An overview of the proposed "tangibles" regulations.
Acquisition and Production Costs
In general, the proposed regulations' treatment of costs incurred to acquire or produce tangible property largely restates existing law. As under the current regulations, costs incurred to acquire or produce real or tangible personal property having a useful life substantially beyond the end of the taxable year must be capitalized. (2) The definitions of real and tangible personal property are intended to have the same definitions used for depreciation purposes. (3)
The proposed regulations do update the current section 263(a) regulations, however, by clarifying their interaction with the uniform capitalization rules under section 263A of the Internal Revenue Code. While the proposed regulations do not necessarily reflect a change in the government's view of the interaction of these two capitalization provisions, this is the first time since the enactment of section 263A as part of the Tax Reform Act of 1986 that Treasury has updated the much older regulations under section 263(a) to explicitly reflect this interaction in the context of tangible property.
For example, the proposed regulations incorporate the expansive definition of "production" found in the uniform capitalization rules of section 263A. Under this standard, "production" means to build, install, manufacture, develop, create, raise, or grow. In addition to explicitly adopting the section 263A definition of "production," the proposed regulations emphasize the potential application of the uniform capitalization rules where a cost is otherwise deductible under the proposed regulations. Thus, for taxpayers engaged in production and resale activities, many of the benefits of the proposed regulations may prove elusive, as costs seemingly deductible under the proposed regulations (for example, under the new 12-month rule) nonetheless may be treated as inventoriable production costs under the uniform capitalization rules as benefiting or being incurred by reason of production or resale activities. The proposed regulations provide a number of examples of such situations. (4)
The proposed regulations provide specific rules and examples regarding costs incurred to defend or perfect title to tangible property, (5) as well as the treatment of transaction costs such as shipping costs, bidding costs, commissions, sales and transfer taxes, and similar charges. (6) A separate section provides rules governing costs incurred to sell tangible property. (7)
12-Month Rule. Potentially resolving a long-standing dispute about whether "substantially beyond the end of the taxable year" is synonymous with an asset's having a useful life of more than 12 months, (8) the proposed regulations adopt a 12-month rule applicable to the costs of acquiring many types of tangible personal property. Under this rule, amounts paid to acquire or produce a unit of property having an "economic useful life" of no more than 12 months is not a capital expenditure. (9) For this purpose, an asset's economic useful life is determined by reference to the taxpayer's treatment of the item as capital or expense in its "applicable financial statement" if it has one (such as an SEC filing or another certified financial statement produced for a substantive, non-tax purpose). If the taxpayer does not have an applicable financial statement, the property's economic useful life is the period over which it is reasonably expected to be useful to the taxpayer in its trade or business.
The 12-month rule is not applicable, however, to the acquisition or production of inventory property, land, components of a unit of property, or to costs incurred to improve rather than acquire or produce tangible property.
De Minimis Rule. Unfortunately, the proposed rules applicable to acquisition costs do not include a de minimis rule. Many taxpayers had requested that the tangibles regulations permit a current deduction for relatively small amounts, recognizing the administrative costs and record keeping burden of accounting for numerous relatively small expenditures. Treasury implicitly acknowledged its authority to adopt a de minimis rule for the acquisition costs of tangible property, as well as the potential benefits of such a rule, in Rev. Proc. 2002-12 (providing a de minimis rule for certain costs incurred by restaurants in purchasing "small wares"). (10)
The preamble to the proposed regulations states that Treasury considered including a de minimis rule in the proposed tangibles regulations as well but ultimately decided not to do so. Instead, the preamble describes the de minimis rule that Treasury contemplated (essentially a book/tax conformity requirement for taxpayers with applicable financial statements, and a dollar threshold for those without), and requests additional comments on the need for this or another formulation of a de minimis rule, as well as certain mechanical aspects of such a rule. Significantly, the preamble to the proposed regulations acknowledges that some taxpayers develop de facto de minimis rules with their IRS examination teams and states that Treasury intentionally chose not to disallow this practice. Treasury has requested comments on whether--if the final regulations do contain a de minimis rule--the Examination team should be allowed to develop higher thresholds for certain taxpayers on a case-by-case basis, based on materiality and risk analysis.
Costs of Repairs or Improvements
The majority of the proposed regulations is devoted to costs to repair or improve tangible property. The treatment of "repair costs" has been the source of seemingly endless controversy between the IRS and taxpayers since the Code's inception, (11) and was the principal impetus behind development of the proposed regulations. As with the acquisition and production cost provisions, the proposed regulations' treatment of repair costs is largely evolutionary, building upon and refining existing standards rather than attempting an entirely new conceptual approach.
The "repair or improvements" section of the proposed regulations can be divided into four key segments: (i) the operative rule, requiring the capitalization of costs incurred either to materially increase the value of a unit of property, or to restore a unit of property, (ii) standards for determining whether the value of a unit of property has been materially increased, (iii) standards for determining whether the unit of property has been restored, and (iv) an elective repair allowance method.
Unit of Property. A highlight of the proposed regulations is a long-awaited and badly needed definition of "unit of property." As under current law, the threshold issue in applying the repair rules is identifying the relevant unit of property. Taxpayers, the IRS, and courts have wrestled with this critical term for many years, with nothing approaching consistency. The government specifically requested comments on the appropriate definition of "unit of property" in Notice 2004-6. (12) In response, some taxpayers suggested adopting the "functional interdependence test" applied for purposes of section 263A(f) in determining whether and how much interest to capitalize in connection with a capital improvement project. Others suggested using the criteria adopted by the court in FedEx Corp. v. United States. (13) The proposed regulations take a middle ground, but focus more heavily on the facts and circumstances approach for most taxpayers.
Determining the unit of property under the proposed regulations is a three-step process. In step one, the taxpayer makes an "initial determination" of the unit of property by applying the functional interdependence standard of Treas. Reg. [section] 1.263A-10. Apart from preserving the potential whip-saw situation discussed below, it is unclear what practical purpose this "initial determination" serves.
In step two, the taxpayer determines which of four specific categories applies, based on the nature of the taxpayer's business in some cases, and the nature of the property in all others.
Category One includes all property owned by taxpayers in a regulated industry (other than "network assets," as discussed below). For these taxpayers, the unit of property is the "USOA unit of property," meaning the unit of property determined under applicable regulatory accounting rules. (14) For this purpose, a regulated industry is one for which a federal regulator has issued a "uniform system of accounts" or "USOA" identifying a particular unit of property (a "USOA unit of property"). This includes the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), and the Surface Transportation Board (STB), but not the Federal Aviation Administration (FAA). Thus, all property other than network assets owned by electric and gas utilities, telecommunications companies, and railroads will be determined under Category One, regardless of whether the taxpayer itself is regulated, and regardless of whether particular assets are unique to the regulated activity. For example, even though Class II railroads are not subject to regulation by the STB, they nonetheless will be required to determine the appropriate unit of property for purposes of the proposed regulations by reference to the regulatory accounting rules otherwise applicable only to Class I railroads. (15)
The preamble to the proposed regulations clarifies that the regulatory accounting rules or decisions of state or local agencies are not relevant for this purpose. It is unclear how the proposed regulations apply where a federal regulatory agency prescribes a USOA, but permits deviations from those general classifications. This may occur, for example, where the federal agency permits (but does not require) a regulated entity to adopt state regulatory accounting rules to the extent they differ from the federal standards. It is also unclear how the Category One rules apply where the USOA addresses or is applied only to broad categories of assets rather than to individual assets (i.e., is the unit of property the aggregate of all items contained in a broadly defined account, or instead only the individual operating assets within that broader description?).
In addition, the proposed regulations also are unclear on whether the nature of "the taxpayer's" business activity is determined at the consolidated group level, the individual entity level, or the trade or business level. The proposed standard is phrased in terms of "a taxpayer" engaged in a trade or business in a regulated industry. Presumably if a consolidated group includes both regulated and non-regulated entities engaged in the same or similar trades or businesses for which a USOA has been promulgated, that USOA will govern the unit of property determination for all property of each of those entities. The result is less clear if the consolidated group also includes an entity in a different industry for which there is no USOA (e.g., one railroad subsidiary and one air transportation subsidiary), or if the consolidated group includes subsidiaries engaged in different regulated businesses for which USOAs have been promulgated by different federal agencies (e.g., one subsidiary regulated by FERC and one subsidiary regulated by the FCC). It also is unclear how this provision would apply to a partnership (not itself a "taxpayer") formed by non-regulated taxpayers to engage in a regulated activity for which there is a USOA (e.g., two manufacturers form a partnership to operate an electric generating facility to service their nearby factories). Presumably these questions will be discussed with Treasury by potentially affected taxpayers and clarified in the final regulations.
Category Two applies to buildings and other structures. (16) The building and its structural components are a single unit of property. Unlike the other three categories, buildings are not first subjected to the functional interdependence test under the "initial determination." This category does not apply to taxpayers described in Category One. For example, while individual buildings comprising a refinery or manufacturing facility each would be treated as separate units of property, determining the units of property comprising an electric generation facility would be determined in accordance with the appropriate USOA and might produce a different result.
Category Three applies to all personal property other than that owned by a taxpayer described in Category One. (17) Category Three provides four criteria for determining the unit of property with respect to such personal property:
* Marketplace Treatment Factor: Is the component being analyzed generally considered a separate unit of property in the marketplace? The proposed regulations provide several criteria to be considered in this regard, such as whether the component is sold, leased, or disposed of separately, is subject to separate warranties or maintenance requirements, is appraised separately, etc.
* Industry Practice and Financial Accounting Factor: Is the component treated separately within the taxpayer's industry or on the taxpayer's non-tax books and records?
* Rotable Part Factor: Is the component a rotable spare part?
* Function Factor: Does the property of which the component is a part generally function for its intended use without the component property?
Apart from providing these factors, the proposed regulations provide no guidance regarding the relative weight to be accorded the various considerations. Taxpayers and the IRS alike must assess each of the factors based on all of the surrounding facts and circumstances, much as the court did in FedEx. (18)
Category Four applies to land. The unit of property with respect to land is determined based entirely on all of the facts and circumstances. (19) Unlike personal property not included in Category One, however, the proposed regulations do not provide an extensive list of factors and sub-factors to consider.
Finally, after first making the "initial determination" under the functional interdependence standard and then applying one of the four specific criteria, the third step in determining the unit of property is applying the "additional rule." (20) The "additional rule" is a conformity requirement providing that if the taxpayer properly treats a component as a separate unit of property for any federal income tax purpose, the taxpayer must treat the component as a separate unit of property for purposes of the proposed repair regulations as well. Examples include having different placed-in-service dates or using different MACRS classes for the component and the larger property of which the component is a part. This "additional rule" appears to trump the first two rules, suggesting that it should be the first rather than the final step in the analysis.
Significantly, the "additional rule" only operates in one direction--to require the use of a smaller unit of property than would otherwise result from application of the preceding standards, thereby increasing the likelihood that costs must be capitalized as improvements rather than deducted as repairs. The "additional rule" does not allow the taxpayer to aggregate into a larger unit of property components that are determined to be separate items under the foregoing standards, but that are treated as part of a single, larger unit of property for other federal tax purposes (such as the interest capitalization rules).
Taxpayers must take consistent positions in defining a unit of property under the proposed tangibles regulations and under the casualty loss rules of section 165. Thus, if the taxpayer claims a casualty loss deduction with respect to a component, it must treat that component as a separate unit of property for purposes of the proposed tangibles regulations as well. Any property that replaces the damaged or destroyed component likewise will be a separate unit of property under the proposed regulations. (21)
The proposed regulations reserve on the definition of "unit of property" as applied to "network assets" such as railroad track oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective industries. The preamble does not discuss which if any definitions of unit of property for network assets were considered during the drafting process, potentially including the standard applied for purposes of the CLADR repair allowance rules under Treas. Reg. [section] 1.167(a)-11(d)(2)(vi)(g). Similarly, it is unclear why the proposed regulations do not determine the unit of property in the context of network assets using the applicable USOA, as they require for all other Category One assets. The proposed regulations instead request comments on the relevant rules for determining the appropriate unit of property for network assets.
The proposed regulations also request comments on whether to include rules for network assets in the final regulations, or whether to develop for network assets industry-specific guidance under the Industry Issue Resolution program. An industry-specific approach to network assets has been successfully applied in other areas. (22) The preamble to the proposed regulations states that these existing standards are not affected by the proposed rules.
One of the most significant concerns arising from the proposed definition of "unit of property," and one with respect to which Treasury is likely to receive a number of comments, is the proposed regulations' preservation of the potential "whip saw" created by having separate definitions of "unit of property" for purposes of the repair regulations and for the interest capitalization rules. Apart from preserving and even endorsing this whip saw, it is unclear what purpose the "initial determination" serves. The "functional interdependence" standard under Treas. Reg. [section] 1.263A-10 results in the largest possible unit of property, maximizing the amount of interest potentially subject to capitalization. At the same time, the different unit-of-property standard applicable for purposes of the proposed tangibles regulations generally will result in that same property instead being treated as a number of smaller units of property, increasing the likelihood that a particular expenditure will be capitalized as either increasing the value of or restoring that smaller unit of property. A consistent definition of the unit of property for purposes of both capitalization provisions would have avoided this all too common whip saw.
Treasury's view, as expressed in the preamble, that preserving inconsistent definitions of unit of property is appropriate because the two capitalization provisions have different purposes is not persuasive. The purpose of both section 263(a) and 263A is to match income with the expenses incurred in producing that income. That fundamental matching principle--and the operative rules used in applying it--should not change depending upon whether the expenses in question are interest or repair costs.
The new definition of "unit of property" is one of the most significant aspects of the proposed regulations. This is the first time that Treasury and the IRS have attempted to define the "unit of property" for purposes of the repair rules. Arguably, defining "unit of property" was the single greatest hurdle that the government faced in attempting to rationalize this area of the tax law, and the regulations' drafters are to be commended for even taking on such a daunting challenge. In finalizing the proposed unit of property definition, however, Treasury will need to wrestle with a number of issues, particularly for those taxpayers falling within the regulated industry category, as well as for those attempting to apply the multitude of factors applicable to tangible personal property.
Material Increase in Value. The second major component of the "repair or improvements" section of the proposed regulations sets forth the standards for when an expenditure materially increases the value of a unit of property. For the most part, these standards are simply restatements of current law. Under the proposed regulations, a material increase in value occurs if the costs--
* Correct a preexisting defect. This reflects the general rule that amounts paid to put property into an ordinarily efficient operating condition (as opposed to keeping it in that condition) must be capitalized; (23)
* Relate to work done prior to the unit of property being placed in service. The preamble to the proposed regulations indicates this standard also is based on the put-versus-keep standard, and that if the property cannot be placed in service prior to work being performed, that work necessarily increases the value of the property;
* Adapt the property to a new or different use. This standard appears in the current regulations as an independent standard, but apart from being recast as a type of "material increase in value" is unchanged;
* Result in a "betterment" or "material addition." This is a qualitative standard, and is not based on increases in fair market value. Examples include a material increase in quality or strength, or a material addition (such as an expansion) to the unit of property. Using upgraded materials when materials comparable to the original were available and would have sufficed also may be considered a betterment, although the use of improved materials is acceptable in certain circumstances; (24) or
* Result in a material increase in the capacity, productivity, efficiency, or quality of the output of the unit of property.
The proposed regulations do not adopt either increases in fair market value or the size of the expenditure as appropriate standards. The proposed regulations declined to adopt as a safe harbor a specified percentage increase in the property's fair market value as a standard for capitalization. Instead, the preamble notes that whether amounts paid materially increase the value of a unit of property requires an analysis of the purpose, the physical nature, and the effect of the work for which the amounts were paid, and not an analysis of the fair market value of the property or the level of monetary expenditures. This final statement is important in dispelling the belief by some IRS revenue agents that large expenditures per se result in a "material" increase in value. The Justice Department attempted (unsuccessfully) to make such an argument before the district court in FedEx. (25)
Significantly, the proposed regulations adopt and clarify the application of the "Plainfield-Union standard" for determining whether an expenditure results in an increase in the value of property. (26) Under this standard, an expenditure is deductible as a repair if it does no more than return the property's condition to that existing immediately before the event necessitating the expenditure. The proposed regulations clarify that in the case of deterioration or damage caused by routine wear and tear (where there is no readily discernible "event"), this standard is applied by comparing the value of the property immediately after the expenditure with the property's condition after the last time that the taxpayer corrected the effects of normal wear and tear, or if the taxpayer has not previously corrected the effects of normal wear and tear, the condition of the property when it was placed in service. (27)
Restorations. A cost also must be capitalized if it "substantially prolongs" the "economic useful life" of a unit of property. (28) The "economic useful life" of an asset depends on whether the taxpayer has an applicable financial statement, as described above. If so, the economic useful life of the unit of property is the depreciable life reflected on the applicable financial statement, unless the taxpayer can show by "clear and convincing evidence" that a shorter useful life is appropriate. Taxpayers having no applicable financial statements determine the economic useful life of a unit of property based on the period over which the property may reasonably be expected to be useful to the taxpayer in its trade or business or for the production of income. This essentially incorporates the standard currently found in Treas. Reg. [section] 1.167(a)-1(b).
The economic useful life of the unit of property is "substantially prolonged" under the proposed regulations if it extends the period over which the property may reasonably be expected to be useful to the taxpayer beyond the end of the taxable year immediately following the tax year in which the economic useful life of the property was originally expected to cease. (29) Rather than applying this 12-month rule based on an extension of the asset's "economic useful life" (which as just discussed has two potential meanings under the proposed regulations), this standard instead incorporates the definition of "economic useful life" otherwise applicable only to taxpayers having no applicable financial statements. Thus, for a taxpayer having an applicable financial statement, even though the unit of property's economic useful life is determined based on the depreciable life reflected on that financial statement, if the period over which the asset is expected to be economically useful to the taxpayer is longer, that longer period will be the measure for whether that property's useful life has been "substantially prolonged." Query whether the IRS will take the converse position that taxpayers that expect to use a unit of property for a period shorter than its depreciable life reflected on the financial statement (but who do not otherwise claim that shorter period as the "economic useful life" for purposes of the repair rules) will be required to use that shorter period in determining whether the asset's useful life has been substantially prolonged.
Certain activities are deemed to substantially prolong the economic useful life of a unit of property. These include replacing either a major component or a substantial structural part of a unit of property with a new or like-new part, or restoring the unit of property to a like-new condition. (30) The proposed regulations do not define a "major component" or a "substantial structural part" for purposes of this requirement. Instead, these concepts are demonstrated through a series of examples. (31) Treasury's reliance on examples rather than the articulation of a definition or other standard for "major component" and "substantial structural part" underscores that despite Treasury's best efforts, the tax treatment of maintenance costs largely will remain fact-intensive and subject to competing interpretations of the nature and result of the activity.
A taxpayer also is deemed to substantially increase the economic useful life of a unit of property if the taxpayer "properly" deducts a casualty loss under section 165 with respect to the unit of property and the amounts restore the unit of property to a condition that is the same or better than before the casualty. (132) In other words, the proposed regulations take the position that if the taxpayer treats the component as a separate unit of property for purposes of claiming a casualty loss deduction, the taxpayer must be consistent and treat itself as having replaced a unit of property with a new or like-new one. If finalized, this rule will adversely affect taxpayers that previously claimed casualty loss deductions for damage inflicted on tangible property and properly deducted the cost of repairing the damage.
The proposed regulations do not specifically address two areas that have been the source of much controversy in recent years. First, they do not prescribe a "plan of rehabilitation" doctrine, but also do not reject this judicially created doctrine. The proposed regulations do, however, contain a number of specific rules and clarifications that, while not directly referencing this doctrine, will as a practical matter place greater constraints on its application. Many of these parameters previously were discussed in Rev. Rul. 2001-4, addressing the treatment of cyclical aircraft maintenance costs. (33) Interestingly, while the government previously tried to explain the parameters of the plan of rehabilitation doctrine through revenue rulings and taxpayer-specific rulings, Treasury chose not to address the doctrine at all in the more definitive context of the proposed regulations.
Second, the proposed regulations do not contain specific rules addressing the treatment of environmental cleanup costs. Rather, the proposed regulations include examples demonstrating how the general rules apply in the context of activities such as soil remediation required by leaking underground storage tanks (34) and asbestos removal costs. (35) This approach is consistent with the government's prior analysis of environmental cleanup costs using the traditional repair or improvement standards. Manufacturers and other taxpayers subject to section 263A also must consider the potential application of the uniform capitalization rules to otherwise deductible environmental cleanup costs incurred in connection with current or even former production activities. (36)
Repair Allowance. Along with the definition of "unit of property," perhaps the most significant development proposed by Treasury is an optional repair allowance method. (37) In lieu of applying the foregoing rules to determine whether an expenditure is required to be capitalized as an improvement, the taxpayer instead can elect to deduct an amount up to the applicable "repair allowance amount," and capitalize the excess. The repair allowance method treats all amounts (other than "excluded additions") for materials and labor to repair, maintain, or improve all of the taxpayer's repair allowance property in a particular MACRS class as deductible expenses under section 162, up to the "repair allowance amount."
Repair allowance property is real or personal property subject to MACRS that is owned (not leased) by the taxpayer and used in its trade or business. Repair allowance property also includes certain tangible property not otherwise subject to MACRS (such as property acquired prior to the effective date of section 168, or with respect to which the taxpayer properly elected out of section 168) if the taxpayer--solely for purposes of the proposed repair allowance method--classifies the property in the appropriate MACRS class in which the property would be included if it were otherwise subject to MACRS. (38) This rule does not apply to certain types of non-MACRS property, however, including property that already is subject to another repair allowance election (such as under Rev. Proc. 2001-46, Rev. Proc. 2002-65, or Treas. Reg. [section] 1.167(a)-11(d)(2)). Although taxpayers may not "cherry pick" actual MACRS property in applying the proposed repair allowance method, the proposed regulations do not expressly prohibit the taxpayer from doing so in designating non-MACRS property as being within the scope of the election.
The ability to designate certain non-MACRS property as repair allowance property is an important feature of the proposed method. It allows taxpayers to apply the proposed repair allowance method to all of its property not already subject to some other repair allowance election, regardless of whether those assets are otherwise MACRS, ACRS, or pre-ACRS property. This greatly improves the utility and eases the application of this method and should make its use more likely.
The repair allowance amount for a particular MACRS class for a given year equals the average unadjusted basis of repair allowance property in that MACRS class multiplied by the repair allowance percentage provided for that MACRS class. The proposed regulations provide the repair allowance percentages for the various MACRS classes. The preamble explains that the proposed repair allowance percentages were based on the assumption that a taxpayer will spend 50 percent of the property's unadjusted basis on repairs over the property's MACRS recovery period. Thus, Treasury determined the repair allowance percentages by dividing 100 percent by the number of years in the recovery period for the MACRS class, which represents the portion of the property's unadjusted basis that is allocated to each year of the recovery period, and multiplying the result by 50 percent.
The extent to which particular taxpayers or industries will benefit from using the proposed repair allowance method will depend in large measure upon how closely their actual repair experiences approximate the 50-percent assumption used by Treasury in deriving the repair allowance percentages. The repair allowance method must be elected on an all-or-nothing basis (i.e., it must be applied to all repair allowance property, so that the taxpayer may not elect the method only for either individual assets or MACRS classes), preventing the taxpayer from excluding individual assets having abnormally high maintenance costs. (39) Treasury notes in the preamble to the proposed regulations, however, that it recognizes that the proposed one-size-fits-all approach will not be appropriate in all circumstances, and asks for comments on whether separate repair allowance percentages should be provided for certain types of property or for certain industries.
Amounts incurred during the year to repair, maintain, or improve repair allowance property in excess of the repair allowance amount for that MACRS class must be capitalized. In addition, the taxpayer must capitalize all of the indirect costs of producing the repair allowance property in the MACRS class, in accordance with the taxpayer's accounting method under the uniform capitalization rules of section 263A. The capitalized amount can be treated as a separate depreciable asset in the same, corresponding MACRS class. Alternatively, the taxpayer can allocate this amount among the various repair allowance properties in that particular MACRS class. The proposed regulations provide rules for the recovery of the capitalized costs.
As with the definition of "unit of property," the repair allowance method currently is inapplicable to network assets such as electric transmission lines, pipelines, and railroad track. Treasury anticipates the repair allowance being applicable to these assets as well "if appropriate unit of property rules can be determined."
As with the repair allowance rules found in the former-CLADR regulations, (40) the proposed repair allowance method is inapplicable to certain types of costs. These "excluded additions" include costs for (i) the acquisition or production of property; (ii) work that corrects a preexisting condition; (iii) work performed prior to the date that the property is placed in service; (iv) work that adapts the property to a new or different use; or (v) increases in the square footage of a building. (41) Amounts paid for excluded additions are treated as capital expenditures under sections 263(a) and 263A.
If elected, the repair allowance method must be used for all of the taxpayer's repair allowance property in all MACRS classes, and cannot be discontinued without the consent of the IRS. The proposed regulations reserve on the manner by which the taxpayer elects to use the repair allowance method.
The regulations are proposed to apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Because the rules contained in the final regulations may well differ in material respects from those proposed, the preamble to the proposed regulations instructs taxpayers not to change a method of accounting in reliance upon the proposed regulations, but instead to wait for the final regulations.
Finally, the preamble notes that although taxpayers generally would change a method of accounting to reflect these new rules using an adjustment under section 481(a) of the Code, the government is concerned about the potential administrative burden on taxpayers and the IRS that may result from section 481(a) adjustments originating many years prior to the effective date of the final regulations. This statement likely signals the government's intention to apply the final regulations on a cut-off basis, denying taxpayers the ability to claim the benefit of the regulations for earlier tax years by including in a section 481(a) adjustment amounts that previously were capitalized under prior law but that may be deducted under the new rules (as may be the case upon application of the 12-month rule for acquisitions or the application of the repair allowance method to improvements, for example). The government recently took an identical cut-off approach in finalizing the "INDOPCO intangibles regulations" under Treas. Reg. [subsection] 1.263(a)4 and 1.263(a)-5. A similar approach here is likely.
Public comments on the proposed regulations are due no later than November 20, 2006, with a public hearing scheduled for December 19, 2006.
(1.) 71 Fed. Reg. 48590.
(2.) Prop. Reg. [section] 1.263(a)-2(d)(1)(i).
(3.) Prop. Reg. [subsection] 1.263(a)-2(b)(2) and (3); Treas. Reg. [section] 1.48-1.
(4.) See, e.g., Prop. Reg. [section] 1.263(a)-2(d)(4)(vi), Exs. 1 and 2.
(5.) Prop. Reg. [section] 1.263(a)-2(d)(2).
(6.) Prop. Reg. [section] 1.263(a)-2(d)(3).
(7.) Prop. Reg. [section] 1.263(a)-1(c).
(8.) U.S. Freightways Corp. v. Commissioner, 270 F.3d 1137 (7th Cir. 2001) (applying 12-month rule), rev'g, 113 T.C. 329 (1999) (rejecting 12-month rule); Zaninovich v. Commissioner, 616 F.2d 429 (9th Cir. 1980) (applying 12-month rule), rev'g, 69 T.C. 605 (1978) (rejecting 12-month rule).
(9.) Prop. Reg. [section] 1.263(a)-2(d)(4). Treasury previously adopted a similar 12-month rule applicable to costs incurred in acquiring intangible assets. Treas. Reg. [section] 1.263(a)-4(f).
(10.) 2002-1 C.B. 374.
(11.) The preamble to the proposed regulations provides a thorough survey of the development of this area. For additional general background, see J. Atkinson, "FedEx v. Commissioner: The Continuing Debate over Cyclical Maintenance Costs," 55 THE TAx EXECUTIVE 462 (Nov.-Dec. 2003).
(12.) 2004-1 C.B. 308.
(13.) 412 F.3d 617 (6th Cir. 2005), aff'g 291 F. Supp. 2d 699 (W.D. Tenn. 2003).
(14). Prop. Reg. [section] 1.263(a)-3(d)(2)(iii).
(15.) Prop. Reg. [section] 1.263(a)-3(d)(2)(viii), Ex. 3 (see also Ex. 1).
(16.) Prop. Reg. [section] 1.263(a)-3(d)(2)(iv).
(17.) Prop. Reg. [section] 1.263(a)-3(d)(2)(v).
(18.) Underscoring that the government does not view the factors listed in Category Three as being the same as those adopted by the court in FedEx, the proposed regulations reach a different conclusion regarding the appropriate unit of property in the case of aircraft. The district court in FedEx concluded (based on its application of its own four factors) that the entire airplane is a single unit of property. The proposed regulations conclude instead that the engine and the airframe are separate units of property under the factors listed under Category Three. Prop. Reg. [section] 1.263(a)-3(d)(2)(viii), Ex. 8. See also Prop. Reg. [section] 1.263(a)3(e)(4), Ex. 8 (applying repair standards to aircraft engine as separate unit of property).
(19.) Prop. Reg. [section] 1.263(a)-3(d)(vi).
(20.) Prop. Reg. [section] 1.263(a)-3(d)(2)(vii).
(21.) Id. See Prop. Reg. [section] 1.263(a)-2(d)(1).
(22.) Rev. Proc. 2001-46, 2001-2 C.B. 263 (track maintenance allowance method for Class I railroads); Rev. Proc. 2002-65, 2002-2 C.B. 700 (track maintenance allowance method for Class II and III railroads); and Rev. Proc. 2003-63, 2003-2 C.B. 304 (safe harbor unit of property rule for cable television distribution systems).
(23.) Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103 (1926). See also United Dairy Farmers, Inc. v. United States, 267 F.3d 510 (6th Cir. 2001); Dominion Resources, Inc. v. United States, 219 F.3d 359 (4th Cir. 2000).
(24.) Prop. Reg. [section] 1.263(a)-3(e)(4), Exs. 11-13.
(25.) 291 F. Supp. 2d at 713.
(26.) Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962).
(27.) Prop. Reg. [section] 1.263(a)-3(e)(3).
(28.) Prop. Reg. [section] 1.263(a)-3(f).
(29.) Prop. Reg. [section] 1.263(a)-3(f)(3).
(30.) Prop. Reg. [subsection] 1.263(a)-3(f)(3)(ii) and (iii).
(31.) Prop. Reg. [section] 1.263(a)-3(f)(4), Exs. 3-9.
(32.) Prop. Reg. [section] 1.263(a)-3(f)(3)(iv).
(33.) 2001-1 C.B. 295. See also TAM 199952075 (Jan. 3, 2000) (discussing application of plan of rehabilitation doctrine in context of environmental cleanup activities).
(34.) Prop. Reg. [section] 1.263(a)-3(e)(4), Ex. 1.
(35.) Prop. Reg. [section] 1.263(a)-3(e)(4), Ex. 2.
(36.) Rev. Rul. 2004-18, 2004-1 C.B. 509. See generally J. Atkinson, "A Bright Line Rule Dims: Manufacturers Must Capitalize Environmental Cleanup Costs," 45 TAX MGMT. MEMO. 227 (June 2004).
(37.) Prop. Reg. [section] 1.263(a)-3(g).
(38.) Prop. Reg. [section] 1.263(a)-3(g)(6)(ii).
(39.) Prop. Reg. [section] 1.263(a)-3(g)(2).
(40.) Treas. Reg. [section] 1.167(a)-11(d)(2).
(41.) Prop. Reg. [section] 1.263(a)-3(g)(7).
James L. Atkinson is a partner in the Washington office of Winston & Strawn LLP. He received his B.A. degree from the University of South Carolina and his J.D. degree from the University of Illinois College of Law. He is a frequent contributor to THE TAX EXECUTIVE and is an adjunct professor at Georgetown University Law Center. He has served as Associate Chief Counsel (Income Tax and Accounting) at the IRS Office of Chief Counsel. He may be reached at email@example.com.
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|Author:||Atkinson, James L.|
|Article Type:||Cover story|
|Date:||Sep 1, 2006|
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