: The activities performed The portion of the fee allocable to each activity The portion allocable to performance before and after the bright-line date The provider s business information 18

19 Treas. Reg (a)-5(f): Rebuttable Presumption Rebuttable presumption that success-based fees are facilitative Must maintain sufficient documentation to rebut Must be completed on or before the due date of the return (including extensions) More than simply an allocation letter. Items could include: Interview notes with service providers Board presentation materials and other provider work product Schedules of meetings or calls Invoice detail Public and corporate transaction documents 19

20 Treas. Reg (a)-5(f): Sufficient Documentation Private Letter Ruling : Taxpayers should consider all evidence. Technical Advisory Memorandum : LMSB argued that the taxpayer had not provided other records to support its allocation. The IRS National Office, however, concluded that an allocation spreadsheet prepared by an accounting firm was an other record. 20

21 Treas. Reg (a)-5(f): Sufficient Documentation (Cont.) Private Letter Ruling : Time records are not required, but the ruling does not specify what is required. How much documentation is enough? How do you evaluate, prove and allocate transaction costs? How should costs be apportioned among various parties? Important issue in cross-border transactions, parentsubsidiary structures and private equity transactions 21

22 Treas. Reg (a)-5(f): Success-based Fee Issues Inconsistent treatment and great uncertainty in the marketplace Corporate constituencies need certainty (board of directors, shareholders/investors). Return and audit issues need to determine return positions, reserves for financial statements, potential Schedule UTP filings and other matters. Practitioners have to evaluate and determine the level of confidence. 22

23 Revenue Procedure , I.R.B. 746 Provides a safe-harbor election for success-based fee allocations under Sect. 263(a) and Treas. Reg (a)-5. Without the election, taxpayers are subject to Treas. Reg (a)-5(f). A taxpayer may treat 70% of the success-based fee as an amount that does not facilitate the transaction. The remaining 30% must be capitalized as an amount that facilitates the transaction. 23

24 Revenue Procedure : Election To make the election, the taxpayer must attach a statement to its return (i) electing the safe harbor, (ii) identifying the covered transaction, and (iii) stating the success-based fee amounts that are deducted and capitalized. The election is made (or not made) by each taxpayer individually, and the election applies only to the identified transaction. The election is irrevocable, once made. Only for success-based fees paid or incurred in taxable years ending on or after April 8,

25 LB&I Directive ( ), July 28, 2011 Examination of Success-Based Fees in the Acquisition of Businesses Instructs LB&I examiners not to challenge allocations of successbased fees incurred or paid in tax years ending prior to April 8, 2011, if the taxpayer capitalized at least 30% of the total successbased fees 25

26 Treas. Reg (a)-4: Intangible Regulations Except as provided, taxpayers must capitalize: Amounts paid to acquire an intangible Treas. Reg (a)-4(c) Amounts paid to create an intangible Treas. Reg (a)-4(d) Amounts paid to create or enhance a separate and distinct intangible asset Treas. Reg (a)-4(b)(3) Amounts paid to create or enhance a future benefit (as defined in guidance) Amounts paid to facilitate an acquisition or creation of any of the above 26

27 Treas. Reg (a)-4(c): Acquired Intangibles Intangibles for these purposes include: Ownership interests (stock, partnership interests) Debt instruments Financial instruments (futures, forwards, currency contracts, notional principal contracts, options, other derivatives) Annuity or insurance contracts Leases Patents or copyrights 27

28 Treas. Reg (a)-4(d): Created Intangibles Intangibles for these purposes include: Financial interests (similar to those in Treas. Reg (a)-4(c)) Prepaid expenses (insurance, rent) Certain memberships and privileges Certain rights obtained from a governmental agency Certain contract rights Certain contract terminations Certain benefits arising from real property Defense or perfection of title to intangible property 28

29 Treas. Reg (a)-4(b)(3): Separate And Distinct Intangible Assets An intangible for these purposes means: A property interest of ascertainable and measurable value, in money s worth, that is subject to protection under applicable law, and The possession and control of which is intrinsically capable of being sold, transferred or pledged separate and apart from a trade or business Catch-all provision, but some exclusions: Creating, renegotiating or terminating contract rights (look to Treas. Reg (a)-4(d)) Performing services under an agreement Creating computer software Creating package designs 29

30 Treas. Reg (a)-4: PLR Private Letter Ruling : The settlement payments at issue did not create a separate and distinct intangible asset under Sect Under the origin of the claim doctrine, the liability originated from common and routine trade or business activities. Payments in the settlement were deductible under Sect

31 Treas. Reg (a)-4: Create Or Enhance A Future Benefit Must be published in the Federal Register or the Internal Revenue Bulletin Treas. Reg (a)-4(b)(2): Any published guidance identifying a future benefit only applies to amounts paid on or after the date published. See, e.g., Rev. Rul

32 Treas. Reg (a)-4(e): Facilitative Costs Similar to the rules in Treas. Reg (a)-5(e) No bright-line date considerations here Rev. Proc and the LB&I directive do not cover these costs. 32

33 Treas. Reg (a)-4(f): 12-Month Rule An important exception to Treas. Reg (a)-4 A taxpayer is not required to capitalize amounts paid to create (or facilitate the creation of) any right or benefit that does not extend beyond the earlier of: 12 months after the first date the right or benefit is realized, or The end of the taxable year following the year in which the payment is made. 33

34 Marla Miller, BDO USA James Liechty, PricewaterhouseCoopers PENDING REVISIONS TO SECT. 263(a) REGS: MATERIAL TERMS

35 Re-Proposed Tangible Regulations The IRS issued re-proposed regulations March 7, 2008 for amounts paid to acquire, produce or repair tangible property. The re-proposed regulations were issued in response to criticism of the August 2006 proposed regulations. 35

36 Re-Proposed Tangible Regulations (Cont.) Overview (regulation sections 1.263(a)-1 through 1.263(a)-3) The general rule of capitalization remains unchanged under Sect (a)-1(a). Additional guidance was provided on: Materials and supplies Unit of property Determining if an expenditure improves the unit of property Establishing a safe harbor for routine maintenance Establising a de minimis rule Adopting a regulatory accounting method safe harbor 36

37 Re-Proposed Tangible Regulations (Cont.) Materials and supplies (M&S) are defined as: Items that are not a UOP Items that are a UOP with expected useful life of 12 months or less Items that are a UOP with an acquisition or production cost of $100 or less (M&S de minimis rule) An item later identified by IRS in published guidance as M&S 37

38 Re-Proposed Tangible Regulations (Cont.) Materials and supplies (Cont.) Timing of deductions Non-incidental M&S deducted when used or consumed Incidental M&S deducted when purchased if either: No record of consumption, or No physical inventories at the beginning of the year; and If taxable income is clearly reflected. Clear reflection is not defined. 38

39 Re-Proposed Tangible Regulations (Cont.) Materials and supplies (Cont.) Timing of deductions: Annual election to capitalize M&S available Election for each M&S Rotable spare parts consumed when disposed of More advantageous to depreciate rotables? 39

40 Re-Proposed Tangible Regulations (Cont.) Unit of property (UOP) No UOP definitions provided for network assets (pipelines, telephone/cable lines, electrical lines, railroad track) 40

41 Re-Proposed Tangible Regulations (Cont.) Network asset industry issue resolution (IIR) Taxpayers invited to participate in the IIR process to define UOP for network assets. Published IIRs Electric transmission and distribution (Rev. Proc ) Wireline and wireless telecommunications assets (Rev. Procs and ) In process Gas distribution property Electric generation Retail likely will be addressed in regulations. 41

42 Re-Proposed Tangible Regulations (Cont.) Leasehold improvements Sect property UOP Government considering whether there should be a bright line rule for real property. Sect property UOP is still unclear. 42

43 Re-Proposed Tangible Regulations (Cont.) Amounts paid to improve a UOP must be capitalized if there is a: Betterment, Restoration, or New or different use 43

44 Re-Proposed Tangible Regulations (Cont.) Sect (a)-3: Safe harbor for routine maintenance In general, an amount paid for routine maintenance performed on a unit of property is deemed to not improve that unit of property. Routine maintenance covers the recurring activities that a taxpayer expects to perform as a result of its use of the unit of property, to keep the unit of property in its ordinarily efficient operating condition. The activities are routine only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life of the unit of property. 44

45 Re-Proposed Tangible Regulations (Cont.) Sect (a)-3: Safe harbor for routine maintenance (Cont.) Among the factors to be considered in determining whether a taxpayer is performing routine maintenance are the recurring nature of the activity, industry practice, manufacturers recommendations, the taxpayer s experience, and the taxpayer s treatment of the activity on its applicable financial statement (as defined in paragraph (b)(4) of this section). Examples of routine maintenance include: Inspection, cleaning and testing of the unit of property, and the replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts. 45

46 Re-Proposed Tangible Regulations (Cont.) Sect (a)-3: Safe harbor for routine maintenance (Cont.) Routine maintenance does not include: Amounts paid for replacement of component of a unit of property, if the taxpayer has properly deducted a loss for that component Amounts paid for replacement of component of a unit of property, if the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component Amounts paid for repair of damage to a unit of property for which the taxpayer has taken a basis adjustment as a result of a casualty loss under Sect. 165, or relating to a casualty event described in Sect. 165 Amounts paid to return a unit of property to its former ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use 46

47 Re-Proposed Tangible Regulations (Cont.) Sect (a)-2: Book conformity de minimis rule Taxpayer is not required to capitalize amounts paid for the acquisition or production (including any amounts paid to facilitate the acquisition or production) of a unit of property, if: Taxpayer has an applicable financial statement. Taxpayer has, at the beginning of the taxable year, written accounting procedures treating as an expense for non-tax purposes the amounts paid for property costing less than a certain dollar amount. Taxpayer treats amounts paid during the taxable year as an expense on its applicable financial statement, in accordance with its written accounting procedures. The total aggregate of amounts paid and not capitalized for the taxable year do not distort the taxpayer s income for the taxable year. 47

48 Re-Proposed Tangible Regulations (Cont.) Sect (a)-2: Book conformity de minimis rule (Cont.) The de minimis rule does not apply to the following: Amounts paid to improve property under Sect (a)-3 Amounts paid for property that is, or is intended to be, included in property produced or acquired for resale Amounts paid for land 48

49 Re-Proposed Tangible Regulations (Cont.) Sect (a)-3: Optional simplified method for regulated taxpayers Eligibility: A taxpayer that is engaged in a trade or business in a regulated industry may use the regulatory accounting method. A taxpayer in a regulated industry is subject to the regulatory accounting rules of the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB). Under the regulatory accounting method, a taxpayer must follow its method of accounting for regulatory accounting purposes in determining whether an amount paid improves property under this section. A taxpayer that uses the regulatory accounting method must use that method for all of its tangible property that is subject to regulatory accounting rules. The method does not apply to tangible property that is not subject to regulatory accounting rules. 49

50 Re-Proposed Tangible Regulations (Cont.) Overview Proposed regulations were taxpayer-friendly. More liberal view of repairs Asbestos removal and replacement Retail store re-imaging and periodic construction Roof replacement (as long as not a betterment ) Turbine blade replacements within a steam turbine Final regulations are expected within the next few weeks, and no later than the end of the year. 50

51 Repairs And Maintenance: Opportunities Benefits of repairs change of accounting methods Accelerated deductions Increased cash flow Reduced estimated payments Automatic method change of accounting 51

52 Repairs And Maintenance: Targets Any capital-intensive taxpayer that incurs significant amounts of routine repairs and maintenance expenses will benefit. Benefit (NPV) is greater with longer-lived tax assets. Tax paying position or ability to use losses Industries with large opportunities: Retail Manufacturing Restaurants Utilities Oil and Gas Hospitality Commercial buildings 52

53 Repairs And Maintenance: Examples Parking lot and sidewalk repairs Ongoing maintenance projects Repainting Replacing windows/doors Re-imaging costs Replacing roofs Equipment maintenance Equipment relocation expenses HVAC repairs 53

54 Impact Of Final Regulations Significant fixed-asset guidance Final regulations will impact many industries Effective 2011 or 2012? May also be proposed and/or temporary regs. for new rules Expect most rules to be temporary or final Unit of property Buildings, HVAC, roof, plant property, leasehold improvements, etc. Exclude network assets Will UOP be the same for repair and retirement purposes? 54

55 Impact Of Final Regulations (Cont.) Definition of material increase in value - betterment Two revenue procedures with transitional rules May be issued at the same time or later than regulations Sect. 481(a) likely Most taxpayers will need to file a change of accounting method. Adjustment may be favorable or unfavorable, depending on taxpayer s current position. Use of statistical sampling? Will there be a multi-year transition period? 55

56 Repairs Method Change: Rev. Proc Rev. Proc issued on August 27, 2009 updated and modified Rev. Proc , which is superseded by Rev. Proc Included new procedural rules, added new automatic method changes and modified prior automatic method changes No unit of property protection Definition of under examination expanded to include a refund under review by the Joint Committee on Taxation [new Sect. 3.08(5)] 56

57 Repairs Method Change: Attachments A detailed summary of the types of property and types of repair and maintenance costs to which the change applies Description of the unit(s) of property under present and proposed method, including legal authority Standard representations regarding the repair and maintenance costs 57

58 Repairs Method Change: Tier I Issue Why is the repairs change a Tier I issue? Large number of Form 3115 filings since 2008 Substantial Sect. 481(a) adjustments May 2009 IRS LMSB emerging issue alert - unit of property concerns IRS needed a coordinated effort to review the change. IRS will be required to review the change, if audited. 58

59 Repairs Method Change: Tier I Issue (Cont.) The IRS Large Business and International Division s tiered issue process will be replaced by a new knowledge management process. One of the issue practice groups is focused on repairs/capitalization. Agents are receiving training in preparation of the final regulation release. 59

60 James Liechty, PricewaterhouseCoopers COMPLIANCE CHALLENGES IN SECT. 263(a)-RELATED CAPITALIZATION

61 Sect. 263(a): Capital Expenditures For federal income tax purposes, taxpayers are required to capitalize expenditures that: Appreciably prolongs the useful life of a 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 UOP retired? Deduct? Continue to depreciate? 61

62 Compliance Challenges: Unit of Property Buildings Structural components Major systems Leasehold Improvements 1245 property Plant property Functional interdependence Discrete and major function UOP for repair and retirement purposes 62

63 Compliance Challenges: Unit of Property (Cont.) UOP available records Invoices Capital expenditure requests Interviews with engineers, manufacturing line employees Diagrams, drawings, plans, etc. Prior cost segregation studies 63

64 Compliance Challenges: Deductible Repairs Identify deductible repairs put vs. keep Fixed asset records How far back? Issues with items previously expensed Invoices Capital expenditure requests Interviews with engineers, maintenance department, etc. 64

65 Compliance Challenges: Deductible Repairs (Cont.) Statistical sampling (Rev. Proc ) Where use permitted by IRS Appropriate Facts and circumstances Time required to analyze large volumes of data Cost of analyzing data Other books and records that are available Valid Maintain records Each observation has a non-zero probability of being selected. Valid sampling plan Independent verification 65

66 Compliance Challenges: Deductible Repairs (Cont.) Consider: Thorough documentation of positions Consistency with: Cost segregation studies Information previously provided to exam, prior closing agreements, etc. A cold read of supporting memos to probe areas of likely IRS scrutiny UOP memos Statistical sampling 66

67 Compliance Challenges: Deductible Repairs (Cont.) Impact of new regulations Information previously provided to exam Transition to new rules Significant effort to put policies, procedures, systems in place in hopes of future simplification and ease of administration 67

68 Marla Miller, BDO USA Anthony J. Balden, Pepper Hamilton RECENT EXPERIENCES WITH IRS AUDITS ON SECT. 263(a)

69 Repairs: IRS Audits Super IDR wide breadth of review It outlines 45 standard questions to be addressed in relation to repairs change in accounting method. Some auditors may reduce the number of questions based on the taxpayer s business. Documentation needed for successful exam Adequate documentation to support the repairs UOP memos Analysis of statistical sampling (if used) Recent IRS audits suggests that agents are seeking adjustments, not necessarily based on case law or consistency. 69

70 Repairs: IRS Audits (Cont.) Focus of IRS audits on: Unit of property (e.g., roofs, HVAC) Lack of documentation Age of the asset Betterment 70

71 Recent Audit Experience And Issues Rev. Proc and the LB&I firective generally are beneficial to taxpayers, but several questions have not been answered. What substantiation is required under the LB&I directive? Which party should be taking the costs into account? What if the same service provider has a time-andmaterial-based fee and a success-based fee? What about amortizable costs? What about financings? 71

72 Recent Audit Experience And Issues (Cont.) Treas. Reg (a)-5(c)(8) Abandoned transactions When are transactions mutually exclusive? Treas. Reg (a)-4(l) examples Do these take precedence over case law? 72