DRAFT- FOR DISCUSSION PURPOSES ONLY ABA Capital Recovery & Leasing Committee Proposed Tangible Property Regulations Outline and Panel Questions Hollywood, FL Meeting January, 2007 Moderator: Susan Minasian Grais, Ernst & Young LLP, Washington, DC. Panelists: Sharon Kay, Taxation Specialist, Office of Tax Legislative Counsel, Department of Treasury, Washington, DC; Kimberly Koch, Special Counsel to the Associate Chief Counsel (Income Tax and Accounting), IRS, Washington, DC; Colleen O Connor, Ernst & Young LLP, Washington, DC A. Unit of Property Under the proposed regulations, amounts paid to repair, improve, or rehabilitate a unit of property generally must be capitalized. A unit of property is improved if the aggregated amounts paid---(1) materially increase the value of the unit of property, or (2) restore the unit of property. The proposed regulations provide standards for determining whether amounts paid "materially increase the value" of a unit of property and for determining whether amounts paid "restore" the unit of property. In addition, the proposed regulations provide a repair allowance safe harbor that may be used to determine whether an expenditure must be capitalized as an improvement to tangible property. The proposed regulations provide a three-part analysis for determining the "unit of property." First, an "initial determination" of the unit of property is determined under a functional interdependence test (similar to that used under Section 263A for interest capitalization). That larger unit of property is then further analyzed through a hierarchy of four categories---(1) federally regulated industries with a uniform system of accounts; (2) buildings and structural components; (3) other personal property, which is subject to further analysis under four factors (i.e., marketplace treatment factor; industry practice and financial accounting factor; rotable part factor; and function factor); and (4) other real property. Finally, notwithstanding the analysis described above, if a taxpayer properly treats a component as a separate unit of property for any federal income tax purpose (e.g. Section 168), the taxpayer must treat the component as a unit of property for purposes of Prop. Reg. Section 1.263(a)-3(d)(2). The three-part analysis discussed above does not apply in the case of so-called "network assets" (e.g., railroad track, oil and gas pipelines, power transmission and distribution lines, telephone and cable lines). The government requests comments regarding the unit property determination for such assets. 1
Q: Based on comments received since issuance of the proposed regulations, what principle issues are of concern to you regarding the initial determination regarding unit of property (UOP)? Q: In a similar vein, category 3 includes industry practice and financial accounting treatment as one factor. These reflect factors used by the court in FedEx. The preamble suggests that Category I was created because it too was considered as a factor by the court in FedEx. Was any consideration given to using regulatory accounting as a factor in the other categories rather than as a stand-alone category? Q: Given that the "additional rule" appears to override any determination made in the Initial Determination and in Step Two, shouldn't it really be the first step? Given the additional rule, the second step (applying all of the factors and making the factual determinations) does not seem to have much effect in many cases. Did the government consider adopting as the definition of UOP the initial determination subject to the additional rule (i.e., eliminating the fact-intensive second step altogether)? Q: Has further consideration been given to the unit of property determination for regulated industries? In this regard, do you have concerns regarding whether use of the Uniform System of Accounts (USOAs) can provide sufficient certainty so as to reduce controversy, uncertainty, etc? In some cases, the uniform system of accounts addresses only broad categories of assets instead of individual assets. Q: In assessing whether a component is treated as a separate unit of property for any other federal income tax purpose, the examples in the proposed regulations focus on depreciation (e.g., placing fixed assets in service). How has the Service considered this rule in relation to cases law and the IRS analysis of these cases in 1997 FSA LEXIS 690 (essentially stating that a taxpayer s method for MACRS depreciation purposes does not affect the identification of the item for purposes of section 263(a) repairs analysis)? B. The 12-Month Rule and De Minimis Standard Subject to a 12-month rule, Prop. Reg. Section 1.263(a)-2 generally requires capitalization of amounts paid to acquire or produce tangible real or personal property having a useful life substantially beyond the end of the tax year. Under the proposed 12- month rule, generally, an amount paid for the acquisition or production of a unit of property with an economic useful life of 12 months or less is not required to be capitalized. The 12-month rule does not apply to (1) property that is or will be included in property produced for sale or acquired for resale, (2) improvements to a unit of property, (3) land, or (4) a component of a unit of property. The rule is mandatory unless the taxpayer makes an irrevocable election not to apply the 12-month rule. The proposed regulations don t include a de minimis rule, but the preamble describes a rule contemplated by the government--essentially book conformity for taxpayers with an applicable financial statement and a set dollar for those without. The preamble also indicates that the absence of a de minimis rule is not intended to disturb the current 2
administrative practice of examining agents who have permitted a capitalization threshold. Q: Some commentators have recommended that the present law standard, whereby items having a useful life not substantially in excess of one year generally are not subject to capitalization, be retained in lieu of a bright-line 12-month rule? [See comments of Uniform & Textile Service Association.] Q: Is consideration actively being given to a de minimis capitalization rule, or is principal consideration focused on the proposed elective repair allowance? C. Material Increase in Value Under the proposed regulations, an amount materially increases the value of a unit of property only if it---(1) ameliorates a pre-existing condition or defect that arose during production of the property (whether or not the taxpayer was aware of the defect); (2) is for work performed prior to the date the property is placed in service; (3) adapts the unit of property to a new or different use; (4) results in a betterment or material addition to the unit of property; or (5) results in a material increase in capacity, productivity, efficiency, or quality of output of the unit of property. An amount paid must be capitalized if it meets any of these five rules. The determination of whether an amount materially increases the value of property is generally made by comparing the value of the property immediately before the event necessitating the expenditure with the value of the property immediately after the expenditure. This is consistent with the current standard set forth in Plainfield-Union. In normal wear and tear situations, the proper comparison is the original placed in service value (if no interim repairs are made) or the value immediately after the prior repair. If interim repairs are made, the comparison is with the property immediately after such repair. Q: Is active consideration being given to the possible addition of a bright-line standard for material increase in value? If not, what principle issues are being considered relative to the determination of whether a material increase in valuce as occurred for purposes of final regulations? Q: D. Restoration of Property The proposed regulations provide that an amount is paid to restore property if such amount substantially prolongs the economic useful life of the unit of property. For a taxpayer with an applicable financial statement (defined in the proposed regulations), the economic useful life is presumed to be the same as the period over which the unit of property is depreciated for purposes of such applicable financial statement. For a taxpayer not having an applicable financial statement, the economic useful life is the period over which the property may reasonably be expected to be useful to the taxpayer in its trade or business or income producing activity. Under the proposed regulations, an amount paid substantially prolongs the economic useful life of a unit of property if ---(1) it extends the period over which the property may 3
reasonably be expected to be useful to the taxpayer beyond the end of the tax year immediately succeeding the tax year in which the economic useful life was originally expected to cease (essentially a 12-month rule); (2) replaces a major component or a substantial structural part of the unit of property; (3) restores a unit of property to a likenew condition; or (4) repairs property after a casualty loss. Q: Why did the government decide to look to the applicable financial statement ( AFS ) recovery period as a surrogate for economic useful life? Q: Why did the IRS use a succeeding tax year rule for measurement purposes instead of a rule similar to the 12-month rule, i.e., capitalization required if the designated economic useful life is extended beyond 12 months (irrespective of the length of the present or next succeeding tax year)? Q: What is a major component or substantial structural part? Did the government consider omitting this standard in the interest of administrability and reduction of controversy, and focus instead on whether the value of the property has been increased or its life expanded under the otherwise applicable rules? Q: Will the final regulations provide the procedures for a taxpayer to rebut the presumption that the AFS recovery period is the economic useful life of a unit of property? In addition, is the government is bound by the presumption? For example, can IRS exam challenge the applicable financial statement recovery period as the economic useful life? Q: The government has requested comments on how to determine the economic useful life of leasehold improvements. What are the government s concerns with respect to this issue? E. Improvement of Property The proposed regulations provide that a regulatory requirement to perform repairs or maintenance to a unit of property is not relevant in determining whether an amount is paid to improve a unit of property. Further, the fact that a taxpayer uses an improved but comparable replacement part (because the unimproved part is no longer available) does not in and of itself result in an improvement in the unit of property. Finally, the proposed regulations provide that repairs that do not directly benefit or are not incurred by reason of the improvement are not required to be capitalized under Section 263(a) (but may still be required to be capitalized under Section 263A, if applicable), without regard to whether such repairs are made at the same time as the improvements. F. Repair Allowance Election The proposed regulations include a new optional repair allowance method. Under the repair allowance method, the taxpayer compares the amounts paid during the tax year to repair, maintain, or improve repair allowance property to the repair allowance amount. The amounts paid are deductible to the extent of the repair allowance amount, and any excess amounts are capitalized. The repair allowance amount is a specified percentage 4
based on the MACRS recovery periods. Repair allowance property is generally MACRS property, but does not include "excluded additions" defined in the proposed regulations. Q: There are at least two principle concerns relative to the repair allowance: (1) the allowance, as presently proposed, may be inadequate with respect to certain industries in terms of the allowable repair expense deduction, and (2) the proposed allowance does not permit taxpayer to carry over unused allowances amounts to future years (an approach that would be beneficial for industries with cyclical maintenance). What are your thoughts in addressing these concerns? Q: What consideration, if any, is being given to the application of the repair allowance to leased property? Q: Are alternatives being considered to the presently proposed use of Rev. Proc. 87-56 for recovery periods in determining the repair allowance percentages? G. Network Assets Q: What is the current thinking as to the pros and cons of defining network assets in the final regulations as opposed to separate guidance, such as a series of IIRs? If the IIR approach is taken, what would be the time table on issuing those? Could they be issued concurrently with the final regulations? Q: Can you generally describe the issues to be addressed by any other separate, industry-specific repair/maintenance guidance planned apart from the proposed regulations? H. Method of Accounting Considerations Because the proposed regulations are not reliance guidance, the proposed regulations do not provide guidance with respect to how a taxpayer should change its method of accounting to a method described in the proposed regulations. It is anticipated that the final regulations will provide method change procedures and the government has asked for comments regarding whether the changes should be made using a cut-off basis rather than section 481(a) adjustment. Q: Is there active consideration being given to allowing taxpayers to elect a cutoff basis or modified 481(a) adjustment (as opposed to requiring this approach) rather than a full 481(a) adjustment for changes to comply with the final regulations? Using an elective provision would permit those taxpayers that could compute a full 481(a) adjustment to do so. Q: Will you entertain method change requests to change the definition of the unit of property? Has further consideration been given to making a change in defining the unit of property automatic under the final regulations, if contemporaneous with a change for repair costs? 5