Current Developments. American Bar Association Section of Taxation Tax Accounting Committee 6 May 2011

Transcription

1 Current Developments American Bar Association Section of Taxation Tax Accounting Committee 6 May 2011 Moderator: Jody Brewster Skadden, Arps, Slate, Meagher & Flom LLP Washington, D.C. Panelists: Andy Keyso Deputy Associate Chief Counsel (Income Tax & Accounting) Internal Revenue Service Washington, D.C. Brandon Carlton Attorney Advisor Office of Tax Policy Department of the Treasury Washington, D.C. George Blaine Associate Chief Counsel (Income Tax & Accounting) Internal Revenue Service Washington, D.C. Eric Lucas Attorney Advisor Office of Tax Policy Department of the Treasury Washington, D.C. Sam Weiler Manager Ernst & Young National Tax Washington, D.C. The information contained herein is of general nature and based on authorities that are subject to change. Applicability to specific situations is to be determined through consultation with your tax advisor. The government panelists did not participate in the preparation of this handout. 1

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3 Tax Accounting Current Developments January 2011 Table of Contents I. Acts a. General Explanations of the Administration s Fiscal Year 2012 Revenue Proposals (Feb. 2011) Tax accounting provisions II. Temporary, Proposed and Final Treasury Regulations a. III. Revenue Rulings, Revenue Procedures, Notices and Announcements IV. Cases a. Rev. Proc (Mar. 21, 2011) Guidance on section 280F limitations for 2011 b. Rev. Proc (Mar. 29, 2011) - Guidance under 2022(a) of the Small Business Jobs Act of 2010, Pub. L. No , 124 Stat (September 27, 2010) (SBJA), and 401(a) and (b) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No , 124 Stat (December 17, 2010) (TRUIRJCA) c. Rev. Proc (Apr. 4, 2011) Guidance providing a safe harbor method for determining the recovery period for depreciation of certain tangible assets used by wireless telecommunications carriers d. Rev. Proc and Rev. Proc (Apr. 4, 2011) Guidance providing safe harbor methods for taxpayers to use in determining whether expenditures to maintain, replace or improve wireline network assets or wireless network assets must be capitalized under section 263(a) e. Rev. Proc (Apr. 8, 2011) Guidance providing safe harbor election for the deduction of a percentage of success-based fees under Treas. Reg (a)-5(f) without further documentation f. Rev. Proc (Apr. 14, 2011) Safe harbor under section 118(a) for certain Clean Coal Technology awards made by the National Energy Technology Laboratory of the United States Department of Energy to corporate taxpayers a. Gibson & Associates, Inc. v. Commissioner, 136 T.C. No. 10 (Feb. 24, 2011) Construction activities that are not repairs qualify for section 199 deduction b. Dominion Resources, Inc. v. U.S., 107 AFTR 2d (Feb. 25, 2011) - Treas. Reg A-11(e)(1)(ii)(B) is not an arbitrary or capricious interpretation of section 263A(f) c. Washington Mutual Inc. v. United States, U.S.T.C. 50,254 (Mar. 3, 2011) - Financial institution has basis in rights received in acquisition of failing thrifts d. Sprint Nextel Corporation and Subsidiaries v. United States, U.S.T.C. 50,269 (Mar. 4, 2011) Universal Service Fund payments were not excludable from income under section 118(a) as nonshareholder contributions to capital 3

4 V. Rulings, Memoranda and Directives (PLRs, TAMs, CCAs, ILMs, LMSB guidance) a. AOD (Feb. 8, 2011) IRS Action on Decision to Robinson Knife Manufacturing Company and Subsidiaries v. Commissioner, 600 F.3d 121 (2d Cir. 2010), rev g T.C. Memo b. ILM (Feb. 18, 2011) Discounted amount of markers included in casino s income c. ILM (Feb. 18, 2011) Loss discounts deductible by casino when gamblers settle markers d. LB&I (Feb. 23, 2011) Status of the super completed contract method of accounting changed from active to monitoring e. LB&I (Mar. 1, 2011) - Field Guidance on the Planning & Examination of Sales- Based Royalty Payments and Sales-Based Vendor Allowances f. Appeals Settlement Guidelines, Exclusion of Income: Non-Corporate Entities and Contributions to Capital (Mar. 2, 2011) Non-corporate entities may not exclude from income amounts received from non-owners under either section 118(a) or any common law contribution to capital doctrine g. Appeals Settlement Guidelines, State and Local Location Tax Incentives (Mar. 2, 2011) SALT incentives do not qualify for exclusion as a contribution to capital by a nonshareholder under section 118(a) h. PLR (Mar. 18, 2011) Alternative Basis Recovery method approved for installment sale transaction i. TAM (Mar. 18, 2011) Involuntarily converted inventory in a presidentially declared disaster area held for productive use under section 1033(h)(2) j. CCA (Mar. 18, 2011) Guidance on pre-contract section 174 costs under the percentage-of-completion method of section 460 k. FAA F (Mar. 18, 2011) Section 197(f)(1) bars car dealership s deduction for worthless goodwill associated with a lost franchise agreement l. Various PLRs granting 9100 relief and election revocations VI. IRS Priority Guidance Plan 4

5 I. Acts a. General Explanations of the Administration s Fiscal Year 2012 Revenue Proposals (Feb. 2011) Tax accounting provisions President Obama released his budget proposals for fiscal year 2012 (the Budget) on Feb. 14, This budget is the third proposal of his term. The Budget contains many of the President s past tax policy proposals that have yet to be passed by Congress. In total, the Budget includes $3.73 trillion in federal spending and $2.6 trillion in federal revenues for a net of deficit of $1.1 trillion in Using the Congressional Budget Office (CBO) baseline that the law will continue to apply as currently written, the Budget is set to increase the deficit by $1.7 trillion (from $5.5 trillion to $7.2 trillion) over 10 years. In comparison, using a modified PAYGO baseline, which reflects the Administration s belief that several current tax provisions scheduled to expire are likely to be extended without revenue offsets, the 10-year deficit would rise to $9.4 trillion. In addition, the Budget assumes GDP growth of 2.7 percent in 2011, 3.6 percent in 2012, and 4.4 percent in 2013 along with a decrease in unemployment from 9.1 percent in 2011 and to 8.2 percent by the fourth quarter of The below summaries highlight the more significant tax accounting proposals. Permanently Extend the Increased Limits on Expensing Small Business Assets Under Internal Revenue Code Section 179(b) as Provided for Under Section 202 of JGTRRA: Expense Up to $125,000 of Investment, Phased Out Dollar for Dollar After Investment Reaches $500,000 For years after 2012, the Administration proposes to permanently extend the section 179 expensing limit of $125,000 and annual investment limit of $500,000 (in 2006 dollars, indexed for inflation thereafter). Enhance and Make Permanent the Research Tax Credit The research tax credit would be made permanent, effective Jan.1, 2012.The credit would also be enhanced by increasing the alternative simplified credit rate from 14 percent to 17 percent. Provide Additional Funds for Advanced Energy Property Manufacturing Credit The $2.3 billion cap on the credit resulted in credit funds going to less than one-third of the eligible projects. The proposal would authorize an additional $5 billion of tax credits for investments in eligible property used in a qualifying advanced energy project. Unlike the similar 2011 budget proposal, taxpayers will only be able to apply for a credit on a portion of their qualifying investment in the project. Also, unlike the original credit program that only provided a twomonth window for submitting applications, this second round of funding would provide a twoyear period to submit applications, beginning on the date the extension of the program is enacted. Provide Tax Credit for Energy Efficient Commercial Building Property Expenditures in Place of Existing Tax Deduction 5

6 The existing deduction would be replaced by a tax credit ranging from $0.60 per square foot for energy cost reductions of at least 20 percent up to $1.80 per square foot for energy cost reductions of 50 percent or more. The energy savings must come from the same three building systems defined in the current law. The baseline for determining energy cost savings would be prescriptive standards based on building types and climate zones as specified in ASHRAE/IESNA Standard The proposal includes special rules allowing the credit to benefit a REIT or its shareholders. The credit would be available for property placed in service during Increase Tax Benefits for Certain Low Income Housing Projects This proposal would allow state housing finance agencies to designate certain projects to receive, for purposes of computing the low-income-housing tax credit, a 30-percent boost in eligible basis, even if they are financed by tax-exempt bonds. Designate Growth Zones The current programs would be replaced by a new Growth Zone program that would provide tax incentives for 14 urban areas and six rural areas. The zones would be selected through a competitive application process by the Secretary of Commerce in consultation with the Secretary of Housing and Urban Development and the Secretary of Agriculture. There would be specific requirements around maximum area size and population. Nominees would be required to submit a competitiveness plan for attracting investment and jobs. Other factors to be considered would include unemployment rates, poverty rates, household income, homeownership, labor force participation and educational attainment. The new growth zones would be eligible for two tax incentives. An employment tax credit for businesses that employ zone residents would apply to the first $15,000 of qualifying zone employee wages. The proposed credit is 20 percent for zone residents employed inside the zone and 10 percent for zone residents employed outside the zone. The second incentive is 100 percent bonus depreciation for qualified property placed in service inside the zone. Qualified property would be new tangible property with a recovery period of 20 years or less, water utility property, certain computer software and qualified leasehold improvements. The taxpayer must purchase the property or begin manufacture or construction after the date of zone designation and before Jan.1, 2017 and the property must be placed in service within the zone before Jan.1, Allow Vehicle Sellers to Claim Qualified Plug-in Electric Drive Motor Vehicle Credit The credit would be claimed by the taxpayer that sells or finances the vehicle rather than the vehicle owner and would only be allowed if the seller clearly discloses the amount of the credit to the purchaser. This change would be effective for vehicles sold after Continue Certain Expiring Tax Provisions through Calendar Year 2012 The Administration proposes to extend most of these provisions (except for temporary incentives for the production of fossil fuels) through Dec. 31, 2012.The provisions to be extended would include the following popular tax breaks: Several energy incentives including: 6

7 o Grants for specified energy property in lieu of tax credits; o Credits for alcohol fuels, biodiesel, renewable diesel, alternative fuel and alternative fuel mixtures; o Credit for alternative fuel vehicle refueling property; o Credit for non-business energy property. Business tax relief, including: o 15-year straight line cost recovery for qualified leasehold, restaurant and retail improvements; o Various enhanced charitable contribution deductions; o Expensing of brownfield environmental remediation costs; o Work opportunity tax credit. Repeal Last-In, First-Out (LIFO) Method of Accounting for Inventories The current proposal is to repeal LIFO effective for the first tax year beginning after Dec. 31, If repealed, a taxpayer would be required to write up the value of its LIFO inventory to its FIFO value, with the increase in gross income taken into account ratably over 10 years. The provision is estimated to raise revenue of approximately $52.9 billion over 10 years. Deny Deduction for Punitive Damages Under the Administration s proposal, no deduction would be allowed for punitive damages paid or incurred by a taxpayer, whether upon a judgment or in settlement of a claim. If the liability for punitive damages is covered by insurance, the damages paid or incurred by the insurer would be included in the gross income of the insured. The insurer would be required to report such payments to the insured and to the IRS. The proposal would apply to damages paid or incurred after Dec. 31, 2012, and would raise approximately $312 million over 10 years. Repeal Lower-Of-Cost-Or-Market (LCM) Inventory Accounting Method The current proposal would prohibit taxpayers from writing down the value of FIFO inventories. These changes would be effective for taxable years beginning after Dec. 31, 2012, and any onetime increase in gross income would be included ratably over a four-year period beginning with the year of change. The provision would raise revenue of approximately $8.2 billion over 10 years. Eliminate Fossil Fuel Preferences The Administration proposal is to eliminate tax benefits for oil and gas producers and for coal and hard-mineral companies after In addition, the amortization period for geological and geophysical expenses for independent producers would increase from two to seven years. II. III. Temporary, Proposed, and Final Treasury Regulations Revenue Rulings, Revenue Procedures, Notices and Announcements a. Rev. Proc (Mar. 21, 2011) Guidance on section 280F limitations for

8 In Rev. Proc , the IRS provides annual guidance on the limitations on depreciation deductions for owners of passenger automobiles first placed in service during calendar year 2011 and the amounts lessees should include in income for passenger automobiles leased during Rev. Proc also includes separate tables setting forth limitations on depreciation deductions and inclusion amounts (for lessees) for trucks and vans. Additionally, the revenue procedure contains revised tables of depreciation limitations and lessee inclusion amounts for passenger automobiles that were first placed in service or leased during 2010 and to which the 50% additional first year depreciation deduction under section 168(k)(1)(A) or the 100% additional first year depreciation deduction under section 168(k)(5) applies. For owners of passenger automobiles, section 280F(a) imposes dollar limitations on the depreciation deduction for the year that the passenger automobile is placed in service by the taxpayer and each succeeding year. Under section 280F(d)(7), the amounts allowable as depreciation deductions must be increased by a price inflation adjustment amount for passenger automobiles placed in service after The method of calculating the price inflation amount for trucks and vans placed in service in, or after, calendar year 2003, uses a different CPI automobile component than that used in the price inflation amount calculation for other passenger automobiles. The result is somewhat higher depreciation deductions for trucks and vans. The Small Business Jobs Act of 2010 (Pub. L. No ) extended the 50% additional first year depreciation deduction under section 168(k) to qualified property acquired by the taxpayer after December 31, 2007, and before January 1, However, to qualify for the additional first year depreciation deduction, a written binding contract for the acquisition of property must not exist before January 1, 2008, and the taxpayer must place the property in service before January 1, Section 401(a) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Pub. L. No ) (the Act ) further extended the 50% additional first year depreciation deduction under section 168(k) to qualified property acquired after December 31, 2007, and before January 1, 2013, if no written binding contract exists before January 1, 2008, and the property is placed in service before January 1, The Act also added section 168(k)(5), which allows a 100% additional first year depreciation deduction for qualified property acquired by a taxpayer after September 8, 2010, and before January 1, 2012, if the taxpayer places the property in service before January 1, Under section 168(k)(2)(D)(i), the 50% additional first year depreciation deduction does not apply to any property required to be depreciated under the alternative depreciation system of section 168(g), including property described in section 280F(b)(1). Further, under section 168(k)(2)(D)(iii) a taxpayer may elect not to claim the 50% additional first year depreciation deduction for any class of property. As amended by the Act, section 168(k)(4) allows a corporation to elect to increase the alternative minimum tax ( AMT ) credit limitation under section 53(c), instead of claiming the section 168(k) additional first year depreciation deduction for all eligible qualified property placed in service after December 31, 2010, that is round 2 extension property (as defined in section 168(k)(4)(l)(iv)). Accordingly, Rev. Proc provides tables for passenger automobiles to which the additional depreciation deduction applies, and for passenger automobiles to which the deduction does not apply. Additionally, for leased passenger automobiles, section 280F(c) requires a reduction in the deduction allowed to the lessee of the passenger automobile. The reduction must be substantially equivalent to the limitations on the depreciation deductions imposed on owners of passenger automobiles. Under Treas. Reg F-7(a), such reduction requires the lessees to include in gross income an inclusion amount determined by applying a formula to the amount obtained from a table in this revenue procedure. There is a table for lessees of trucks and vans and a table for all other passenger automobiles. Each table shows inclusion amounts for a range of fair market values for each tax year after the passenger automobile is first leased. 8

9 Rev. Proc provides limitations on depreciation deductions for passenger automobiles that are first placed in service during calendar year 2011 and the amounts lessees should include in income for passenger automobiles leased during Rev. Proc also includes separate tables setting forth limitations on depreciation deductions and inclusion amounts (for lessees), for trucks and vans. The limitations on depreciation deductions in 4.01(2) of Rev. Proc apply to passenger automobiles (other than leased passenger automobiles) that are placed in service by the taxpayer in calendar year 2011, and continue to apply for each tax year that the passenger automobile remains in service. Tables 1 and 2 should be used for passenger automobiles and trucks or vans for which the additional first year depreciation deduction applies. Tables 3 and 4 are for passenger automobiles and trucks or vans for which the deduction does not apply. The IRS intends to issue additional guidance on the interaction between the 100% additional first year depreciation deduction and section 280F(a) for the tax years subsequent to the first tax year. The tables in 4.02 of Rev. Proc apply to leased passenger automobiles for which the lease term begins during calendar year Lessees of such passenger automobiles must use these tables (Tables 5 and 6) to determine the inclusion amount for each tax year during which the passenger automobile is leased. Section 4.03 of Rev. Proc contains the revised amounts for passenger automobiles placed in service in Tables 7 and 8 apply to passenger automobiles and trucks or vans placed in service in 2010 for which the additional first year depreciation deduction applies. If the additional first year depreciation deduction does not apply, the depreciation limitations for each tax year in Tables 1 and 2 of Rev. Proc apply. b. Rev. Proc (Mar. 29, 2011) - guidance under 2022(a) of the Small Business Jobs Act of 2010, Pub. L. No , 124 Stat (September 27, 2010) (SBJA), and 401(a) and (b) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L. No , 124 Stat (December 17, 2010) (TRUIRJCA) The IRS on March 29 released Rev. Proc covering the recently enacted provision allowing 100 percent expensing of bonus depreciation property placed in service through the end of The IRS offers important guidance in the release, including the addition of rules that: Do not allow 100 percent bonus deprecation for self-constructed property when construction begins before Sep. 9, Provide a special exception allowing 100 percent bonus for certain components of a larger selfconstructed project that is not eligible. Allow taxpayers to elect to take 50 percent bonus depreciation for all property placed in service in the 2010 tax year. General rules Bonus depreciation under current law generally allows taxpayers an additional first-year depreciation deduction of 50 percent of the cost of original use property acquired and placed in service in 2008 through However, the recently enacted TRUIRJCA provides a more generous 100 percent deduction for bonus property both acquired and placed in service after Sep. 8, 2010 and before Jan. 1, (Aircraft and other long-production period property qualify for 100 percent bonus if placed in service before Jan. 1, 2013 and 50 percent bonus if placed in service before Jan. 1, 2014). Property qualifying for bonus depreciation is defined as: modified accelerated cost recovery system (MACRS) property with a useful life of 20 years or less; computer software; 9

10 water utility property; and qualified leasehold improvements. Qualified restaurant and qualified retail property are specifically excluded from bonus depreciation, but the new revenue procedure confirms that this property is eligible if it also qualifies as leasehold improvement property. Electing bonus depreciation Taxpayers that do not want to use bonus depreciation must make an election to forgo the additional depreciation by attaching a statement to a timely filed tax return. Taxpayers may make separate elections for each class of property, but each election will apply to all the property placed in service in that class for the year. The revenue procedure confirms that taxpayers may not make separate elections for 50 percent bonus depreciation property and 100 percent bonus depreciation property in the same tax year. (So a calendar year taxpayer may not elect out of 50 percent bonus for property placed in service before Sep. 9, 2010 while using 100 percent bonus for property placed in service for the rest of 2010.) However, the revenue procedure does provide relief that will allow taxpayers to elect 50 percent bonus depreciation for all property in each class for the tax year that includes Sep. 9, (So calendar year taxpayers can use 50 percent bonus for all property placed in service in 2010 if it is difficult to determine which property was placed in service after Sep. 8, 2010.) Bonus depreciation is not available for property acquired pursuant to a binding written contract in place before Jan. 1, 2008, but there is generally no additional binding contract rule applying specifically to 100 percent bonus depreciation. For example, qualified property acquired and placed in service in 2011 will qualify for full expensing even if acquired pursuant to a binding contract entered into in July of The revenue procedure provides that property is considered acquired when the taxpayer has incurred the expense. Self-constructed property Property that a taxpayer manufactures, constructs, or produces is considered acquired when the taxpayer begins construction, manufacture, or production. So any self-constructed property in which construction began before Sep. 9, 2010 will not qualify for full expensing regardless of whether it is placed in service in However, the IRS provides a special exception for components of a larger self-constructed project. Taxpayers may carve out components of a non-qualifying large self-constructed project and apply 100 percent bonus depreciation if the components themselves meet the acquisition and placed-in-service requirements. It appears the exception will function similar to the shrink-back rule that allows taxpayers to evaluate subcomponents of a research project as stand-alone business components for purposes of the research credit. The revenue procedure defines component broadly, saying it is intended to refer to any part used in the manufacture, construction, or production of larger self-constructed property even if they are considered the same asset or unit of property for depreciation purposes or other code sections. The revenue procedure provides several examples on how the component rules operate. In Example 2, a taxpayer enters into a binding written contract on Sep. 1, 2010 to acquire an uncompleted power plant for $5 million. The original owner began construction in August of The taxpayer incurs $10 million between 10

11 Sep. 15, 2010 and November 2011 to complete the power plant. The example states that $5 million of the $15 million unadjusted basis qualifies for 50 percent bonus depreciation because it was acquired before Sep. 9, The other $10 million qualifies for 100 percent bonus because the taxpayer acquired or began selfconstructing all of those components after Sep. 8, Taxpayers wishing to use these rules must make an election on a timely filed tax return by attaching a statement that indicates the taxpayer is making the election specified in Section 3.02(2)(b) of Rev. Proc The taxpayer must specify whether the election includes all or some of the eligible components. Section 280F automobile limits For passenger automobiles placed in service in 2010 and 2011, section 280F limits the amount of first year depreciation that can be claimed to $11,060 (See Rev. Proc ). Since 100 percent bonus depreciation does not provide for a depreciation deduction after the year the property is placed in service, a strict application of the section 280F rules would defer the recovery of basis in excess of the $11,060 limit until the 7th year after the automobile is placed in service. Rev. Proc provides a special safe harbor method of accounting that allows the excess to be recovered as if the first year calculation had been done using 50 percent bonus depreciation. This does not reduce the amount that can be claimed in the year the automobile is placed in service, but does accelerate the recovery of the remainder of the cost of the automobile. The safe harbor described in Rev. Proc is adopted by its use on a return in the first taxable year succeeding the year in which the automobile is placed in service. For automobiles placed in service in 2010, the safe harbor will be elected by its use on the taxpayer s 2011 Federal income tax return. It is not available for property that is the subject of a section 179 election. Mid-quarter convention The IRS provides that the depreciable basis of property eligible for bonus depreciation is taken into account in determining whether the mid-quarter convention applies. Tax credit basis reduction Property qualifying for tax credits that require a basis reduction (such as the Section 48 energy tax credit) will be eligible for 100 percent bonus depreciation after the basis reduction is applied, with an exception for the Section 47 rehabilitation credit. Previously filed tax returns The SBJA did not extend bonus depreciation to 2010 until its enactment on Sep. 27, Many fiscal year taxpayers may have filed returns for months in 2010 before the enactment of the legislation. Taxpayers who made no election but filed and did not deduct 50 percent bonus depreciation for 2010 qualified property may claim the additional depreciation by: Filing an amended return for the applicable 2009 tax year or 2010 short tax year before filing a return for the following taxable year; or Filing a Form 3115 for change in method of accounting with the tax year following the 2009 tax year or 2010 short tax year 11

12 Taxpayers who made an election not to deduct the 50 percent bonus depreciation may revoke this election and claim the depreciation on an amended return before the taxpayer s next tax return or June 17, 2011, whichever is later. c. Rev. Proc (Apr. 4, 2011) Guidance providing a safe harbor method for determining the recovery period for depreciation of certain tangible assets used by wireless telecommunications carriers Rev. Proc provides a safe harbor method of accounting for determining the recovery periods for depreciation of certain tangible assets used by wireless telecommunications carriers. The safe harbor provides recovery periods that will not be challenged by the Service for assets located at the taxpayer s mobile telephone switching office (MTSO) and cell sites. A taxpayer may elect to use one or all of the safe harbor recovery periods for its wireless assets, provided the property for which it is electing the safe harbor method meets the specific definitions of each type of property included in the revenue procedure. The revenue procedure applies to taxpayers with a depreciable interest in telecommunication assets used primarily to provide wireless communications or broadband services by mobile phones. The revenue procedure does not apply to taxpayers that are primarily cable operators or primarily wireline telecommunications companies. Rev. Proc was updated to include a new automatic change in appendix section 6.26 for taxpayers choosing to change to the safe harbor method provided in Rev. Proc Rev. Proc is effective for tax years ending on or after December 31, d. Rev. Proc and Rev. Proc (Apr. 4, 2011) Guidance providing safe harbor methods for taxpayers to use in determining whether expenditures to maintain, replace or improve wireline network assets or wireless network assets must be capitalized under section 263(a) Revenue Procedure and Rev. Proc provide two alternative safe harbor methods for taxpayers to use in determining whether expenditures to maintain, replace or improve wireline network assets (Rev. Proc ) or wireless network assets (Rev. Proc ) must be capitalized under section 263(a). The revenue procedures state that taxpayers and the IRS often disagree on which items within a network constitute discrete units of property and whether certain repairs materially increase the value or prolong the useful life of a unit of property. The revenue procedures are intended to reduce disputes in this area. Neither of these revenue procedures applies to taxpayers that are cable operators primarily. The network asset maintenance allowance method allows a taxpayer to take a certain percentage of the adjusted basis of network assets, as defined in the revenue procedures, and treat that amount as deductible maintenance expenses. The network asset maintenance expenses in excess of the allowance amount would be treated as capital expenditures. For wireless network assets the safe harbor maintenance percentage is five percent. For wireline network assets that percentage is twelve percent. The adjusted basis of the assets (upon which the allowance is calculated) includes a reduction for the cost of property other than wireless or wireline network assets (such as land); the cost of any network assets acquired in an applicable asset acquisition under section 1060 or acquired in a transaction to which section 338(h)(10) applies; and any other basis adjustments described in 1016 other than basis adjustments attributable to changes made after December 31, 2007 to the taxpayer s unit of property definitions or any adjustments described in sections 1016(a)(2) and 1016(a)(3). 12

13 The units of property method provides that the IRS will not challenge any of the specifically described unit of property determinations for purposes of the application of section 263(a) for both wireless and wireline network assets. Taxpayers wishing to change their method of accounting under either of these two revenue procedures may do so under the automatic procedures of Rev. Proc (as amended by Rev. Proc and ). These methods apply only to taxpayers that own a depreciable interest in wireless or wireline network assets used primarily to provide telecommunication or broadband services; however, the revenue procedure does not apply to a company that is primarily a cable operator, or is in some other industry. e. Rev. Proc (Apr. 8, 2011) Guidance providing safe harbor election for the deduction of a percentage of success-based fees under Treas. Reg (a)-5(f) without further documentation On April 8, 2011, the IRS issued Rev. Proc providing a safe harbor election for the deduction of a percentage of success-based fees under Treas. Reg (a)-5(f) without further documentation. Treas. Reg (a)-5 requires a taxpayer to capitalize an amount paid to facilitate a business acquisition or reorganization transaction described in Treas. Reg (a)-5(a). An amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction. Under Treas. Reg (a)-5(f), an amount that is contingent on the successful closing of a transaction (i.e., success-based fee) is presumed to facilitate the transaction. That presumption may be rebutted by sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. Specifically, in Rev. Proc , the IRS acknowledged the controversy regarding the success-based fee documentation requirement and notes that in order to eliminate much of this controversy, it is providing a safe harbor for allocating success-based fees between facilitative and non-facilitative costs. In lieu of maintaining sufficient documentation as required by Treas. Reg (a)-5(f), a taxpayer may irrevocably elect to treat 70% of the success-based fees paid in a transaction as non-facilitative under Treas. Reg (a)-5. The remaining 30% must be capitalized as facilitative transaction costs. Such election is made by attaching a statement to the original federal income tax return for the taxable year in which the success-based fee is paid or incurred that: (i) States the taxpayer is electing the safe harbor, (ii) Identifies the transaction, and (iii) States the success-baesd fee amounts that are deducted and capitalized. The election applies to all success-based fees paid or incurred in connection with the transaction for which the election is made. The election is made on a transaction-by-transaction basis, and does not represent a change in the taxpayer s method of accounting for such costs. Rev. Proc is effective for success-based fees paid or incurred in taxable years ending on or after April 8, 2011 (i.e., transactions closing on or after April 8, 2011). f. Rev. Proc (Apr. 14, 2011) Safe harbor under section 118(a) for certain Clean Coal Technology awards made by the National Energy Technology Laboratory of the United States Department of Energy to corporate taxpayers In Rev. Proc , the IRS announced a safe harbor under section 118(a) for certain Clean Coal Technology awards made by the National Energy Technology Laboratory (NETL) of the United States Department of Energy (DOE) to corporate taxpayers. Section 118(a) allows a corporation to exclude 13

14 contributions to its capital from gross income. Treas. Reg further provides that section 118(a) applies to contributions to capital made by a person other than a shareholder (e.g., property contributed to a corporation by a governmental unit to enable the corporation to expand its operating facilities). When a corporation receives money from a nonshareholder as a contribution to capital, section 362(c)(2) requires the corporation to reduce the basis in its property. The DOE has been directed to (1) provide assistance for projects that advance efficiency, environmental performance, and cost competitiveness well beyond the level of technologies that are in commercial service or have been demonstrated on a scale that the DOE determines is sufficient to demonstrate that commercial service is viable as of August 8, 2005, and (2) carry out a program to demonstrate technologies for the largescale capture of carbon dioxide from industrial sources. To implement these programs, NETL issued two Financial Assistance Funding Opportunity Announcements (hereinafter referred to as CCPI-Round 3 and ICCS ). Additionally, on September 27, 2010, NETL awarded assistance for a commercial-scale, oxycombustion power plant and carbon dioxide sequestration facility ( FutureGen 2.0 ). The DOE subsequently allocated approximately $796 million to CCPI - Round 3, approximately $703 million to ICCS, and approximately $995 million to FutureGen 2.0. In Rev. Proc , the IRS stated that it will not challenge a corporate taxpayer s treatment of any award received from the DOE under either the CCPI-Round 3, ICCS, or FutureGen 2.0 programs as nonshareholder capital contributions under section 118(a), provided that the taxpayer properly reduces the basis of their property under section 362(c)(2) and the regulations thereunder. In addition the revenue procedure further indicates that it applies to a corporate taxpayer that has the right to retain ownership of its inventions made under an award, either by statute or under waiver of patent rights from DOE. However, Rev. Proc does not apply to the portion of an award paid or incurred for non-capital expenditures (i.e., operating expenses) or for research and experimental expenditures under section 174. Further, Rev. Proc does not apply to noncorporate taxpayers. Rev. Proc is effective April 14, IV. Cases a. Gibson & Associates, Inc. v. Commissioner, 136 T.C. No. 10 (Feb. 24, 2011) Construction activities that are not repairs qualify for section 199 deduction In Gibson & Associates, Inc. v. Commissioner, 136 T.C. No. 10 ( Gibson ), the Tax Court recently held that the activities of an engineering and heavy construction company were qualified activities for purposes of section 199. The issue in Gibson was whether certain of the taxpayer s activities constituted construction for purposes of section 199. Section 199 allows taxpayers to claim a deduction equal to a percentage of the income earned from production activities undertaken in the United States. The deduction, called the domestic production activities deduction, is limited the smaller of the qualified production activities income or taxable income multiplied by the applicable percentage. The deduction cannot be greater than fifty percent of the Form W-2 wages of the taxpayer for the tax year that relate to the qualifying production activity. Qualified production activities income is the excess of gross receipts earned from qualified activities within the United States over the allocable cost of goods sold and other expenses related to those activities. 14

15 Section 199(c)(4)(iii) provides that income earned by a taxpayer engaged in the active conduct of a construction trade or business is qualified production activities income. Qualifying construction activities include the construction of real property performed in the United States by the taxpayer in the ordinary course of such trade or business. Treasury Reg (m) clarifies that activities constituting construction are those performed in connection with a project to erect or substantially renovate real property. Substantial renovation is defined in the regulations as the renovation of a major component or substantial structural part of real property where that renovation materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use. Real property is defined as buildings (including items that are structural components of such buildings), inherently permanent structures, inherently permanent land improvements, oil and gas wells, and infrastructure. In Gibson, the taxpayer was an engineering and heavy construction company that erected or rehabilitated streets, bridges, airport runways, and other related real property. The rehabilitation services at issue in the case related mainly to real property that was significantly damaged from a casualty or to real property which had fallen into a state of disrepair and was no longer fit for its intended use. The court looked at all 136 construction projects worked on by the taxpayer in the year at issue in order to determine whether the contracts qualified as the erection or substantial renovation of real property. The Tax Court looked to section 263 and the rules thereunder in order to determine whether the taxpayer s activities constituted substantial renovations. Specifically, the court looked at numerous cases and the proposed regulations under section 263(a) in order to interpret the phrases materially increases the value of the property, substantially prolongs the useful life of the property, and adapts the property to a new or different use. Based on the testimony of two expert witnesses, the Tax Court concluded that the subject projects extended the useful life of the real property and/or substantially increased the value of such property. Accordingly, the Tax Court held that the taxpayer s activities constituted construction for purposes of section 199 and that its revenue from such activities constitutes domestic production gross receipts under section 199. b. Dominion Resources, Inc. v. U.S., 107 AFTR 2d (Feb. 25, 2011) - Treas. Reg A-11(e)(1)(ii)(B) is not an arbitrary or capricious interpretation of section 263A(f) In a recent Court of Federal Claims case, Dominion Resources, Inc. v. U.S., 107 AFTR 2d (2011), the court held that Treas. Reg A-11(e)(1)(ii)(B) is not an arbitrary or capricious interpretation of section 263A(f). Dominion Resources ( Dominion ), whose primary business is providing electric power and natural gas to individual and commercial customers, replaced burners in two of its electric generating units. The generating units had to be taken out of service for several months while burners were replaced. Existing coal burners were replaced with low-nitrous-oxide burners in order to comply with requirements of the Clean Air Act. The court stated that Dominion s improved burners are subject to the overarching provisions of section 263A.... Therefore, the cost of the replacement had to be capitalized rather than deducted. Section 263A requires that direct and indirect costs related to property produced by the taxpayer be capitalized to such property. Section 263A(f)(2) provides that interest related to certain property with a long useful life or a long production period must be capitalized. Capitalizable interest includes interest that is directly attributable (traced) to production expenditures related to the covered property and also interest on any other indebtedness to the extent that the taxpayer s interest on the other debt (not directly related to the project) could have been reduced or avoided had the production expenditures not been incurred. In other words, section 263A(f) requires capitalization of interest on unrelated debt to the extent of the production expenditures incurred on the project. Other than that general statement of the rule, the statute does not 15

16 provide any specific rules as to the allocation of interest on debt that is not directly related to the project. The definition of production expenditures in section 263A(f)(4)(C) states that The term production expenditures means the cost (whether or not incurred during the production period) required to be capitalized under [263A(a)]. The definition of production expenditures is important because the amount of production expenditures will drive in part the amount of interest capitalized to a project. Treasury Reg A-11(e)(1)(ii)(B) provides that accumulated production expenditures with respect to the improvement consist of... in the case of any improvement to a unit of real property... the adjusted basis of any property that...must be temporarily withdrawn from service to complete the improvement as long as the property withdrawn from service benefits from or the improvement was incurred by reason of the property removed from service. The taxpayer did not include the basis of the property temporarily removed from service in its interest capitalization calculation arguing that to include the basis of the temporarily withdrawn property would be inconsistent with the requirements of the statute itself. IRS exam argued that Dominion was not capitalizing the required amount of interest under Section 263A(f), and the regulations thereunder, because it was not including the basis of the temporarily closed plant in the interest allocation. Dominion filed a claim for refund of taxes paid claiming that the regulation requiring the inclusion of the basis of temporarily withdrawn property in the interest capitalization calculation - is inconsistent with the statutory text of section 263A(f). Dominion argued that the inclusion of the adjusted basis of the boilers and associated generating units in production expenditures violates the allocation rule set forth in 263A(f)(2)(A)(ii), because the amount representing the basis of the boilers could not have been used to reduce debt (and reduce interest expense) if Dominion had not replaced the burners. Dominion also argued that the inclusion of the basis of temporarily removed property in the calculation is inconsistent with the definition of production expenditures as defined in section 263A(f)(4)(C) which included only the costs that were required to be capitalized under section 263A(a). In order to determine whether the regulations interpreting section 263A(f) were valid, the court applied the deference standards set out in two Supreme Court cases, Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc., 467 U.S. 837 (1984) and Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704 (2011). Under the standard set out in Chevron, when a court reviews an agency s construction of a statute which the agency administers, it must ask two questions. The first question is whether Congress (i.e., the statute) speaks to the precise question at issue. If the statute is clear, that is the end of the analysis. If the statute is silent or ambiguous with respect to a specific issue, the next question for the court is whether the agency s answer [to the question at issue] is based on a permissible construction of the statute. In the more recent Mayo decision, the Court held that these steps apply to all Treasury Regulations whether interpretive or legislative. When applying the second question from the Chevron analysis, a regulation is binding in the courts unless procedurally defective, arbitrary or capricious in substance, or manifestly contrary to the statute. In this case, the court determined that the section 263A(f) was ambiguous with respect to the specific issue presented. Because the statute was not clear, the court looked at the second question in the Chevron analysis- whether or not the Treasury Regulation is based on a permissible construction of the statute. In the Dominion case, the court agreed that including the associated property basis in the interest computation is at best an approximation of economic costs of closing the plant. However, the court could not say that the regulations overstepped the latitude granted by the statute. Therefore, Treas. Reg A-11(e)(1) survived Dominion s challenge that the regulation is inconsistent with the statute itself. Thus, Dominion was 16

17 required to include the basis of the burners and the temporarily closed plants in its interest allocation method under Section 263A c. Washington Mutual Inc. v. United States, U.S.T.C. 50,254 (Mar. 3, 2011) - Financial institution has basis in rights received in acquisition of failing thrifts During the late 1970s and early 1980s, in response to the savings and loan industry crisis, the Federal Savings and Loan Insurance Corporation (FSLIC) offered incentives to strong financial institutions that were willing to acquire failing savings and loan associations ( thrifts ). In 1981, Home Savings of America FSB ( Home Savings ) acquired three failing thrifts. Among the incentives provided to Home Savings by FSLIC was the right to maintain branches in other states ( branching rights ) and the right to use the purchase method of accounting for regulatory capital reserve purposes ( RAP rights ). The purchase method of accounting allowed an acquiring bank to create an asset for financial statement purposes (known as supervisory goodwill ) that was equal to the amount of the failing thrifts liabilities assumed by the acquiring bank over the fair market value of the acquired thrifts assets. The supervisory goodwill benefitted the acquiring bank by helping it meet its capital reserve obligations. In Washington Mutual Inc. v. United States (No ), the Ninth Circuit held Home Savings had cost basis in branching rights and the RAP rights acquired as part of the above described transaction. Washington Mutual Inc. acquired Home Savings and filed amended tax returns for the 1990, 1992, and 1993 tax years seeking refunds based on the amortization of RAP rights and a section 165 loss based on the abandonment of some of the branching rights received when it acquired the failing thrifts. The IRS denied the refund claims and a district court granted the government summary judgment, finding that Home Savings had no basis the branching rights or the RAP rights. The court stated that the case required a return to the very basics of tax law and explained that the fundamental concept of basis is a taxpayer s capital stake in an asset for tax purposes. The IRS argued that, while the taxpayer did assume liabilities in excess of the fair market value of the assets received, the RAP rights and branching rights were not received as part of that actual transaction, but were, instead, received from FSLIC. The IRS argued that excess of liabilities over the fair market value of the assets received did not relate to the rights received from FSLIC in what amounted to a separate transaction. The court examined the documentary evidence, including merger and assistance agreements between Home Savings and the FSLIC, as well as a resolution issued by the Federal Home Loan Bank Board, and found that acquisition of the RAP and branching rights; and the acquisition of the failing thrifts were all part of one transaction. The branching rights and the RAP rights were part of the consideration received by Home Savings and that by acquiring the failing thrifts, it lowered the FSLIC s own insurance liability regarding those thrifts. According to the court, the cost to Home Savings for acquiring these various incentives and benefits was the excess of the three failing thrifts liabilities over the value of their assets. The court found that Home Savings, therefore, received a cost basis in the branching rights and the RAP rights equal to some part of the total amount of that excess liability. The Ninth Circuit rejected the government s argument that allowing a cost basis in the rights was incompatible with the merger being recognized as a tax-free G reorganization under section 368. The court found that the government had taken certain statements made by Washington Mutual out of context in reaching this conclusion and held that recognizing that Home Savings had a cost basis in the branching 17