February 22, Dear Sir/Madam:

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1 American Institute of CPAs 1455 Pennsylvania Avenue, NW Washington, DC February 22, 2011 Internal Revenue Service Attention: CC:PA:LPD:PR (REG ) Room 5203 P.O. Box 7604 Benjamin Franklin Station Washington, D.C RE: Comments on Proposed Regulations under Section 263(a) Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (REG ) Dear Sir/Madam: The American Institute of Certified Public Accountants (AICPA) Tax Division is writing in response to Notice of Proposed Rulemaking (REG ), 1 which requested comments regarding proposed regulations under section 263(a) of the Internal Revenue Code, relating to the deduction and capitalization of expenditures related to tangible property. These comments were developed by the Section 263(a) Task Force of the AICPA s Tax Methods and Periods Technical Resource Panel, and approved by the Tax Executive Committee. The AICPA is the national professional organization of certified public accountants comprised of approximately 370,000 members. Our members advise clients on federal, state and international tax matters and prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America s largest businesses. The AICPA commends the Internal Revenue Service ( IRS ) and the Department of the Treasury ( Treasury ) for issuing the proposed regulations, which provide much needed guidance regarding the capitalization of expenditures related to tangible property. The guidance, once finalized, will be helpful to our members. 1 T: F: aicpa.org

2 Internal Revenue Service February 22, 2011 Page 2 of 5 Our attached comments cover a variety of key considerations as Treasury and IRS work on guidance in this area. In particular, our comments address the following sections of the proposed regulations: A. Materials and Supplies The AICPA recommends (i) removing the clear reflection of income requirement from Prop. Reg (a)(2), (ii) revising Prop. Reg (d)(1)(iii) to clarify that only de minimis materials and supplies must be included in the de minimis capitalization threshold test for tangible property provided in Prop. Reg (a)-2(d)(4), and (iii) increasing the de minimis limit from $100 to $1,000. B. Capitalized Costs The AICPA believes that Prop. Reg (a)-1(c)(5) should be modified to provide that an interest in land does not include any franchise granted by a governmental unit (including an agency or instrumentality thereof), such that any amount paid by a taxpayer to the governmental unit that is properly allocable to the franchise (e.g., the right to operate a toll road, airport, seaport, or similar facility) would not be subject to capitalization as an amount paid to acquire or create an interest in land. C. Transaction Costs The AICPA suggests that Prop. Reg (a)-2(d)(3)(ii)(C) be modified to extend the special rule for real property acquisition costs to include tangible personal property that is acquired as part of the same transaction. D. De Minimis Rule For a taxpayer with an applicable financial statement ( AFS ), the AICPA suggests the de minimis rule in Prop. Reg (a)-2(d)(4)(i) be modified by removing requirement (D). For a taxpayer without an AFS, the AICPA proposes that a modified version of the safe harbor provided in Prop. Reg (a)- 2(d)(4)(iii) be developed to establish whether the amounts currently deducted under a de minimis threshold distort taxable income. The AICPA also recommends that the final regulations provide, for purposes of applying the capitalization threshold, a definition of taxpayer that would permit a taxpayer with an AFS to determine the capitalization threshold consistent with the determination of the capitalization threshold used in its AFS. For a taxpayer without an AFS, the definition of taxpayer should be sufficiently broad to determine such threshold at the entity level or the consolidated group level, but require the modified safe harbor test to be applied at the same level as the capitalization threshold. E. Unit of Property The AICPA recommends including an example to illustrate clearly whether a taxpayer may treat all section 1250 leasehold improvements that are part of the same building as a single unit of property. The AICPA also recommends including an example of a building and its structural components that are considered to be a single unit of property consistent with the rule in Prop. Reg (a)-3(d)(2)(ii).

3 Internal Revenue Service February 22, 2011 Page 3 of 5 The AICPA believes the final regulations should include examples of what does and does not constitute plant property and examples of the unit of property in typical manufacturing processes. In addition, the AICPA recommends the final regulations provide a clearer definition of the terms industrial process and discrete and major function or operation in order to assist taxpayers in applying the special rule applicable to plant property. In addition, AICPA recommends that Prop. Reg (a)- 3(d)(2)(iii)(D)(1) (i.e., the financial accounting rule for unit of property determinations) be omitted from the final regulations. F. Betterment The AICPA believes that the final regulations should provide an exception to the general rule requiring capitalization of amounts paid or incurred to remediate a pre-existing condition for a taxpayer that reacquires property that it previously contaminated. The AICPA also believes that an exception should be provided to allow a taxpayer to deduct the cost of environmental remediation to correct contamination caused by the taxpayer on property owned by another party. With respect to materiality, the AICPA recommends that, similar to the bright-line tests under the restoration provisions, the final regulations include bright-line rules for determining whether an expenditure results in a betterment. In addition, the AICPA recommends that the final regulations provide consistency between capitalizable improvements under section 263(a) and substantial renovations under section 199. G. Restoration The AICPA recommends that the substantive rules and related examples in Prop. Reg (a)- 3(g)(1)(iii) and Prop. Reg (a)-3(g)(1)(i)-(ii) be omitted from the final regulations. H. Routine Maintenance Safe Harbor The AICPA suggests that the term routine be defined by reference to economic useful life and that the government provide objective rules in administrative guidance for taxpayers to follow in determining the appropriate economic useful life for the various major categories of property. The AICPA also recommends that the safe harbor affirmatively apply to both real and personal property and the safe harbors provided in existing guidance remain available to taxpayers. I. Repair Allowance The AICPA suggests the final regulations include an elective repair allowance method utilizing the one-divided-by-the-macrs-class-life methodology proposed in the 2006 regulations without the 50 percent reduction. Taxpayers in specific industries where the general guideline percentages provided in the final regulations are determined to be inadequate relative to actual experience should be encouraged to seek industry-specific relief from the IRS through the Industry Issue Resolution program.

4 Internal Revenue Service February 22, 2011 Page 4 of 5 J. Effective Dates/Method Changes The AICPA suggests that a taxpayer be permitted to change its method of accounting for amounts paid or incurred in taxable years prior to the taxable year in which the final regulations are issued, and that automatic consent be provided for a taxpayer to change its method of accounting to comply with the final regulations with a waiver of the scope limitations under Section 4.02 of Rev. Proc for the first taxable year following the issuance of the final regulations. The AICPA recommends that the final regulations apply the general rules of section 481(a) and provide that taxpayers are to make the change to comply with the final regulations by computing a section 481(a) adjustment. To the extent that the books and records necessary to compute a section 481(a) adjustment are not readily available, the AICPA recommends that the final regulations provide that reasonable estimates and reasonable estimation techniques, similar to those in Treas. Reg A-7, be permitted in computing the section 481(a) adjustment. If, however, the IRS and Treasury determine that changes to comply with the final regulations should be made on a cut-off or modified cut-off basis, taxpayers should be permitted to change to the law applicable to the years preceding the effective date of the final regulations. The AICPA also recommends that the general audit protection provisions under the accounting method change procedural guidance apply to changes made to comply with the final regulations. Additionally, to the extent that an issue under consideration relates to a method of accounting that is consistent with the rules in the final regulations, the AICPA recommends that the issue not be pursued by IRS examining agents ( Exam ). Each of the above areas is addressed in detail in the attachment. * * * * * We appreciate your consideration of our comments and welcome a further discussion of the comments. Members of the task force would be happy to meet with government officials to discuss any of our comments, including relevant real-world examples regarding plant property and unit of property determinations in typical manufacturing processes. If you have any questions, please contact Natalie Tucker, Chair, AICPA Section 263(a) Task Force at (904) , or natalie.tucker@mcgladrey.com; David Auclair, Chair, AICPA Tax Methods and Periods Technical Resource Panel at (202) , or david.auclair@us.gt.com; Christine Turgeon, AICPA Tax Executive Committee Liaison to Tax Methods and Periods Technical Resource Panel at (646) or christine.turgeon@us.pwc.com; or Michelle R. Koroghlanian, AICPA Technical Manager, at (202) , or mkoroghlanian@aicpa.org. Respectfully submitted, Patricia A. Thompson, CPA Chair, AICPA Tax Executive Committee Attachment

5 Internal Revenue Service February 22, 2011 Page 5 of 5 cc: George Blaine, Associate Chief Counsel (Income Tax & Accounting), Internal Revenue Service Andrew Keyso, Jr. Deputy Associate Chief Counsel (Income Tax & Accounting), Internal Revenue Service Scott Dinwiddie, Special Counsel to the Associate Chief Counsel (Income Tax & Accounting), Internal Revenue Service Brandon Carlton, Attorney-Advisor, Department of the Treasury Eric Lucas, Attorney-Advisory, Department of the Treasury

6 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS Comments on Proposed Regulations under Section 263(a) Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (REG ) Developed by: Section 263(a) Task Force Natalie Tucker, Chair David Auclair Bob Baird David Crawford Gary Hecimovich James Liechty George Manousos Kristine Mora Jeremy Rubischko Les Schneider Jan Skelton David Strong David Auclair, Tax Methods and Periods Technical Resource Panel, Chair Jan Skelton, Tax Methods and Periods Technical Resource Panel, Immediate Past Chair Christine Turgeon, Tax Executive Committee Liaison to Tax Methods and Periods Technical Resource Panel Michelle Koroghlanian, Technical Manager Approved by: Tax Methods and Periods Technical Resource Panel and Tax Executive Committee Submitted to: Department of the Treasury Internal Revenue Service February 22, 2011

7 AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS Comments on Proposed Regulations under Section 263(a) Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (REG ) February 22, 2011 Set forth below are the AICPA s comments on the proposed regulations under section 263(a) in response to Notice of Proposed Rulemaking (REG ), 1 pertaining to the deduction and capitalization of expenditures related to tangible property. Executive Summary In general, the AICPA recommends: A. Materials and Supplies The AICPA recommends (i) removing the clear reflection of income requirement from Prop. Reg (a)(2), (ii) revising Prop. Reg (d)(1)(iii) to clarify that only de minimis materials and supplies must be included in the de minimis capitalization threshold test for tangible property provided in Prop. Reg (a)-2(d)(4), and (iii) increasing the de minimis limit from $100 to $1,000. B. Capitalized Costs The AICPA believes that Prop. Reg (a)-1(c)(5) should be modified to provide that an interest in land does not include any franchise granted by a governmental unit (including an agency or instrumentality thereof), such that any amount paid by a taxpayer to the governmental unit that is properly allocable to the franchise (e.g., the right to operate a toll road, airport, seaport, or similar facility) would not be subject to capitalization as an amount paid to acquire or create an interest in land. C. Transaction Costs The AICPA suggests that Prop. Reg (a)-2(d)(3)(ii)(C) be modified to extend the special rule for real property acquisition costs to include tangible personal property that is acquired as part of the same transaction. D. De Minimis Rule For a taxpayer with an applicable financial statement ( AFS ), the AICPA suggests the de minimis rule in Prop. Reg (a)-2(d)(4)(i) be modified by removing requirement (D). For taxpayers without an AFS, the AICPA proposes that a modified version of the safe harbor provided in Prop. Reg (a)-2(d)(4)(iii) be developed to establish whether the amounts 1 Page 1 of 27

8 currently deducted under a de minimis threshold distort taxable income. The AICPA also recommends that the final regulations provide, for purposes of applying the capitalization threshold, a definition of taxpayer that would permit a taxpayer with an AFS to determine the capitalization threshold consistent with the determination of the capitalization threshold used in its AFS. For a taxpayer without an AFS, the definition of taxpayer should be sufficiently broad to determine such threshold at the entity level or the consolidated group level, but require the modified safe harbor test to be applied at the same level as the capitalization threshold. E. Unit of Property The AICPA recommends including an example to illustrate clearly whether a taxpayer may treat all section 1250 leasehold improvements that are part of the same building as a single unit of property ( UOP ). The AICPA also recommends including an example of a building and its structural components that are considered to be a single UOP consistent with the rule in Prop. Reg (a)-3(d)(2)(ii). The AICPA believes the final regulations should include examples of what does and does not constitute plant property and examples of the UOP in typical manufacturing processes. In addition, the AICPA recommends the final regulations provide a clearer definition of the terms industrial process and discrete and major function or operation in order to assist taxpayers in applying the special rule applicable to plant property. In addition, the AICPA recommends that Prop. Reg (a)-3(d)(2)(iii)(D)(1) (i.e., the financial accounting rule for UOP determinations) be omitted from the final regulations. F. Betterment The AICPA believes that the final regulations should provide an exception to the general rule requiring capitalization of amounts paid or incurred to remediate a pre-existing condition for a taxpayer that re-acquires property that it previously contaminated. The AICPA also believes that an exception should be provided to allow a taxpayer to deduct the cost of environmental remediation to correct contamination caused by the taxpayer on property owned by another party. With respect to materiality, the AICPA recommends that, similar to the bright-line tests under the restoration provisions, the final regulations include bright-line rules for determining whether an expenditure results in a betterment. In addition, the AICPA recommends that the final regulations provide consistency between capitalizable improvements under section 263(a) and substantial renovations under section 199. G. Restoration The AICPA recommends that the substantive rules and related examples in Prop. Reg (a)-3(g)(1)(iii) and Prop. Reg (a)-3(g)(1)(i)-(ii) be omitted from the final regulations. H. Routine Maintenance Safe Harbor The AICPA suggests that the term routine be defined by reference to economic useful life and that the government provide objective rules in administrative guidance for taxpayers to follow in determining the appropriate economic useful life for the various major categories of property. Page 2 of 27

9 The AICPA also recommends that the safe harbor affirmatively apply to both real and personal property and the safe harbors provided in existing guidance remain available to taxpayers. I. Repair Allowance The AICPA suggests the final regulations include an elective repair allowance method utilizing the one-divided-by-the-macrs-class-life methodology proposed in the 2006 regulations without the 50 percent reduction. Taxpayers in specific industries where the general guideline percentages provided in the final regulations are determined to be inadequate relative to actual experience should be encouraged to seek industry-specific relief from the Internal Revenue Service ( IRS ) through the Industry Issue Resolution ( IIR ) program. J. Effective Dates/Method Changes The AICPA suggests that a taxpayer be permitted to change its method of accounting for amounts paid or incurred in taxable years prior to the taxable year in which the final regulations are issued, and that automatic consent be provided for a taxpayer to change its method of accounting to comply with the final regulations with a waiver of the scope limitations under Section 4.02 of Rev. Proc for the first taxable year following the issuance of the final regulations. The AICPA recommends that the final regulations apply the general rules of section 481(a) and provide that a taxpayer is to make the change to comply with the final regulations by computing a section 481(a) adjustment. To the extent that the books and records necessary to compute a section 481(a) adjustment are not readily available, the AICPA recommends that the final regulations provide that reasonable estimates and reasonable estimation techniques, similar to those in Treas. Reg A-7, be permitted in computing the section 481(a) adjustment. If, however, the IRS and the Department of the Treasury ( Treasury ) determine that changes to comply with the final regulations should be made on a cut-off or modified cut-off basis, taxpayers should be permitted to change to the law applicable for costs paid or incurred in the years preceding the effective date of the final regulations. The AICPA also recommends that the general audit protection provisions under the accounting method change procedural guidance apply to changes made to comply with the final regulations. Additionally, to the extent that an issue under consideration relates to a method of accounting that is consistent with the rules in the final regulations, the AICPA recommends that the issue not be pursued by IRS examining agents ( Exam ). These areas are addressed in detail below. A. Materials and Supplies Prop. Reg (a)(2) Incidental Materials The AICPA commends the Treasury and the IRS in their effort to coordinate the current materials and supplies rules found in Treas. Reg with the proposed regulations. Prop. Reg (a)(2) provides that [a]mounts paid to acquire or produce incidental materials and supplies that are carried on hand and for which no record of consumption is kept or physical inventories at the beginning and end of the year are not taken, are deductible in the tax year in Page 3 of 27

10 which these amounts are paid, provided taxable income is clearly reflected. The AICPA offers the following comments and suggestions with respect to the proposed material and supply provisions. The AICPA first recommends removing the clear reflection of income requirement from Prop. Reg (a)(2). Pursuant to section 446(b), the Secretary of the Treasury and the Commissioner of the IRS possess broad authority to recompute taxable income in the event that, in the Commissioner's opinion, a taxpayer s method of accounting does not clearly reflect income. Thus, the AICPA feels that it is unnecessary to include a clear reflection of income requirement in this proposed regulation as such requirement is included in section 446(b). Furthermore, including a separate clear reflection of income test in this regulation might lead to unintended controversy as some taxpayers or Exam might conclude that the regulation provides an additional clear reflection income requirement above and beyond section 446(b). The AICPA therefore suggests omitting the phrase provided taxable income is clearly reflected from the final regulation. Rotable Spare Parts The AICPA recommends clarifying the rule in Prop. Reg (b) and accompanying Example 2 under Prop. Reg (f). Prop. Reg (b) provides that a rotable spare part is used or consumed in a taxpayer's business during the taxable year in which a taxpayer disposes of the spare part. The fact that the regulation and accompanying example indicate that the cost of the rotable spare part is recovered upon disposition could be misinterpreted to imply that the rotable spare parts may not be depreciated when they first are placed in service in the rotable pool in accordance with Rev. Proc , C.B To prevent such a misinterpretation, the AICPA suggests adding a reference to the fact that the rotable spare parts may be depreciable, including a cross reference to section 167, section 168 or Rev. Proc in the final regulations. Priority Rule for Prop. Reg (d)(1)(ii) and -3(d)(1)(iii) The AICPA recommends modifying Prop. Reg (d)(1)(ii) and -3(d)(1)(iii) to eliminate potential ambiguities. A UOP is defined by reference to Prop. Reg (a)-3(d)(2), regarding a UOP with a useful life of 12 months or less or a cost of $100 or less in both Prop. Reg (d)(1)(ii) and -3(d)(1)(iii). The distinction between a classification under -3(d)(1)(ii) versus -3(d)(1)(iii) is meaningful for purposes of the proposed de minimis rule safe harbor set forth in Prop. Reg (a)-2(d)(4)(iii). Materials and supplies included in Prop. Reg (d)(1)(ii) are not included in the de minimis safe harbor computation, whereas those included in Prop. Reg (d)(1)(iii) are included. However, because of the possibility that a UOP can be described in both Prop. Reg (d)(1)(ii) and -3(d)(1)(iii) (i.e., the material and supply has an economic life of 12 months or less and a cost of $100 or less) there is uncertainty as to whether the UOP is included in the de minimis safe harbor of Prop. Reg (a)-2(d)(4)(iii). Accordingly, to eliminate the potential for ambiguity and improve administrability, the AICPA suggests that the government revise Prop. Reg (d)(1)(iii) to specifically exclude a UOP described in Prop. Reg (d)(1)(ii). The AICPA suggests that Prop. Reg (d)(1)(iii) be modified to read as follows: Page 4 of 27

11 (iii) Is a unit of property (as determined under 1.263(a)-3(d)(2)) that has an acquisition cost or production cost (as determined under section 263A) of $100 or less and has an economic useful life of more than 12 months; or Prop. Reg (d)(1)(iii) - Increasing the $100 Limit Proposed Reg (d)(1)(iii) includes in the definition of a material or supply a UOP consumed in the taxpayer s operations that has an acquisition or production cost of $100 or less. Many taxpayers purchase de minimis units of property for consumption in their operations that cost more than $100. Accordingly, the AICPA recommends that the $100 limit be increased to $1,000. The AICPA also recommends that if the $1,000 dollar value is not chosen, that the $100 limit be indexed for inflation annually. We also recommend that the inflation adjusted limit be published annually. B. Capitalized Costs Proposed Reg (a)-1(c) provides a list of expenditures that must be capitalized. Specifically, Prop. Reg (a)-1(c)(5) provides that a capital expenditure includes [a]n amount paid to acquire or create interests in land, such as easements, life estates, mineral interests, timber rights, zoning variances, or other interests in land. The AICPA believes that for purposes of clarification, Prop. Reg (a)-1(c)(5) should be modified to provide the following: An amount paid to acquire or create interests in land, such as easements, life estates, mineral interests, timber rights, zoning variances, or other interests in land. An interest in land does not include any franchise granted by a governmental unit (including an agency or instrumentality thereof). Thus, any amount paid by a taxpayer to the governmental entity that is properly allocable to the franchise, such as the right to operate a toll road, airport, seaport, or similar facility, is not capitalized as an amount paid to acquire or create an interest in land. C. Transaction Costs The AICPA notes with approval the addition of the rule that, if finalized, would permit a taxpayer to deduct costs incurred to investigate whether to acquire real property, and which real property to acquire. Specifically, Prop. Reg (a)-2(d)(3)(ii)(C) provides that [e]xcept as provided in paragraph (d)(3)(ii)(b) of this section (relating to inherently facilitative amounts), an amount paid by the taxpayer in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it relates to activities performed in the process of determining whether to acquire real property and which real property to acquire. This whether and which rule was provided in response to commentators who suggested that, with respect to the rules requiring the capitalization of facilitative transaction costs, an exception should be provided for transaction costs that are pre-decisional investigatory costs, similar to the exception provided with respect to certain intangibles. Page 5 of 27

12 The AICPA understands that IRS and Treasury believe it is appropriate to provide an exception for real property acquisitions because these types of transactions most often raise the issue of whether the investigatory costs are deductible business expansion costs, rather than capital expenditures to acquire a specific asset. However, in many cases the real property in such transactions includes tangible personal property that is an integral part of the real property to which the whether and which provision applies. Accordingly, the AICPA suggests that Prop. Reg (a)-2(d)(3)(ii)(C) be modified to provide the following: Except as provided in paragraph (d)(3)(ii)(b) of this section (relating to inherently facilitative amounts), an amount paid by the taxpayer in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it relates to activities performed in the process of determining whether to acquire real property and which real property to acquire. Solely for purposes of applying this paragraph (d)(3)(ii)(c), real property includes any tangible personal property that is acquired as part of the same transaction. Alternatively, if IRS and Treasury determine that it is not appropriate to extend the special rule for real property acquisition transaction costs, the AICPA suggests that the final regulations provide guidance on appropriate methods to allocate transaction costs between real property, which under Prop. Reg (a)-2(d)(3)(ii)(C) do not facilitate the transaction, and tangible personal property integral to such real property, which could be considered facilitative of the transaction. The AICPA also recommends that the final regulations clarify that section 263A does not require the capitalization of otherwise deductible transaction costs into the basis of the real or tangible property ultimately acquired. D. De Minimis Rule Proposed Reg (a)-2(d)(4)(i) generally provides that a taxpayer may currently deduct an amount paid for the acquisition or production of a UOP if: (A) (B) (C) (D) The taxpayer has an AFS; The 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; The taxpayer treats the amounts paid during the taxable year as an expense on its AFS in accordance with its written accounting procedures; and, The total aggregate of the amounts paid and not capitalized pursuant to (A), (B), and (C) above for the taxable year do not distort the taxpayer s income for the taxable year. The AICPA commends IRS and Treasury for the inclusion of a de minimis rule in the proposed regulations that, if finalized, would permit a taxpayer to deduct amounts paid for the acquisition or production of a UOP when the cost is de minimis ( de minimis rule or capitalization threshold ). The AICPA believes that a de minimis rule is necessary and urges the IRS and Page 6 of 27

13 Treasury to consider a rule that permits any taxpayer to currently deduct the cost to acquire or produce a UOP when the cost is de minimis. With respect to the capitalization rule, the AICPA has concerns regarding the Potential disruption of current administrative practice; Exclusion of taxpayers without an AFS from eligibility for the capitalization threshold; Definition of taxpayer for purposes of applying the capitalization threshold; and, Clarification of exceptions to the de minimis rule. Each of these concerns is addressed in detail below. Potential Disruption of Current Administrative Practice In the preamble to the proposed regulations, IRS and Treasury acknowledge that many taxpayers reach informal agreements with Exam to permit the use of a de minimis rule that conforms to those thresholds used by the taxpayers for financial accounting purposes ( financial statement conformity ), and that this widespread practice has not been generally altered. These informal agreements benefit both the government and the taxpayers, as they balance resources and administration for both taxpayers and the IRS. The preamble clearly communicates that this regulation project is not intended to disrupt this balance. The AICPA believes that the addition of the does not distort taxable income requirement in the proposed regulations will increase audit controversy and create uncertainty for taxpayers, notwithstanding the preamble language noted above. Most taxpayers have established financial statement capitalization thresholds that balance the administrative burdens of accounting for all individual depreciable assets with the need to accurately reflect their financial accounting income. The AICPA believes that if a taxpayer s capitalization threshold is appropriate for financial statement purposes, then conforming to that threshold for federal income tax purposes likewise will not result in a distortion of that taxpayer s taxable income. Accordingly, for a taxpayer with an AFS, the AICPA suggests the de minimis rule in Prop. Reg (a)-2(d)(4)(i) be modified in the final regulations by removing requirement (D). This modification essentially requires financial statement conformity for such taxpayers, and the AICPA believes that such conformity will prevent any potential distortion of a taxpayer s taxable income. By modifying the final regulations in this manner, IRS and Treasury would prevent disturbance of current agreements between taxpayers and their examining agents, and would provide certainty to taxpayers that their capitalization thresholds are permissible for federal income tax purposes. Moreover, the recommended changes avoid the additional administrative burden of tracking de minimis assets to ascertain whether the aggregate amounts deducted exceed the applicable thresholds. Exclusion of Taxpayers Without an AFS The AICPA believes the capitalization threshold provisions of the proposed regulations inappropriately exclude from eligibility a taxpayer that does not have an AFS (primarily small Page 7 of 27

14 businesses). The AICPA believes that, at a minimum, the definition of AFS in the final regulations should be expanded to include a compilation or reviewed, but unaudited, financial statements. The AICPA believes that all taxpayers, not just one with an AFS, should be eligible for the capitalization threshold provisions. However, the AICPA understands the government s concerns that a taxpayer s capitalization threshold clearly reflect income. Accordingly, the AICPA proposes that a modified version of the safe harbor provided in Prop. Reg (a)- 2(d)(4)(iii) be developed to establish whether the amounts currently deducted under a de minimis threshold distort taxable income for a taxpayer without an AFS. The safe harbor provided in Prop. Reg (a)-2(d)(4)(iii) states that the amount not required to be capitalized by a taxpayer under the de minimis rule is deemed to not distort taxable income if the amount, when added to the amount the taxpayer deducts as materials and supplies under Prop. Reg , is equal to or less than 0.1 percent of the taxpayer s gross receipts for the year or two percent of the taxpayer s total depreciation and amortization expense for the taxable year as determined in the taxpayer s AFS. The AICPA believes that this safe harbor requires information that taxpayers do not have readily available, and will therefore be burdensome to taxpayers and difficult for the IRS to administer. Taxpayers generally currently deduct the amounts below their capitalization threshold and therefore do not account for those amounts. Similarly, taxpayers do not account for amounts deducted as materials and supplies. The safe harbor is further burdensome in that it can only be computed after year-end, thus denying taxpayers certainty until after year-end as to whether they satisfy the safe harbor. The AICPA suggests a modified safe harbor that would apply only to taxpayers without an AFS. Under this safe harbor, the de minimis capitalization threshold would be deemed to not distort taxable income if the amount deducted is less than or equal to 0.1 percent of the taxpayer s average annual gross receipts reported on its federal income tax returns for the 3 taxable years immediately prior to the current taxable year (or, if shorter, the taxable years during which such taxpayer was in existence). The operative rules could be similar to the gross receipts tests under section 263A (for small resellers), section 448 (cash method for certain corporations), and section 460 (use of the completed contract method by certain homebuilders). The AICPA believes that this approach addresses the concerns of the government and meets the government s stated goal of ease of administration. Definition of Taxpayer As noted above, the capitalization threshold eligibility is determined for a taxpayer. However, the proposed regulations do not provide a definition of taxpayer for purposes of applying the provision and any related safe harbor tests. In the absence of a specific definition, the general definitional rules apply. Section 7701(a)(14) defines taxpayer as any person subject to any internal revenue tax. Section 7701(a)(1) defines person as an individual, a trust, estate, partnership, association, company or corporation. It does not include a consolidated group or a combined reporting group. The lack of a definition of taxpayer for purposes of applying this section may lead to unnecessary confusion and controversy. Accordingly, the AICPA recommends that the final Page 8 of 27

15 regulations provide, for purposes of applying the capitalization threshold, a definition of taxpayer that would permit a taxpayer with an AFS to determine the capitalization threshold consistent with the determination of the capitalization threshold used in its AFS. For taxpayers without an AFS, the definition of taxpayer should be sufficiently broad to determine such threshold at the entity level or the consolidated group level, but require the modified safe harbor test be applied at the same level as the capitalization threshold. Clarification of Exceptions to De Minimis Rule Proposed Reg (a)-2(d)(4)(ii) provides that the de minimis rule in Prop. Reg (a)- 4(d)(4)(i) does not apply to the following: (A) Amounts paid to improve property under Prop. Reg (a)-3. (B) Amounts paid for property that is or is intended to be included in property produced or acquired for resale. (C) Amounts paid for land. For clarification purposes, the AICPA recommends that a reference to section 263A be added to Prop. Reg (a)-4(d)(4)(ii)(B), such that it would read: Amounts paid for property that is or is intended to be included in property produced or acquired for resale. See, e.g., section 263A and the regulations thereunder. In summary, most taxpayers that employ a capitalization threshold for federal income tax purposes have a threshold that conforms to the threshold used for financial accounting purposes. Inclusion of the aforementioned suggested changes in the final regulations would provide certainty to taxpayers, rather than leaving the determination of an appropriate threshold to the discretion of the IRS examining agents. These modifications, if adopted, would demonstrate the commitment of the Treasury and IRS to improving the balance between financial accounting and federal income tax reporting for capitalization purposes. Such demonstration would bring benefits and reduce compliance costs to the government and to taxpayers. E. Unit of Property The proposed regulations provide guidance concerning the appropriate UOP to which the betterment and restoration rules should be applied. We commend the IRS and Treasury in their efforts to modify and simplify these rules from the 2006 Proposed Regulations in response to the concerns raised by commentators. Prop. Reg (a)-3(d)(2) provides UOP rules that generally are based on the functional interdependence standard, and include special rules for buildings, leasehold improvements, and plant property. Leasehold Improvements A building and its structural components are generally treated as a single UOP under Prop. Reg (a)-3(d)(2)(ii). Where a taxpayer leases, rather than owns, a building or portion thereof and makes a leasehold improvement that constitutes section 1250 property, the leasehold Page 9 of 27

16 improvement is a separate UOP. Section 1250 property that is part of the same building generally may not be componentized for depreciation purposes. The proposed regulations do not clearly indicate whether a taxpayer may treat all section 1250 leasehold improvements that are part of the same building as a single UOP. The AICPA recommends including the following illustrative example: M owns and operates a restaurant in a stand-alone building that it leases from an unrelated third party pursuant to a 15-year lease entered into in Under the terms of the lease, M is required to repair and maintain the building, including the roof and HVAC system. In 2015, M incurs $100X to re-tar portions of the building s roof due to leakage. In applying the provisions of Treas. Reg , the building, including all of the leasehold improvements that are structural components of the building, is the appropriate unit of property. Buildings and Structural Components As noted above, a building (as defined in Treas. Reg (e)(1)) and its structural components (as defined in Treas. Reg (e)(2)) are treated as a single UOP under Prop. Reg (a)-3(d)(2)(ii). The AICPA agrees with this UOP determination as it is consistent with all other areas of the tax law. However, the AICPA believes that the inclusion of examples of specific structural components of a building that are included in the UOP of the building would be illustrative, instructive and reduce controversy. The AICPA recommends modifying Prop. Reg (a)-3(d)(2)(iv), Example 1, to read as follows: Example 1. Buildings and structural components; plant property. X owns a building containing various types of manufacturing equipment that are not structural components of the building. Because the property is a building, as defined in (e)(1), the unit of property for the building must be determined under paragraph (d)(2)(ii) of this section. Under the rules of that paragraph, X must treat the building and all its structural components (including walls; floors; ceilings; windows; doors; all components (whether in, on, or adjacent to the building) of a central air conditioning or heating system, including motors, compressors, pipes and ducts; plumbing and plumbing fixtures, such as sinks and bathtubs; electric wiring and lighting fixtures; chimneys; stairs, escalators, and elevators, including all components thereof; sprinkler systems; fire escapes; and other components relating to the operation or maintenance of the building) as a single unit of property. In addition, because the manufacturing equipment contained within the building constitutes property other than a building, the units of property for the manufacturing equipment are initially determined under the general rule in paragraph (d)(2)(iii)(a) of this section and are therefore comprised of all the components that are functionally interdependent. Moreover, because the manufacturing equipment is plant property, under paragraph (d)(2)(iii)(b) of this section, the units of property under the general rule are further divided into smaller units of property by determining the components (or groups of components) that perform discrete and major functions within the plant. Finally, X must apply the additional rules in paragraph (d)(2)(iii)(d) of this section to determine whether any of the units of property determined under paragraphs (d)(2)(iii)(a) and (B) of this section contain components that must be treated as separate units of property. Page 10 of 27

17 If, however, the IRS and Treasury decide to change the determination of a UOP such that the building and each major system within the building are treated as separate units of property for purposes of determining whether an expenditure must be capitalized, the AICPA suggests that the same UOP determination be used for other purposes of the tax law, such as determining when an asset is retired for depreciation purposes. The AICPA believes that a single set of rules should be consistently applied for purposes of determining the appropriate UOP. The AICPA understands that in certain cases Exam currently uses one UOP for purposes of determining when an asset is retired and a different UOP to determine when an expenditure must be capitalized (see, e.g., the Capitalization v Repairs Audit Technique Guide, LB&I (Nov. 12, 2010)). One common example of this disparate treatment involves the replacement of a building s HVAC system. Many exam agents are disallowing the retirement of the old HVAC system taking the position that the HVAC system is a structural component of a larger UOP, the building of which the HVAC system is a part (and that the removal the HVAC system is a partial retirement of the building), while also taking the position that the replacement HVAC system is sufficiently separable from the building to be its own UOP for purposes of determining whether the expenditure must be capitalized. The AICPA believes that to require a taxpayer to apply multiple sets of rules to determine the appropriate UOP for different purposes of the tax law increases complexity, increases the potential for controversy, increases the administrative burden on both taxpayers and the government, and negatively impacts the administrability of the law. Further, allowing this disparate treatment to continue perpetuates the type of controversy that this regulation project should, in the AICPA s view, bring to an end. Accordingly, the AICPA strongly encourages Treasury and the IRS to promulgate a single UOP rule for purposes of determining both when an expenditure must be capitalized and when a UOP is retired. 2 Plant Property Under the functional interdependence criterion in Prop. Reg (a)-3(d)(2)(iii)(A), components that are functionally interdependent generally comprise a single UOP. In the case of functionally interdependent machinery or equipment used to perform an industrial process ( plant property ), the UOP is separated into smaller units that consist of each component that performs a discrete and major function or operation within the functionally interdependent machinery or equipment (e.g., the boiler, turbine, generator, and pulverizers in an electric power plant, even though they are all functionally interdependent because each of these components performs a discrete and major function within the power plant). The proposed regulations provide examples of activities constituting a discrete and major function at extreme ends of the spectrum with respect to production activities, and do not necessarily provide sufficient information for a majority of taxpayers to evaluate the application of the rules to typical production equipment. The example regarding the process to prepare and cook tortillas at a restaurant provides no guidance for taxpayers as it is clearly not an industrial process and would not be subject to the regulations. The laundry example is at the other end of 2 Using one set of rules to determine the appropriate UOP is also, generally, consistent with the current automatic change in accounting method for retired assets where the IRS requires a taxpayer to state whether the proposed UOP for purposes of determining when an asset is retired is the same UOP used for purposes of determining when depreciation begins and ends or explain any difference. See Section 6.24(2)(b), 6.24(2)(d), 6.25(2)(b) and 6.25(2)(d) of the Appendix of Rev. Proc Page 11 of 27

18 the spectrum--a process that is clearly an industrial process with significant, clearly delineated discrete and major functions. Most production processes fall somewhere between these two examples and the final regulations should provide illustrations of how the rule would apply to more typical production processes. The AICPA believes the final regulations should include examples of what does and does not constitute plant property as well as additional examples of UOP determinations in typical manufacturing processes. The AICPA further recommends the final regulations provide a clearer definition of the terms industrial process and discrete and major function or operation to assist taxpayers in applying the special rule applicable to plant property. In this regard, members of the AICPA task force would be happy to meet with government officials to discuss relevant real-world examples. Limiting Rules Proposed Reg (a)-3(d)(2)(iii)(D) provides Notwithstanding the UOP determination under paragraphs (d)(2)(iii)(a), (B), and (C) of this section, a component (or a group of components) of a unit property must be treated as a separate UOP if (1) At the time the UOP (as determined under paragraph (d)(2)(iii)(a), (B), and (C) of this section) is placed in service by the taxpayer (without regard to subsequent improvements), the taxpayer has recorded on its books and records for financial or regulatory accounting purposes an economic useful life for the component that is different from the economic useful life of the UOP of which the component is a part; or (2) The taxpayer has properly treated the component as being within a different class of property under section 168(e) (MACRS classes) than the class of the UOP of which the component is a part or, the taxpayer, at the time the component was placed in service by the taxpayer, has properly depreciated the component using a different depreciation method under section 167 or section 168 than the depreciation method of the UOP of which the component is a part. IRS and Treasury requested comments on the application of these limiting rules and comments to identify situations (if any) in which the limiting rules may not operate as intended. The AICPA believes the financial accounting rule appears to give too much weight to financial statement or regulatory accounting practices because the considerations made by taxpayers in classifying components of property for financial or regulatory accounting purposes vary from those taken into account for federal income tax purposes. The AICPA anticipates that this concern will be especially true for companies complying with International Financial Reporting Standards ( IFRS ) because IFRS requires an asset to be broken down into its various components for purposes of determining depreciation, repairs and retirements. As a result of this componentization, it is likely that functionally interdependent components could have different economic useful lives for financial accounting purposes. For Page 12 of 27

19 example, under IFRS, an airplane likely would be broken down into its major components, such as the airframe, landing gear, engines, wheels and brakes. These major components of the airplane likely would have different economic lives and be separate units of property for financial accounting purposes. In our view, requiring a taxpayer to use these financial accounting units of property for functionally interdependent components that make up the airplane would be inappropriate and would be in direct contrast to the Sixth Circuit Court of Appeals decision in FedEx Corporation v. U.S., 291 F.Supp.2d 699 (2003) aff d 412 F.3d 617 (6 th Cir. 2005). Another area that could result in a different UOP is a building and major components or systems thereof as discussed above in Section E. Unit of Property. Due to the differing goals and guidelines for financial or regulatory accounting and tax accounting, the AICPA does not believe that financial or regulatory classifications of components of property should control for tax purposes. Accordingly, the AICPA recommends that this rule not be included in the final regulations. F. Betterment Proposed Reg (a)-3(f) requires capitalization of expenditures that result in a betterment with respect to the UOP, and describes the factors to be used in determining whether an expenditure results in a betterment of a UOP, including: Ameliorates a material condition or defect, Results in a material addition, or Results in a material increase in capacity, productivity, efficiency, strength, or quality. The AICPA has several concerns with respect to these criteria, particularly with respect to environmental remediation costs as described in more detail below. Environmental Remediation Costs Under Prop. Reg (a)-3(f)(1)(i), the remediation of a material defect that either existed prior to the acquisition or arose during the production of the UOP results in a betterment of the UOP. Under this rule, it appears a taxpayer would be required to capitalize the costs incurred to remediate a UOP acquired post-contamination by a taxpayer, even if that taxpayer was the party who contaminated the property. In the preamble to the proposed regulations, the IRS and Treasury requested comments regarding the appropriate treatment of environmental remediation costs in these circumstances, considering that the remediation is performed as a result of the taxpayer s own use of the property. IRS and Treasury also requested comments regarding how to determine whether the contamination was due solely to the taxpayer s prior operations or, if an interim owner may have added to the contamination, how to determine the appropriate treatment of remediation costs in that circumstance. The AICPA believes that the final regulations should provide an exception to the general rule requiring capitalization of amounts paid or incurred to remediate a pre-existing condition for a Page 13 of 27