Supplemental comments on the proposed "Tangibles Regulations".

On June 19, 2007, TEI President David L. Bernard submitted a letter to Assistant Treasury Secretary for Tax Policy Eric Solomon providing supplemental comments on the proposed regulations relating to the treatment of expenditures for tangible property and repairs. The letter responds to a Treasury Department request for comments on whether a taxpayer's Applicable Financial Statement (or "book") life is appropriate for measuring whether an acquired or produced unit of property has a life of 12 months or less--and thus qualifies for an immediate deduction--or has a life in excess of 12 months and should be capitalized and depreciated or amortized for tax purposes. TEI's comments were prepared under the aegis of TEI's Federal Tax Committee whose chair is Susan A. Bauer of Moore Investment Group. Contributing substantially to the development of TEI's comments was Carita R. Twinem of Briggs & Stratton Corporation.

During Tax Executives Institute's 2007 liaison meeting with the Treasury's Office of Tax Policy, we discussed the proposed tangibles regulations (REG-168745-03). It was noted that commentators, including TEI, uniformly disagreed with the proposed regulations' equating the economic useful life of an asset with the taxpayer's Applicable Financial Statement (AFS) (1) or "book" life for purposes of determining whether an expenditure should be capitalized as a restoration. It was also noted that few comments were submitted on the proposed regulations' use of the AFS life rule in connection with the proposed 12-month rule of Prop. Reg. [section] 1.263(a)-2(d)(4). The Treasury Department invited TEI's comments on whether a taxpayer's AFS life is appropriate for measuring whether an acquired or produced unit of property has a life of 12 months or less -and thus qualifies for an immediate deduction --or has a life in excess of 12 months and should be capitalized and depreciated or amortized for tax purposes.

Tax Executives Institute is the preeminent global association of business tax professionals with our 7,000 members representing 3,000 of the leading companies in the United States, Canada, Europe, and Asia. On behalf of TEI, I am pleased to submit the following additional comments on the proposed tangibles regulations.

The current regulations under sections 263(a), 446, and 461 require taxpayers to capitalize amounts paid to acquire property having a useful life substantially beyond the taxable year. Some courts have adopted a 12-month rule for determining whether property has a useful life substantially beyond the taxable year, (2) and the proposed regulations would adopt a bright-line 12-month rule for determining whether amounts paid to acquire or produce a tangible unit of property must be capitalized. As a result, the tangibles regulations would parallel the 12-month rule of Treas. Reg. [section] 1.263(a)-4(f) governing intangible property. The Treasury Department requested TEI's views about adopting a corollary bright-line rule for tangible assets.

As a preliminary matter, the current capitalization rules generally afford taxpayers flexibility in determining whether an expenditure has a useful life "substantially beyond the taxable year." The 12-month rule in Prop. Reg. [section] 1.263(a)-2(d)(4) would transform a flexible judicial guidepost for capitalization into an inflexible per se rule. Consequently, taxpayers in some industries, such as textile, linen, and uniform suppliers, may be adversely affected. The rapid turnover of the high-volume, low-cost items in these businesses makes it difficult to track them on an item-by-item basis and they are generally deducted when placed in service even though the economic useful life of specific items might last from 12 to 18 months. (3) Taxpayers in other industries may have similar pragmatic, economic, or administrative reasons that justify longstanding practices of deducting expenditures for items that have a useful life in excess of a strict 12-month period.

Although bright-line rules such as the proposed regulation have appeal, TEI would not support a rule that mandates that taxpayers follow their AFS life for purposes of determining whether the 12-month rule requires capitalization. The initial determination of an asset's life is often made by fixed asset or corporate accountants or analysts whose principal focus is the financial accounting treatment of the asset. In some cases, the tax treatment of the expenditure is also considered immediately. In other cases, the tax department will periodically review the book treatment of items after the fact. Often the post hoc review is performed on an exception basis for high-dollar value items. Moreover, in smaller companies the fixed-asset acquisition review may occur annually (after year end) during the preparation of the tax provision or tax return. (4) Under current rules, if the financial accountants assign a life that is inappropriate for tax purposes, the tax department can make appropriate adjustments in the tax return workpapers and on the Schedule M-3 of Form 1120. The proposed bright-line rule would preclude the tax department from adjusting the treatment for tax purposes and require the adjustment to be made directly in the books. For many taxpayers, however, the materiality threshold for adjusting an improperly capitalized item will be much higher for financial reporting purposes than it is for tax reporting purposes. As a result, a bright-line rule requiring a taxpayer to follow its AFS for purposes of the 12-month rule could lead to excessive capitalization.

As an alternative to the per se rule of Prop. Reg. [section] 1.263(a)-2(d)(4), TEI recommends that the Treasury Department and IRS consider providing a safe harbor that would permit taxpayers to deduct amounts where the AFS life is 12 months or less. If the taxpayer assigns the expenditure an AFS life in excess of 12 months, the taxpayer might be required to demonstrate why the expenditures should be deductible. Another alternative would be to permit taxpayers to elect an accounting method affording a deduction for expenditures with an AFS life of 12 months or less.

We understand that the Treasury Department may wish to provide a bright-line rule for tangible assets that parallels the intangible capitalization rule, but we do not believe the proposed 12-month rule for tangible assets is necessary. The regulations governing expenditures for intangible assets were issued in order to quell substantial, systemic, and contentious controversies about the scope, life, and timing of deductions for expenditures for many forms of "soft" assets. Although there are clearly disputes about the life and timing of deductions for repairs to tangible, "hard" assets as well, the scope and frequency of the controversies are far less than for intangibles because engineering studies, industry practices, and taxpayer experience supply empirical guidance on the economic useful life for tangibles. Indeed, industry-level guidance is likely a more efficacious means of resolving recurring disputes over the life and timing of deductions for tangible expenditures rather than promulgating a one-size-fits-all, 12-month AFS rule.

Finally, we note that TEI and others have urged that the IRS and Treasury Department adopt a rule affording taxpayers a deduction for the acquisition of units of property of de minimis value. Should a de minimis rule be adopted, it should be applied before any other rule requiring capitalization, including the proposed 12-month rule. In other words, once a taxpayer makes a determination that the unit of property is of de minimis value and should be deducted, the AFS and tax life of the unit of property are not relevant. If a de minimis rule is not adopted and the proposed 12-month rule is retained, we urge the Treasury Department to confirm that the absence of a de minimis rule is not intended to change the practice of examining agents and taxpayers entering agreements obviating IRS review of the acquisition of tangible assets of small value.

Tax Executives Institute appreciates this opportunity to provide supplemental comments on the proposed regulations under section 263(a), relating to the capitalization of expenditures for tangible assets and repairs. If you have any questions, please do not hesitate to call Susan A. Bauer, chair of TEI's Federal Tax Committee, at 404.233.4533, or Jeffery P. Rasmussen of the Institute's legal staff at 202.638.5601 (or [e-mail]).

(1.) The applicable financial statement is defined in Prop. Reg. [section] 1.263(a)-3(f)(2).

(2.) 2006-39 I.R.B. 532, 534 (September 25, 2006).

(3.) See, e.g., Prudential Overall Supply v. Commissioner, T.C. Memo 2002-103; Commissioner v. Anders, 414 F.2d 1283 (10th Cir. 1969); Rev. Rul. 78-382, 1978-2 C.B. 111.

(4.) The per se rule would be especially harsh if the tax department discovers later that short-lived capitalized expenditures--for which adjustments were deemed immaterial for book purposes--should have been expensed as research and development expenditures qualifying for the section 41 research credit.