Comments on proposed interest capitalization regulations: December 12, 1991.
On August 9, 1991, the Internal Revenue Service issued proposed regulations under section 263A(f) of the Internal Revenue Code, concerning the allocation and capitalization of interest on certain property produced by taxpayers. The proposed regulations (IA-120-86) were published in the Federal Register on August 16, 1991 (56 Fed. Reg. 40815), and in the September 16, 1991, issue of the Internal Revenue Bulletin (1991-37 I.R.B. 8).(1) A public hearing on the proposed regulations was held on November 20, 1991.
Tax Executives Institute is the principal association of corporate tax executives in North America. Our nearly 4,600 members represent approximately 2,000 of the leading corporations in the United States and Canada. TEI represents a cross-section of the business community, and is dedicated to the development and effective implementation of sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEI is firmly committed to maintaining a tax system that works -- one that is administrable and with which taxpayers can comply.
TEI members are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring an important, balanced, and practical perspective to the issues raised by the proposed regulations on the capitalization of interest with respect to certain property under section 263A(f).
Section 263A(f) of the Code contains special rules for capitalizing interest under certain circumstances. In general, an allocable portion of interest paid or incurred during the production period of real property and specified tangible personal property must be capitalized. Under the avoided cost method prescribed by section 293A(f)(2), "traced debt" incurred specifically for production expenditures attributable to the property is allocated first. Interest expense on non-"traced" indebtedness is allocated to the property to the extent that funds used for production expenditures could have been applied instead to reduce debt. All amounts of allocated interest are capitalized under section 263A(f)(3). Under section 263A(i), the Secretary is authorized to prescribe regulations to carry out the purposes of the statute and to adopt simplifying assumptions where the cost of compliance is deemed burdensome.
TEI commends the Internal Revenue Service for the many simplifying provisions included in the proposed regulations. The proposed regulations reflect a clear effort to make these rules administrable. TEI appreciates especially the inclusion in the proposed regulations of a de minimis rule, an election to capitalize interest on a yearly basis (rather than the monthly basis required under Notice 88-99)(2), and the permitted use of reasonable estimates to determine the production period of an asset and the total cost of production. These changes will simplify the computation of capitalized interest under section 263A(f).
TEI recommends, however, that the IRS broaden its view of the simplification horizon to achieve more workable rules. In particular, for the reasons set forth below, we urge the IRS to expand the de minimis rule to cover assets with a production period of 3 months or less or a cost of $100,000. Furthermore, TEI believes that the related-party interest rules promulgated in Notice 88-99 should be restricted substantially. Finally, TEI recommends adoption of an election permitting conformity of the tax and financial statement amounts of capitalized interest. In addition to simplification suggestions, TEI has a number of substantive comments in respect of the proposed regulations. They are set forth below.
1. De Minimis Rule
TEI commends the IRS for adopting a de minimis rule in Prop. Reg. [section] 1.263A(f)-1(b)(3)(iii) under which interest capitalization is not necessary if (i) designated property has a production period of 3 months or less and (ii) the total cost of production is less than $10,000. TEI believes, however, that the rule requires a higher dollar threshold and should be cast in the disjunctive.
Taxpayers frequently make small modifications to buildings or other long-lived assets that are completed in less than three months, but have a cost in excess of $10,000. The administrative burden of tracking the interest costs by project could exceed the revenue gain to the government from interest capitalization. Assume, for example, a capital improvement project of $10,001 is undertaken by a company. The project requires 3 months and a day to complete, is paid for solely by incurring "traceable" debt, and the interest rate is 10 percent. Under the proposed regulations, the company would be required to allocate and capitalize interest amounts as low as $125.(3) The tax revenue foregone of $42.50 on such a nominal timing difference is probably less than the direct cost of an IRS agent's spending time to verify the allocation -- let alone the taxpayer's expense in tracking the expenses and administering its compliance procedures.
Ideally, the de minimis dollar amount threshold established by the regulations would be flexible enough to accommodate the variety of business facts and circumstances in different industries. Although TEI recognizes the need for certainty and an objective cutoff point, the Institute believes the threshold prescribed in the regulations is too low. The inherent complexity of the allocation calculation, the data collection effort required to complete the computations, and the potentially large number of discrete projects for which any single taxpayer may be required to complete the calculations are conditions that all demand a higher threshold than $10,000, which for most larger companies is an insignificant amount for capital expenditures. TEI believes that an appropriate dollar threshold is $100,000. TEI, therefore, recommends that this threshold be adopted in the regulations.
Finally, TEI agrees with the proposed regulations insofar as they adopt a time-based de minimis threshold for avoiding allocation of interest under section 263A(f) for property produced within a three-month period. TEI believes, however, that the three-month period should operate as a separate threshold and not be linked to the dollar-amount threshold. In other words, TEI recommends that a time-based de minimis rule be stated disjunctively.
In conclusion, we recommend that capitalization should not apply to a property or improvement that has a production period of 3 months or less or a total cost of less than $100,000.
2. Definition of Designated Property
The proposed regulations require capitalization of interest incurred for the production of "designated" property. Prop. Reg. [sections] 1.263A(f)-1(b) defines designated property to include property that is produced (within the meaning of section 263A(g) and Treas. Reg. [sections] 1.263A-1T(a)(5)(ii)) and that is either real property or tangible personal property that is (1) property with a class life of 20 years or more under section 168 produced for self-use, (2) property with a production period exceeding 2 years, or (3) property with a production period exceeding 1 year with an estimated cost of production in excess of $1 million.
TEI believes that the proposed regulations improperly include within the definition of "real property" -- and hence "designated property" -- other tangible property with a class life of less than 20 years. The proposed regulations also improperly imply that tangible personal property (with class lives of less than 20 years) in the nature of machinery or equipment that is "affixed" to land or a building is an "inherently permanent structure." We do not believe that the statute or its legislative history requires that interest incurred during the production of assets in these categories be capitalized.
Prop. Reg. [sections] 1.263A(f)-1(c) defines real property as land, unsevered natural products of land, buildings and "inherently permanent structures." "Inherently permanent structures" are defined under Prop. Reg. [sections] 1.263A(f)-1(c)(3) to include property that is affixed to real property that will ordinarily remain affixed for an indefinite period of time. For purposes of this rule, affixation to real property may be accomplished by weight alone. The proposed regulations continue by stating that, even though a structure is not a building for purposes of former section 48(a)(1)(B) and Treas. Reg. [sections] 1.48-1, it may be an inherently permanent structure. Moreover, any property not otherwise described in the proposed regulations that constitutes "other tangible property" under former section 48(a)(1)(B) and Treas. Reg. [sections] 1.48-1(d) is treated as an inherently permanent structure.
TEI believes that the expansive definition of inherently permanent structure in the proposed regulations is not warranted by the statute. Although Prop. Reg. [sections] 1.263A(f)-1(b) attempts to segregate real property from the definition of long-lived property, section 263A(f)(1) makes it clear that -- other than the rules of sections 263A(f)(1)(B)(ii) and (iii) establishing production period and dollar thresholds to identify property subject to interest capitalization -- the only properties that require interest capitalization are those with a "long useful life."
Section 263A(f)(4) provides the relevant definition for property subject to interest capitalization. The first definition in section 263A(f)(4), entitled "Long Useful Life," provides:
Property has a long useful life
if such property is (i) real property,
or (ii) property with a class
life of 20 years or more (as determined
under section 168).
TEI submits that Congress did not intend to treat as assets with a "long useful life" property that constituted other tangible property under former section 48(a)(1)(B) and [sections]1.48-1 (i.e., property that would have qualified for the investment tax credit under section 38) with a class life under section 168 of less than 20 years. The statute itself is clear that only depreciable assets with a class life of 20 years or more fall within its ambit. Moreover, TEI believes the term "real property" was not intended to cover assets that had been subject to long-standing treatment as tangible personal property under section 1245(a)(3)(A) and former section 48(a)(1)(A) solely by reason of the asset being affixed to real property.
The preamble avers that this expansive view of real property is consistent with the definition of real property under former section 189. It cites the legislative history of the Tax Equity and Fiscal Responsibility Act of 1982 as supporting the application of section 189 to pipelines and other improvements.(4)
The preamble's references to the definition of real property under former section 189 are perplexing for several reasons. First, that statute is silent on the definition of real property. Second, the legislative history of section 189 is less than persuasive that any property other than buildings or structural components was intended to be subject to the statute. Third, no regulations were ever issued under section 189. Finally, one may question whether the definition of real property contained in that section is at all relevant in defining "long useful life" assets (whether real or personal) under section 263A(f)(4), since the only references to section 189 in the legislative history of section 263A(f) concern the adoption of the "avoided cost" method enumerated in the former section.(5) Furthermore, unlike section 263A(f), former section 189 provided for capitalization of interest only with regard to the construction period of "real property." This former section did not apply to "other tangible property" with a "long useful life." It is therefore difficult to see how, from the standpoint of statutory construction, former section 189 can be relevant in determining what property is subject to section 263A(f) interest capitalization.
Rather than adopt a new, expansive definition of "real property," TEI recommends that the IRS adopt the long-standing definition of "real property" under section 1250(c) and Treas. Reg. [sections] 1.1250-1(e)(3) (which excludes property defined as other tangible property under former section 48(a)(1)) for purposes of section 263A(f)(4)(A)(i). Different rules of depreciation recapture apply depending upon whether property is classified as section 1250 or 1245 property. Congress was presumably aware of the distinction and the long-standing definition of real property in the section 1250 regulations when it enacted section 263A(f)(4). Providing a new definition of "real property" violates the congressional mandate to adopt simplifying assumptions to reduce compliance and administrative burdens.
TEI also recommends that the regulations clarify that inherently permanent property in the nature of machinery that is closely related in design, construction, and use to associated tangible personal property is not real property for purposes of section 263A(f). Treating such tangible personal property as real property because it is permanently attached to land or buildings is contrary to Treas. Reg. [subsections] 1.48-1(c), 1.1245-3(b), and 1.179-3(a). The regulations should specifically exclude such property from the definition of real property in accordance with case law(6) and extant IRS rulings(7) in the depreciation and investment tax credit areas.
In summary, we believe that section 263A(f) was intended to require interest capitalization only in respect of depreciable real property or property with a class life of 20 years or more under section 168. In addition, tangible personal property should not be considered real property for purposes of section 263A(f) because it is affixed to land or a building where the current regulations under sections 48, 1245, and 179 and existing precedents treat the property as tangible personal property.
3. Suspension of Production Period
Under Prop. Reg. [sections] 1.263A(f)-5(g), if production activities related to the production of a unit of designated property cease for a period of 12 consecutive months, the taxpayer may suspend interest capitalization with respect to the unit of designated property. Suspension of capitalization begins with interest incurred the 13th month following cessation of production.
TEI applaude the IRS for allowing suspension of interest capitalization where the production of the unit of designated property ceases. The requirement that all production activities cease for 12 consecutive months, however, is too restrictive. The 12-month rule certainly provides bright-line guidance that a project is suspended. TEI submits, however, that the 12-month rule is so long that many truly suspended projects will be subject to capitalization for an excessive period of time.
The preamble notes that paragraph 17 of Statement of Financial Accounting Standards (FAS) No. 34 provides for a temporary cessation of interest capitalization owing to a suspension of production activity.(8) Paragraph 17 provides that interest capitalization will cease where substantially all of the "acquisition activities" are suspended. "Brief interruptions" in activity, however, do not require cessation of interest capitalization. TEI believes that paragraph 17 of FAS 34 supports a shorter trigger period for suspension of capitalization of interest because it applies to all but "brief" interruptions of activity. Specifically, TEI recommends that the duration of the objective time-passage test of suspension of the production activities be reduced. Three consecutive months of inactivity should ensure objective evidence that a project's status is on hold and should trigger suspension of interest capitalization. Thus, TEI recommends that the suspension period be reduced to three months.(9) In addition, where the cessation period extends beyond 12 months, the taxpayer should be permitted to deduct any interest previously capitalized during the cessation period.
4. Related-Party Interest
Prop. Reg. [sections] 1.263A(f)-8 states that taxpayers must account for average excess expenditures allocated to related parties under "existing administrative pronouncements." A separate regulation project will provide proposed regulations for related-party interest at a future date.(10) The related-party rules contained in Notice 88-99, therefore, continue to apply.
TEI continues to believe the related-party rules of Notice 88-99 are too onerous and strongly urges that the IRS modify its position in several areas. By allocating nontraceable debt to production property across a corporate group, the deferred asset and substitute cost methods of Notice 88-99 engender substantial administrative burdens, which are not justified by either the statute or its legislative history. The Senate Report on the Tax Reform Act of 1986, which the Conference Committee generally followed in respect to section 263A(f), provides that the Secretary of the Treasury is to promulgate rules requiring capitalization of related-party interest expense in cases where the interest capitalization rules would otherwise be avoided.(11) Blanket application of the section 263A(f) rules to affiliated or related corporate groups was not mandated by the statute. In other words, in the absence of specific attempts to manipulate or avoid application of the interest capitalization rules, the legislative history does not require the capitalization of related-party interest. Accordingly, TEI questions whether the controlled-group approach to interest capitalization promulgated in Notice 88-99 is consistent with the legislative intent under section 263A(f).
If a general rule is to be applied to related corporations, it should simply state that interest on the indebtedness of related corporations will be attributed to a subject corporation only to the extent indebtedness is incurred to finance intercompany loans, paid-in capital, and capital contributions made to such corporation by related corporations. Thus, to the extent capital projects are financed with the retained earnings of a corporation, there should be no attribution of indebtedness from a related corporation.
b. Application to Foreign Corporations
Capitalization of interest in the context of foreign corporations imposes particularly difficult administrative and compliance burdens for U.S. corporations having foreign subsidiaries outside the consolidated return group. The imposition of related-party interest capitalization on a U.S. multinational's controlled foreign corporations (CFCs) creates substantial compliance burdens, with little or no effect on the U.S. parent's U.S. tax liability. Where the interest to be capitalized is not based in the U.S. return, the U.S. tax effect is deferred until a CFCs income is includible in the U.S. parent tax return.(12) Thus, the effect of pooling post-1986 earnings and profits will diminish the already nominal revenue impact to the U.S. government.(13) Consequently, we recommend that CFCs be exempted from the related-party rules. At a minimum, actual loans involving third parties that are deemed to be loans between "sister" CFCs should be excluded from the application of these rules.
5. Avoided Cost Interest Calculation
TEI believes that determination of the interest rate and amount to be capitalized should be simplified. Taxpayers who issue financial statements in conformity with FAS No. 34 should be permitted an accounting method election to adopt the calculation of the interest rate and amount that is consistent with the amount determined under their book accounting method.(14) Under this proposal, however, taxpayers would not be permitted to use financial accounting standards of materiality to supplant or supersede the de minimis standards set forth in the regulations; thus, the avoided cost method prescribed at Prop. Reg. [sections] 1.263A(f)-2 would still be used for projects that exceed the scope of the de minimis rule for tax purposes but fall short of being "material."(15) TEI believes that the amount of capitalized interest for financial accounting purposes under FAS No. 34 will not be significantly different from that calculated under the avoided cost method prescribed in the proposed regulations. Thus, where interest capitalization is required under a taxpayer's method of accounting for financial reporting, the burden to taxpayers of calculating the amount of interest to be capitalized under a separate tax method (and the concomitant burden to the government of examining the calculations) may exceed the benefit from any additional capitalized interest over and above what is required to be capitalized for financial accounting purposes. Furthermore, the amount capitalized under FAS No. 34 may be more or less than what is required by the proposed regulations. TEI believes that taxpayers should be given the opportunity to weigh the risk of possibly capitalizing more interest than is required by the regulations using a FAS No. 34 approach against the administrative convenience of conforming their tax and financial accounting methods. TEI suggests that if the regulations permitted an election to conform the book and tax calculation of the avoided cost amount, then the average annual recordkeeping burden per recordkeeper might possibly approach the 15 minutes noted in the preamble's Paperwork Reduction Act notice. Without the conformity election, the average recordkeeping burden per TEI member is measurable in staff weeks.
6. Long-Term Contracts
Section 460(c)(3) provides that interest costs are allocated to long-term contracts in the manner provided in section 263A(f), subject to certain modifications. The preamble states that guidance on the interest allocation rules under section 263A(f) applicable to long-term contracts is expected to be issued in regulations under section 460.(16) TEI submits the following comments in anticipation of proposed regulations under section 460.
Under section 460, all long-term contracts entered into after July 11, 1989, are accounted for on the percentage-of-completion (percentage) method.(17) Under the percentage method, all costs of production that are allocable to a contract are allowed as deductions from gross income in computing taxable income in the year in which the costs are incurred.(18) Thus, although a taxpayer is required to capitalize interest allocable to a long-term contract, the interest is included as a cost of production and deducted immediately under the percentage method.
As provided under section 460, gross income recognized each year from a percentage-of-completion contract is computed by multiplying the total income expected under the contract by a ratio of the total production costs incurred divided by total estimated costs to complete. In other words, interest allocated to a long-term contract under the interest capitalization rules is included in both the numerator and denominator of the fraction used to determine gross income recognized in a given year. Under all long-term contracts let by the U.S. government, a contractor is not permitted to include its interest costs as a reimbursable cost. Accordingly, progress payments are often structured to keep the contractor's net investment (i.e., accumulated production expenditures) in the contract and, hence, its carrying cost directly traceable to the contract relatively low. Thus, capitalizing interest to a long-term contract will have a measurable impact on taxable income only where interest incurred fluctuates widely from year to year, though, typically this will not happen where a substantial portion of a business is devoted to U.S. government contracting.
The time and expense required to calculate the property used to produce the property produced under long-term contracts and then allocate and capitalize interest related to costs incurred in long-term contracts where the contract calls for frequent and substantial progress payments is extremely time consuming and burdensome -- especially when weighed against the nominal revenue the government may collect from the exercise. TEI recommends that the regulations operate to reduce the compliance burdens on taxpayers and reduce the government's administrative expense in auditing compliance. Because there is little if any deferral of income under the percentage-of-completion method (particularly where progress payments are scheduled to effectively shift the interest cost to the contracting customer), the regulations could provide that for purposes of section 460(c)(3) that, where 100 percent of the contract is accounted for under the percentage-of-completion method, a contract shall be deemed not to be a long-term contract. Alternatively, a rule might be crafted providing that where a taxpayer's total interest expense has not deviated from a prior year average by more than 20 percent, the taxpayer shall be deemed to have allocated interest to 100 percent percentage-of-completion contracts for the year. Either approach would provide much needed relief, particularly to US. government contractors.
Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations relating to the capitalization of interest under section 263A(f) of the Code. If you have any questions concerning these comments, please do not hesitate to call David F. Nitschke, chair of TEI's Federal Tax Committee, at (908) 750-6782 or Jeffery P. Rasmussen of the Institute's professional tax staff at (202) 638-5601. (1) For simplicity's sake, the proposed regulations are referred to as the "proposed regulations"; specific provisions are cited as "Prop. Reg. [section]." References to page numbers are to the proposed regulations (and preamble) as published in the Internal Revenue Bulletin. (2) 1988-2 C.B. 422. (3) The interest amount assumes production is ratable through the period and debt is incurred as production occurs (i.e., average production expenditures are one-half of the total expended amount.) (4) 1991-37 I.R.B. at 9. (5) See S. Rep. No. 99-313, 99th Cong., 2d Sess. 144 (1986); H.R. Rep. No. 99-426, 99th Cong., 1st Sess. 627 (1985). (6) See Weirick v. Commissioner, 62 T.C. 446 (1979) (dealing with ski-lift tower cable supports), and Marineland of the Pacific, Inc. v. Commissioner, 34 T.C.M. (CCH) 1250 (1975) (support towers for an amusement park skyride). See also Vail Associates v. Commissioner, 88 T.C. 1391 n.13 (1987) (snowmaking equipment). (7) See Rev. Rul. 68-530, 1968-2 C.B. 37 (power outlets, air and vacuum lines, refrigeration units, and steam boilers used to achieve controlled environment in a "clean room"); Rev. Rul. 69-170, 1969-1 C.B. 28 (seats in a baseball stadium); Rev. Rul. 74-602, 1974-2 C.B. 12 (underground gasoline storage tanks at a service station); Rev. Rul. 85-156, 1986-2 C.B. 11 (oil lease and well equipment). There are asset classes in Rev. Proc. 87-56, 1987-2 C.B. 674, containing assets that may be affixed to land or buildings by weight, yet are in the nature of depreciable equipment. See, eg., assets class 26.1, Manufacture of Pulp and Paper (depreciable land improvements associated with a factory site such as effluent ponds and canals); asset class 28.0, Manufacture of Chemicals and Allied Products (same); asset class 33.3, Manufacture of Foundry Products (depreciable land improvements related to casting); and asset class 37.32, Ship and Boat Building Dry Docks and Land Improvements. (8) 1991-37 I.R.B. at 14. (9) External events can provide objective evidence to establish when production is suspended with respect to a property. We recommend that additional objective tests based on independent events be incorporated into the regulations. Among the objective events that should permit temporary cessation of interest capitalization include: strikes or work stoppages; fires, explosions or other industrial accidents; and storms, floods or other natural disasters. (10) 1991-37 I.R.B. at 9. (11) S. Rep. No. 99-313, 99th Cong., 2d Sess. 144 (1986). (12) CFC income is included in the U.S. parent's taxable income (i) through repatriation as a dividend to the U.S. shareholder, (ii) as a Subpart F inclusion to the U.S. shareholder; or (iii) when the CFC stock is sold for a gain and a portion of the gain is recharacterized as dividend income to the U.S. shareholder. (13) The capitalized interest is recovered through increased depreciation deductions (or other basis recovery provisions) against subsequent CFC income. The effect on U.S. tax liability depends upon the interaction of a number of variables including the net effect of the interest capitalization adjustment to the earnings and profits pool, the ratio of the dividend to the accumulated pool of E&P, the effective foreign tax rate, and the U.S. parent's tax position with respect to available foreign tax credit limitation. For U.S. parent companies with excess foreign tax credits the tax effect is probably nil. Notwithstanding a potentially small revenue pin in respect of U.S. companies with excess limitation, the principal point of the text remains: the cost of compliance clearly exceeds the revenue benefit to the government. This issue cries out for simplification. (14) The proposed regulations' avoided cost method would be required for taxpayers who do not issue financial statements in conformity with FAS No. 34 or do not avail themselves of the election. (15) TEI believes that, if such an accounting method election is permitted, many companies might change their accounting systems to conform the financial accounting threshold of a "material" capital project to the de minimis standard. (16) 1991-37 I.R.B. at 15. (17) Since enactment in the Tax Reform Act of 1986, section 460 has been repeatedly amended to reduce and ultimately eliminate the deferral benefit of the completed-contract method of accounting for long-term contracts. For contracts entered after July 11, 1989, no portion of a long-term contract may be accounted for under the completed-contract method. Transition rules, however, do apply to grandfather contracts entered prior to the effective dates of changes in the statute. (18) Notice 89-15, Q&A 32, 1989-1 C.B. 634, 642.
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|Title Annotation:||Tax Executives Institute|
|Date:||Jan 1, 1992|
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