Deconstructing the Tangible Property Temporary Regulations Understanding how the new guidance may affect your company

Transcription

1 Deconstructing the Tangible Property Temporary Regulations Understanding how the new guidance may affect your company March 2012

2 Contents Overview 2 Materials and Supplies 3 Amounts Paid to Acquire or Produce Tangible Property 4 Amounts Paid to Improve Tangible Property 6 Dispositions of MACRS Property 12 Transition Guidance Revenue Procedures and Large Business and International Division Directive 17 Tangible Property Temporary Regulations Automatic Method Change Guidance Chart 18 Contacts 23 Deconstructing the Tangible Property Temporary Regulations 1

3 Overview Overview On December 27, 2011, the Treasury Department ( Treasury ) and the Internal Revenue Service ( IRS ) issued temporary 1 and proposed 2 regulations ( the Temporary Regulations ) that provide guidance with respect to the treatment of materials and supplies, dispositions of MACRS property, capitalization of amounts paid to acquire or produce (or facilitate the acquisition or production of) tangible property, and the determination of whether an expenditure with respect to tangible property is a deductible repair or must capitalized. Thus, the Temporary Regulations address a broad range of capitalization and deduction issues for expenditures related to tangible property and may likely impact taxpayers in all industries. The Temporary Regulations are generally effective for taxable years beginning on or after January 1, 2012; however, a number of provisions are effective for amounts paid or incurred in taxable years beginning on or after January 1, Early adoption of the Temporary Regulations is not allowed. Changes to comply with or adopt the provisions in the Temporary Regulations generally will be made through an accounting method change, most of which require the computation of an IRC 481(a) adjustment. Rev. Proc and Rev. Proc provide guidance on implementing the Temporary Regulations. The Temporary Regulations retain many of the provisions included in the proposed regulations issued in 2008 ( 2008 Proposed Regulations 3 ); however, there are a number of new provisions and changes from the 2008 Proposed Regulations as well as changes to pre-january 1, 2012 law. The major changes include: Disposition of structural components of a building Rules for determining whether there is an improvement to a unit of property, including the replacement of a major component or substantial structural part of a unit of property Expansion of the definition of materials and supplies Revision of the proposed de minimis rule allowing taxpayers to deduct certain amounts that cost less than a minimum threshold amount Numerous examples analyzing a variety of costs incurred to remodel or refresh stores Simplifying conventions for amounts paid that facilitate the acquisition of certain tangible property Replacement of the plan of rehabilitation doctrine with a benefit or incurred by reason of standard from IRC 263A Various elections, including general asset account elections that interact with the rules for restorations Material changes to the routine maintenance safe harbor The Temporary Regulations withdraw the 2008 Proposed Regulations and serve as the text of the current proposed regulations. Treasury and the IRS have requested comments on the proposed regulations by April 17, 2012, in advance of the public hearing on the regulations scheduled for May 9, T.D REG FR Deconstructing the Tangible Property Temporary Regulations 2

4 Materials and Supplies Materials and Supplies As under pre-january 1, 2012 law, incidental materials and supplies (i.e., materials and supplies for which the taxpayer does not maintain a record of consumption or take physical inventories at year end) are deductible when purchased. Non-incidental materials and supplies are deductible when used or consumed. In response to comments received with respect to the 2008 Proposed Regulations, Treasury and the IRS clarify and expand the definition of materials and supplies in the Temporary Regulations by eliminating the requirement that such property not be a unit of property and including a new category of qualifying property. Accordingly, the Temporary Regulations define a material and supply as tangible property used or consumed in the taxpayer s operations that is not inventory and is: A component acquired to maintain, repair, or improve a unit of tangible property (includes rotable and temporary spare parts); Fuel, lubricants, water, or similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in taxpayer s operations (new category); A unit of property that has an economic useful life of 12 months or less; A unit of property with an acquisition or production cost of $100 or less; or Property identified in future published guidance. A taxpayer may elect to capitalize and depreciate each material or supply. A taxpayer makes the election annually by capitalizing the particular material or supply in the taxable year the amounts are paid and by beginning to recover the costs on its timely filed original federal income tax return (including extensions) for the taxable year the asset is placed in service. A taxpayer may also elect annually to treat each material or supply under the de minimis rule (discussed below), provided all requirements under such rule are met for such material or supply. The Temporary Regulations include special rules for rotable and temporary spare parts ( rotables ). The default treatment is to deduct rotables when used or consumed (i.e., when disposed of); however, a taxpayer may elect to capitalize and depreciate rotables or elect an optional method treatment. Under the optional method, the taxpayer deducts its basis in the rotable in the year it is placed in service, recognizes income when the rotable is removed, capitalizes costs to fix the rotable, and then claims a deduction for such basis when the rotable is once again placed in service. Additionally, otherwise deductible materials and supplies may be subject to capitalization under IRC 263A, or as an improvement under Temp. Reg (a)-3T. Deconstructing the Tangible Property Temporary Regulations 3

5 Amounts Paid to Acquire or Produce Tangible Property Amounts Paid to Acquire or Produce Tangible Property Amounts paid to acquire or produce tangible property or to defend or perfect title to such property must be capitalized. In addition, a taxpayer must capitalize amounts paid to facilitate the acquisition or production of tangible property. The determination of whether costs associated with activities are facilitative is based on facts and circumstances. However, the Temporary Regulations provide a list of inherently facilitative activities that is similar to the list in Treas. Reg (a)-5, and include bidding costs, finders fees or brokers commissions, and securing an appraisal, among other activities. Facilitative Costs Under the Temporary Regulations non-inherently facilitative pre-decisional investigatory costs paid in pursuing the acquisition of real property are not considered facilitative, and therefore are not required to be capitalized, if paid for activities performed in the process of determining whether and which real property to acquire. Because this special rule only applies to the acquisition of real property, an allocation of facilitative costs between real and tangible personal properties may be required if both real and tangible personal properties are acquired in a single transaction. The amount of non-inherently facilitative pre-decisional investigatory costs reasonably allocated to the real property can be deducted, while costs reasonably allocated to the acquisition of personal property must be capitalized. The Temporary Regulations also provide that employee compensation and overhead costs related to the acquisition of tangible property are not subject to capitalization under IRC 263(a); however, such costs may be required to be capitalized under IRC 263A. De Minimis Rule The de minimis rule provided in the Temporary Regulations permits a taxpayer to deduct certain expenditures consistent with the treatment on its applicable financial statement ( AFS ) subject to a ceiling. An AFS is a financial statement provided to the Securities and Exchange Commission ( SEC ), an audited financial statement used for creditors or other non-tax purpose, or a financial statement provided to a governmental agency other than the IRS or SEC. To be eligible for the de minimis rule, the taxpayer must have in place at the beginning of the year, a written financial accounting policy to deduct amounts below a certain dollar threshold and expense amounts on its AFS consistent with the written policy. The ceiling amount (i.e., the maximum deduction under the de minimis rule) is equal to the greater of: 0.1% of the taxpayer s gross receipts for federal income tax purposes, or 2% of the taxpayer s total depreciation and amortization expense for the tax year reflected on its AFS If the amount expensed pursuant to the taxpayer s AFS minimum capitalization threshold exceeds the ceiling, then no amount is deductible under the de minimis rule. However, the taxpayer may Deconstructing the Tangible Property Temporary Regulations 4

6 Amounts Paid to Acquire or Produce Tangible Property elect to capitalize a portion of the amounts expensed under its AFS capitalization threshold so as to allow it to deduct the ceiling amount. For consolidated groups, the determination of whether the taxpayer has an AFS and a written policy to expense amounts below a certain threshold can be made at the consolidated group level. The determination and application of the ceiling amount is made separately for each consolidated group member. As noted above, amounts deducted as materials and supplies (discussed above) are not included in the ceiling computation unless the taxpayer so elects. Practice Consideration The favorable de minimis rule likely comes with an additional compliance burden for taxpayers. Specifically, many taxpayers do not currently track the total amount expensed under their capitalization threshold. The revised ceiling test, and the flexibility afforded taxpayers in the form of elections, requires that taxpayers track the total amount deducted under the de minimis rule. The preamble to the Temporary Regulations indicates that the issuance of the regulations is not intended to disturb the treatment of minimum capitalization threshold agreements between examiners and taxpayers, provided such agreements clearly reflect income. There is speculation that the IRS will view the ceiling in the Temporary Regulations as the test in determining whether the previously agreed upon minimum capitalization threshold clearly reflects income. Taxpayers should consider evaluating whether they are capable of capturing the information necessary to apply the de minimis rule and whether amounts deducted pursuant to their present capitalization policies exceed the ceiling. Example Assume the taxpayer is a member of a consolidated group that has an AFS and a written policy at the beginning of Year 1, under which it expenses amounts paid for property costing less than $500. In Year 1, the taxpayer pays $160,000 to purchase 400 computers at $400 each. Each computer is a unit of property, is not a material or supply, and the taxpayer intends to treat the cost of only the computers as de minimis. Assume that for its Year 1 taxable year, the taxpayer has tax gross receipts of $125M and book depreciation/amortization of $7M. To be eligible for the de minimis rule, the total aggregate amounts paid and not capitalized by the taxpayer must be less than or equal to the greater of $125,000 (0.1 % of its total tax gross receipts of $125M) or $140,000 (2% of its total book depreciation/amortization of $7M). Because the taxpayer pays $160,000 for the computers and this amount exceeds $140,000, it may not apply the de minimis rule to the total amounts paid for the 400 computers. However, if the taxpayer makes an election to capitalize $20,000 (the amounts paid to acquire 50 of the 400 computers purchased in Year 1), it would not be required to capitalize the amounts paid to acquire the 350 computers in Year 1. Deconstructing the Tangible Property Temporary Regulations 5

7 Amounts Paid to Improve Tangible Property Amounts Paid to Improve Tangible Property For many taxpayers, the more significant aspects of the Temporary Regulations are the provisions addressing the treatment of amounts paid to improve tangible property (i.e., the so-called repair regulations). The Temporary Regulations generally provide that amounts paid to improve a unit of real or personal tangible property must be capitalized. An amount is considered paid to improve a unit of property ( UoP ) if it results in: (i) a betterment of the UoP, (ii) a restoration of the UoP, or (iii) an adaptation of the UoP to a new or different use. If a type of maintenance is a recurring activity that the taxpayer reasonably expects to perform as a result of the taxpayer s use of the UoP (other than a building or structural component of a building) to keep the UoP in its ordinarily efficient operating condition, then the amount paid may qualify for the routine maintenance safe harbor (discussed below). Definition of Unit of Property The Temporary Regulations provide that unless otherwise specified, the UoP is determined using a functional interdependence standard, under which the placing in service of one component by the taxpayer depends on the placing in service of the other component by the taxpayer. Special UoP rules are provided for buildings, leased property, plant property, and network assets. The Temporary Regulations also provide that a component of a UoP must be treated as a separate UoP if that component (i) is properly treated as being within a different MACRS class (as determined under IRC 168(e)) than the class of the larger UoP, or (ii) has been properly depreciated using a different depreciation method. This MACRS consistency rule applies during the placed in service year of the asset and in future years (e.g., if the taxpayer completes a cost segregation study). Building and its Structural Components The Temporary Regulations define a building and its structural components as a single UoP, but require that the improvement standards be applied separately to the building structure and the following building systems: Heating, ventilation, and air conditioning systems (HVAC); Plumbing systems; Electrical systems; All escalators; All elevators; Fire protection and alarm systems; Security systems; Gas distribution systems; and Any other structural component identified in published guidance. Deconstructing the Tangible Property Temporary Regulations 6

8 Amounts Paid to Improve Tangible Property Practice Consideration Roof replacements are a common example used to illustrate the operation of the building UoP rules. The work performed on the roof must be measured against the building structure (defined as the building and its structural components, other than the building systems above) to determine whether an improvement to the UoP occurs. The requirement to apply the improvement standards to the building structure and building systems is a significant change that will likely result in additional capitalizable improvements. Taxpayers that previously categorized repair expenditures as deductible or capitalizable by comparing work performed to the entire building should consider changing their method of accounting to comply with the Temporary Regulations. Plant Property Plant property is "functionally interdependent machinery or equipment, other than network assets, used to perform an industrial process, such as manufacturing, generation, warehousing, distribution, automated materials handling in service industries, or similar activities." The UoP for plant property is initially determined based on the functional interdependence standard. However, the Temporary Regulations provide that functionally interdependent plant property is further divided into smaller UoPs based on a component or a group of components that perform a discrete and major function or operation. The preamble to the Temporary Regulations states, The discrete and major function rule provides a reasonable and administrable limitation on the functional interdependence standard, which otherwise could be overly broad in its application to industrial equipment. Practice Consideration The discrete and major function standard often results in a UoP smaller than the taxpayer s UoP under its present method of accounting. This is particularly relevant for taxpayers whose industrial process requires that a product move uninterrupted from one end of the production line to another to produce a salable product. Taxpayers with functionally interdependent production lines (e.g., aluminum milling or certain chemical manufacturers) often defined the entire line as the UoP under prior law. Taxpayers with plant property that previously categorized repair expenditures as deductible or capitalizable by comparing work performed to the entire production line should consider changing their method of accounting to comply with the Temporary Regulations. Examples Taxpayer uses many different machines in an assembly-line like process to treat, launder and prepare linens. Because this equipment is plant property used in an industrial process, each sorter, boiler, washer, dryer, etc. must be treated as a separate UoP. Taxpayer, a restaurant, serves food to customers on its premises. The restaurant employs equipment in an assembly-line like process to prepare and cook tortillas. Contrary to the example above, because this equipment is property that is not used in an industrial process (i.e., it performs a small-scale function in a restaurant), the UoP in this example is the tortilla making equipment apparatus as a whole. Deconstructing the Tangible Property Temporary Regulations 7

9 Amounts Paid to Improve Tangible Property Network Assets The Temporary Regulations provide that the UoP for network assets is determined by the taxpayer s particular facts and circumstances or as provided in published guidance (see e.g., Rev. Proc for wireline network assets, Rev. Proc for wireless networks assets and Rev. Proc for electric transmission and distribution property). It is anticipated that the IRS will issue similar guidance for other industries with network assets (e.g., gas transmission and distribution) in the coming year. Leased Property A taxpayer that is a lessor of a building or other non-building property applies the general rule for determining the UoP and improvements. For a taxpayer that is a lessee of all or a portion of one or more buildings, the UoP is each building and its structural components associated with the leased portion of the building. Accordingly, a taxpayer-lessee must apply the improvement standards (as discussed below) to the leased building or leased portion of the building and the related building systems. Lessee improvement made to a unit of leased property is a separate UoP. For nonbuilding leased property, the general functional interdependence test applies except that the UoP may not be larger than the unit of leased property. Practice Consideration The Temporary Regulations provide, for the first time, guidance for units of leased property. Example Taxpayer leases two office spaces in the same building under separate agreements. Each office space contains a separate HVAC unit. The taxpayer must treat the HVAC unit associated with one leased office space as a building system of that leased space and the HVAC unit associated with the second leased office space as a building system of that second leased space. Improvement Standards Once a taxpayer has determined the appropriate UoP, the next step is to assess whether the expenditure is an improvement to the UoP resulting in capitalization. As discussed above, an amount is considered paid to improve a UoP if it results in: (i) a betterment of the UoP, (ii) a restoration of the UoP, or (iii) an adaptation of the UoP to a new or different use. The Temporary Regulations generally require a facts and circumstances analysis to determine whether an expenditure is an improvement; however, the Temporary Regulations provide a conceptual framework in applying the improvement standards including numerous examples. In applying the standards, the Temporary Regulations provide that an amount is not necessarily deductible solely because the repair is required to comply with regulatory requirements. Additionally, the Temporary Regulations effectively replace the plan of rehabilitation doctrine with the IRC 263A directly benefit or are incurred by reason of standard. Betterment The Temporary Regulations provide that, in general, an amount paid results in a betterment of a UoP if it: Corrects a material condition or defect existing prior to the taxpayer s acquisition of the UoP or one that arose during the production of the UoP, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production; Results in a material addition to the UoP; or Deconstructing the Tangible Property Temporary Regulations 8

10 Amounts Paid to Improve Tangible Property Results in a material increase in capacity, productivity, efficiency, strength or quality of the UoP. The Temporary Regulations provide an appropriate comparison rule instructing taxpayers how to apply the betterment analysis. When a particular event necessitates the expenditure, the analysis is performed by comparing the condition of the property after the expenditure with the condition of the property immediately before the event. If an expenditure is necessitated by normal wear and tear, the condition of the property after the expenditure is compared with the condition of the property immediately after the last time the taxpayer corrected the effects of wear and tear. In determining whether an expenditure results in a betterment, the purpose of the expenditure, the physical nature of the work performed, the effect of the expenditure on the UoP, and the taxpayer s treatment of the expenditure on its AFS are all considered. Practice Consideration The betterment standard is highly factual, and combined with the revisions to certain UoP definitions (discussed above), requires taxpayers to compare the repair cost against the UoP to determine whether an amount paid results in a betterment to that UoP. Three sequential examples in the Temporary Regulations (as summarized below) illustrate the betterment standard, including the interplay of IRC 263A (otherwise deductible amounts must be capitalized if they directly benefit or are incurred by reason of an improvement to a UoP) by analyzing the refresh and remodel of a chain of retail stores. In relevant part, the examples conclude that the replacement of bathroom fixtures (e.g., sinks, toilets, etc.) results in a capitalizable betterment to the plumbing system because the replacements result in material increase in quality to the plumbing system. Examples Taxpayer owns a retail store and periodically refreshes the appearance and layout of its store by replacing and reconfiguring a small number of display tables and racks, relocating lighting, repairing floors, moving one wall to accommodate the reconfiguration of tables and racks and repainting the interior structure. Assuming the work does not ameliorate any pre-existing material conditions or defects, the amounts paid for the refresh of the building are not considered betterments because they do not result in material increases in capacity, productivity, efficiency, strength or quality of the building s structure or building system compared to the condition before the refresh. However, amounts paid to acquire and install each display table and rack (i.e. tangible personal property) must be capitalized. In the course of the store refresh, the taxpayer decides to update all the restroom facilities in the building by removing the bathroom fixtures and replacing them with updated ones. The taxpayer also pays amounts to replace floor and wall tiles that were damaged as a result of the installation of the bathroom fixtures. Because the updated fixtures materially increase the quality of the plumbing system of the building, the amounts paid to replace the fixtures are considered betterments and must be capitalized. The replacement of floor and wall tiles must also be capitalized because they directly benefit and are incurred by reason of the improvement to the plumbing system. If the taxpayer decides to substantially remodel the retail store by performing significant additional work to alter the appearance and layout of its stores in order to increase customer traffic and sales volume, then the amounts paid for the remodel result in betterments to the building s structure and system due to the increased efficiency as a result. In addition, the amounts paid to refresh the appearance of the store (above) must also be capitalized because they directly benefit and are incurred by reason of the remodel. Deconstructing the Tangible Property Temporary Regulations 9

11 Amounts Paid to Improve Tangible Property Restoration of Property In general, the Temporary Regulations require the capitalization of amounts paid to restore a UoP. For these purposes, restoration includes: Replacing a component of a UoP if the taxpayer has properly deducted a loss for that component (other than a casualty loss under Treas. Reg ); Replacing a component of a UoP if the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss from the sale or exchange of the component; Repairing damage to a UoP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under IRC 165, or relating to a casualty event described in IRC 165; Returning a property to its ordinarily efficient operating condition from a state of nonfunctional disrepair; Rebuilding the property to a like-new condition after the end of its class life; Replacing a major component or substantial structural part of a UoP (where a major component or substantial structural part includes a part or combination of parts that comprise a large portion of the physical structure of the UoP or that perform a discrete and critical function in operation of the UoP). Practice Consideration Basis recovery on the disposition of property is a critical component of the restoration improvement standard. As a result, understanding the disposition rules (discussed below) is important for making the appropriate asset account elections to maintain flexibility in determining whether to claim a deduction for a retirement or for a repair. Capitalizable restorations include an otherwise deductible repair when the taxpayer recovers adjusted basis on the disposition of a replaced component or part. If a taxpayer has properly taken a basis adjustment as a result of a casualty loss, or relating to a casualty event under IRC 165, then an amount paid to restore the damaged UoP is a capital expenditure. The impact of the restoration improvement standard and the new disposition rules on casualty losses are further discussed the disposition and General Asset Account section below. Examples Assume a taxpayer decides to replace several non-functional components of its walk-in freezer. The taxpayer abandons the old freezer components and properly recognizes a loss from the abandonment of the components. The taxpayer replaces the abandoned freezer components with new components and incurs costs to acquire and install the new components. The costs to acquire and install the replacement components are capitalized as a restoration because the taxpayer replaced components for which it had properly deducted a loss. Taxpayer owns an office building which has a HVAC system containing ten roof-mounted units, controls and air ducts. Due to malfunction, the taxpayer replaces two of the roof-mounted units. The two units do not comprise a large portion of the physical structure of the HVAC system or perform a discrete and critical function in the operation of the system and therefore do not constitute a major component or substantial structural part of the building system. The taxpayer does not recover basis on the retirement of the two roof-mounted units. Accordingly, the taxpayer is not required to treat the amount paid to replace the two units as a restoration of a building system. Deconstructing the Tangible Property Temporary Regulations 10

12 Amounts Paid to Improve Tangible Property Adaption to New or Different Use In general, a taxpayer must capitalize amounts paid to adapt a UoP to a new or different use. An amount paid is considered for a new or different use if the adaptation is not consistent with the taxpayer s intended ordinary use of the UoP at the time originally placed in service by the taxpayer. For example, the Temporary Regulations provide that in the case of a building, an amount is paid to adapt the UoP to a new or different use if it adapts to a new or different use any of the properties specifically designated in the Temporary Regulations (i.e., buildings, condominiums, cooperatives and leased buildings). Routine Maintenance Safe Harbor A routine maintenance safe harbor is provided for routine and recurring activities that a taxpayer expects to perform as a result of a taxpayer s use of the property. The safe harbor is not applicable to a building or its structural components or to certain rotables. An activity is considered recurring only if at the time the property is placed in service the taxpayer reasonably expects to perform the activity more than once during the Alternative Depreciation System ( ADS ) class life of the UoP. A taxpayer must take into consideration the recurring nature of the activity, industry practice, manufacturers recommendations, the taxpayer s experience and the taxpayer s treatment of the activity on its AFS when determining whether activities are considered routine maintenance. An activity is not considered routine and recurring if it results in a betterment or adaptation, is performed on property where a taxpayer has taken into account the adjusted basis of the property (e.g. by claiming a loss), or if the property is in a state of nonfunctional disrepair prior to the expenditure. Practice Consideration The routine maintenance safe harbor effectively offers relief for certain expenditures that are otherwise capitalizable as restorations. Thus, for example, the routine maintenance safe harbor may allow a deductible repair for what was otherwise a replacement of a major component or substantial structural part of a UoP (see definition of restoration above). Examples Aircraft engines undergo engine shop visits ( ESV ) on a regular basis. Taxpayer performs ESV during and after the class life of the aircraft. The costs associated with the ESV are deemed not to improve the aircraft under the safe-harbor for routine maintenance because the ESV involved the same routine maintenance activities (that also qualified under the safe harbor) that were performed on the same aircraft engines during their class life. Taxpayer replaced the lining of a container that constitutes 60% of the physical structure of the container. These replacements occur on a regular basis throughout the life of the container. Notwithstanding the substantial nature of the replacement, the costs qualify as repairs activities under the routine maintenance safe harbor. Deconstructing the Tangible Property Temporary Regulations 11

13 Dispositions of MACRS Property Dispositions of MACRS Property Under the Temporary Regulations, a disposition occurs when ownership of the asset is transferred or when the asset is permanently withdrawn from use. A disposition includes the sale, exchange, retirement, physical abandonment, destruction of an asset or transfers of an asset to a supplies, scrap, or similar account. In a significant change from prior law, the Temporary Regulations provide that the retirement of a structural component of a building is a disposition of MACRS property. Accordingly, the rules for accounting for assets to which IRC 168 applies and determining the gain or loss upon the disposition of the MACRS property are outlined in the Temporary Regulations. Disposition of an Asset The Temporary Regulations provide that the facts and circumstances of each disposition are considered in determining the appropriate asset disposed. In general, the asset for disposition purposes cannot be larger than the UoP. A taxpayer may generally use any reasonable, consistent method to treat each of an asset s components as the asset for disposition purposes unless specifically described otherwise. To maintain consistency with the UoP under the improvement standards, each structural component of a building is the asset for disposition purposes. Under prior law, a taxpayer was precluded from recovering basis on the disposal of a component of the building, yet was required to capitalize the cost of the new replacement component. The new disposition rules work with the new restoration rules to provide a more balanced approach. Under the Temporary Regulations, a taxpayer generally recovers the adjusted basis of the disposed component, but must capitalize repair costs for which the taxpayer has recovered the basis on the component of the UoP removed during the repair. Deconstructing the Tangible Property Temporary Regulations 12

14 Dispositions of MACRS Property Practice Consideration The ability to dispose of a portion of a building is generally a taxpayer favorable provision intended to alleviate certain inequities that existed in prior law (e.g., a taxpayer who replaced the roof on a building was required to capitalize the new roof and also required to continue depreciating the old roof over the remainder of the 39-year recovery period). Componentization of buildings for purposes of dispositions allows taxpayers to accelerate the cost recovery of the retired building component. As discussed above, the disposition rules significantly impact the operation of the restoration improvement standard. The example highlights the relationship between the restoration improvement standard and the revised disposition rules for structural components. Example On July 1, 2009, a calendar-year taxpayer, purchased and placed in service a multi-story office building that costs $20,000,000. The cost of each structural component of the building was not separately stated. Taxpayer accounts for the building in its records as a single asset with a cost of $20,000,000. Taxpayer depreciates the building as nonresidential real property and uses the straight-line method, a 39-year recovery period, and the mid-month convention. On June 30, 2012, Taxpayer replaces one of the building s elevators. Because Taxpayer cannot identify the cost of the structural components of the office building from its records, Taxpayer uses a reasonable method that is consistently applied to all of the structural components of the office building to determine the cost of the elevator. Using this reasonable method, Taxpayer allocates $150,000 of the $20,000,000 purchase price for the building to the retired elevator. For Taxpayer s 2012 Federal income tax return, loss for the retired elevator is the adjusted basis of the retired elevator on the date of disposition. Using the straight-line method, a 39-year recovery period, and the mid-month convention, the adjusted basis of the retired elevator on the date of disposition is $138,782 (unadjusted depreciable basis of $150,000 less accumulated depreciation allowed or allowable of $11,218 ( $150,000 x 35 months the asset is in service/ 468 total number of months in the recovery period)). As a result, Taxpayer recognizes a loss of $138,782 for the retired elevator in 2012, which is subject to IRC Because Taxpayer recognized a loss on the disposition of a structural component of a building, the cost to replace the elevator is automatically capitalized as a restoration under Temp. Reg (a)-3T(i)(1)(i). General Asset Accounts As an alternative to the general rule of depreciation is the election to use the general asset accounts ( GAA ). Under the Temporary Regulations, each GAA is effectively treated as the asset. However, each GAA must include only assets that have the same depreciation method, recovery period, convention and are placed-in-service in the same taxable year. Consistent with the expansion of the definition of disposition of MACRS property, the retirement of a structural component of a building is included in the definition of the disposition from a GAA and the same methods of identifying the placed-in-service year of the asset disposed apply. No loss is realized upon the disposition of an asset in a GAA. The disposed asset is treated as having an adjusted depreciable basis of zero immediately before the disposition. Therefore, the unadjusted depreciable basis and depreciation reserve of the GAA is unaffected by the disposition. A taxpayer can elect to terminate GAA treatment for an asset in a GAA when the taxpayer disposes of the asset in a qualifying disposition. The Temporary Regulations expand a qualifying disposition to include generally any disposition (such as a structural component of a building) not involving all assets or the last asset in the GAA. Deconstructing the Tangible Property Temporary Regulations 13

15 Dispositions of MACRS Property Practice Consideration Although a taxpayer is required to recognize the gain or loss on the disposition of structural components of a building, the GAA election provides a taxpayer the flexibility to choose whether it wants to recover basis on the disposition of the component and recover the related repair cost over the life of the asset or forgo basis recovery on the disposition and currently deduct the replacement costs as a repair (assuming the expenditure otherwise qualifies). A taxpayer should also consider whether a GAA election is appropriate to reduce administrative burden and protect its ability to deduct qualifying repair costs. Example Assume the same facts as the above example. If Taxpayer made a GAA election in the placed in service year of the building, the subsequent removal of the elevator is not a disposition. Because Taxpayer does not recover basis through a disposition, the restoration improvement rule does not automatically characterize the replacement of the elevator as an improvement. Rather, Taxpayer must evaluate the replacement of the elevator against the relevant building system (all of the elevators) to determine if the replacement must be capitalized as a betterment, restoration, or adaptation of the elevator building system. Casualty Loss The government received a number of comments regarding the treatment of expenditures following a casualty event. A number of taxpayers have historically taken a casualty loss deduction under IRC 165 and deducted the costs to repair the damaged property under Treas. Reg Under the Temporary Regulations, the damaged part of a property is treated as retired, the basis attributable to the damaged part is recovered, and the damaged part is restored or replaced. The costs to restore or replace the portion of property for which the taxpayer has properly taken the basis adjustment as a result of the casualty loss under IRC 165 is treated as a capital expenditure. The casualty loss rule does not limit a taxpayer s ability to accelerate the recovery of the basis attributable to the damaged property through the IRC 165 loss provisions. Instead, it requires a taxpayer to capitalize the costs of restoring the property, with recovery of such costs permitted through depreciation over the proper recovery period. The Temporary Regulations permit taxpayers (via the GAA election) to deduct qualifying expenditures as a repair under IRC 162 rather than recover basis as a casualty loss under IRC 165 (thereby triggering the restoration capitalization rule). Deconstructing the Tangible Property Temporary Regulations 14

16 Transition Guidance Revenue Procedures and Transition Guidance Revenue Procedures and General On March 7, 2012, the IRS issued Rev. Proc and Rev. Proc (the Revenue Procedures ), which provide procedures for a taxpayer to obtain automatic consent of the Commissioner to comply with the Temporary Regulations. The Revenue Procedures apply for taxable years beginning on or after January 1, Accordingly, taxpayers may not early adopt the provisions in the Temporary Regulations. Complying with the Temporary Regulations generally requires a change in method of accounting under IRC 446. Method changes filed under the revenue procedures for a taxpayer s first and second tax year beginning after December 31, 2011, are not subject to the normal scope limitations that apply to automatic method changes. Thus, for example, a taxpayer under examination is not precluded from filing a method change to comply with the Temporary Regulations. Similarly, a taxpayer that made a change for repairs in the prior five taxable years is not precluded from making a change for the same items under the Revenue Procedures. It is unlikely that a taxpayer s present methods of accounting for tangible property are in full compliance with the Temporary Regulations. Rev. Proc provides guidance on obtaining automatic consent for method changes related to repair and maintenance, materials and supplies, capital expenditures, costs to acquire or produce tangible property or costs to improve tangible property. Rev. Proc provides guidance on obtaining automatic consent for method changes related to depreciation, including single, mass or general asset accounts, as well as dispositions of MACRS property. Upon filing a change in method of accounting pursuant to the Revenue Procedures, a taxpayer receives IRS audit protection on the treatment of such item for taxable years prior to the year of change. Additionally, the back-year audit protection effectively stops the IRS from further examining the issue covered by the Revenue Procedures. These changes can impact unrecognized tax benefits for financial statement purposes. IRC 481(a) adjustment In general, accounting method changes made pursuant to the Revenue Procedures are effectuated with an IRC 481(a) adjustment. However, for certain changes (e.g., materials and supplies, de minimis rule, facilitative costs), the IRC 481(a) adjustment is computed taking into account only amounts paid or incurred in taxable years beginning on or after January 1, Additionally, certain changes are made using a cut-off method (i.e., the new method is applied prospectively) or a modified cut-off method (e.g., the unadjusted depreciable basis and the depreciation reserve for an asset as of the beginning of the year of change are accounted for using the new accounting method). The Revenue Procedures also expressly authorize the use of statistical sampling (using the sampling methodologies described in Rev. Proc ) to compute IRC 481(a) adjustments with respect to accounting method changes for certain items, and to support the item on a tax return Deconstructing the Tangible Property Temporary Regulations 15

17 Transition Guidance Revenue Procedures and (such items include, repair expenditures, materials and supplies, improvements, and certain dispositions). Practice Consideration Rev. Proc provides guidance on sampling plan standards, sampling documentation standards and technical formulas used when applying statistical sampling to substantiate items on the income tax returns. Concurrent Method Changes Rev. Proc provides that certain method changes involving an IRC 263A cost that was previously excluded from capitalization must include a concurrent uniform capitalization ( UNICAP ) method change. As such, Rev. Proc and Rev. Proc generally allow a taxpayer to make a concurrent UNICAP change when it makes a change to comply with the Temporary Regulations. Practice Consideration The attached chart highlights certain aspects of the accounting method change procedures set forth in Rev. Proc and Rev. Proc Deconstructing the Tangible Property Temporary Regulations 16

18 Large Business and International Division Directive Large Business and International Division Directive General On March 15, 2012, the Large Business and International Division ( LB&I ) at the IRS issued a directive to discontinue any exam activity relating to positions taken on original returns for tax years beginning before January 1, 2012, relating to (1) whether costs incurred to maintain, replace, or improve tangible property must be capitalized under IRC 263(a); and (2) any correlative issues involving the disposition of structural components of a building or tangible depreciable assets (other than a building or its structural components). The directive does not apply to current examination activity relating to costs for which the IRS provided specific guidance separate from the Temporary Regulations (e.g., Rev. Procs , , or ), or issues that do not address capitalization of costs under IRC 263(a). In addition to directing examiners to cease current exam activity, the directive instructs examiners: Not to begin new exam activity with respect to the issues; If the taxpayer has filed a method change on or after December 23, 2011, for a tax year before the effective date of the Temporary Regulations, to assess and determine whether to review the Form 3115; For examination of tax years beginning on or after January 1, 2012 and before January 1, 2014, to determine if Form 3115 is filed in accordance with the applicable guidance, and if so, to perform the appropriate risk assessment; if no, and the scope limitation period has passed, perform a risk assessment on the issue; and For examination of tax years beginning on or after January 1, 2014, apply the guidance in effect, and perform normal exam procedures. Deconstructing the Tangible Property Temporary Regulations 17

19 Tangible Property Temporary Regulations Automatic Method Change Guidance Tangible Property Temporary Regulations Automatic Method Change Guidance On March 7, 2012, the IRS issued Rev. Proc and Rev. Proc , which provide the procedures for taxpayers to obtain automatic consent of the Commissioner to comply with the tangible property Temporary Regulations. Rev. Proc covers accounting method changes in Rev. Proc , App and Rev. Proc covers accounting method changes in Rev. Proc , App The following chart provides an overview of the automatic method changes applicable to the Temporary Regulations. For accounting method changes made pursuant to Rev. Procs and , the following general rules apply: All changes have automatic consent under Rev. Proc ; The scope limitations under Section 4.02 of Rev. Proc are waived for method changes filed for the taxpayer s first or second taxable year beginning after December 31, 2011; The taxpayer may obtain audit protection for prior years with respect to the item for which the change is requested, provided the taxpayer timely files a copy of the application with the national office, or if applicable the Ogden office, complies with the provisions of the applicable revenue procedures and complies with the provisions of Rev. Proc ; For those items impacted by IRC 263A, taxpayers who are not properly accounting for such items under IRC 263A, the provisions of Rev. Procs and are not available for such items, unless the taxpayer concurrently changes to a permissible UNICAP method under Appendix Section or of Rev. Proc ; and A copy of the Form 3115 is to be filed with the Ogden, UT office in lieu of filing a copy with the national office. The chart should be read together with Deconstructing the Tangible Property Temporary Regulations. The following chart provides a high level overview of the automatic method changes available under Rev. Proc and Rev. Proc Automatic Method Change Guidance Chart 18

20 Tangible Property Temporary Regulations Automatic Method Change Guidance Rev. Proc Appendix Method Changes for Materials and Supplies Item Being Changed Inapplicability IRC 481(a) Adjustment Rev. Proc Statistical Sampling 3.12 Change to deduct non-incidental materials and supplies when used or consumed Does not apply to rotable or temporary spare parts described in Treas. Reg T(a)(3), but includes only amounts paid or incurred in tax years beginning on or after 1/1/ Change to deduct incidental materials and supplies when paid or incurred, but includes only amounts paid or incurred in tax years beginning on or after 1/1/ Change to deduct non-incidental rotable and temporary spare parts when disposed of, but includes only amounts paid or incurred in tax years beginning on or after 1/1/ Change to the optional method for rotable and temporary spare parts Automatic Method Change Guidance Chart 19

21 Tangible Property Temporary Regulations Automatic Method Change Guidance Method Changes for Costs of Acquiring or Producing Tangible Property Rev. Proc Appendix Item Being Changed Inapplicability IRC 481(a) Adjustment Rev. Proc Statistical Sampling Does not apply to 3.16 Change to deduct dealer expenses that facilitate the sale of property Non-dealers in property; or Liabilities incurred to facilitate the disposition of assets that constitute a trade or business No Does not apply to 3.17 Change to apply the de minimis rule under Treas. Reg (a)-2T(g) Amounts paid for property that is or is intended to be included in inventory; Amounts paid for land; or, but includes only amounts paid or incurred in tax years beginning on or after 1/1/2012 No Start-up expenditures as defined in IRC 195(c)(1) 3.18 Change to deduct certain costs for investigating or pursuing the acquisition of real property Does not apply to start-up expenditures as defined in IRC 195(c)(1), but includes only amounts paid or incurred in tax years beginning on or after 1/1/2012 No Change to capitalize non-dealer expenses that facilitate the sale of property Does not apply to Dealers in property; or Liabilities incurred to facilitate the disposition of assets that constitute a trade or business No Change to capitalize acquisition or production costs Automatic Method Change Guidance Chart 20