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Proposed regulations on capitalization of expenditures related to tangible property: April 24, 2012.

On April 24, 2012, the Institute submitted the following comments to the Internal Revenue Service on temporary regulations relating to the treatment of materials and supplies, capitalization or deduction of expenditures for tangible property, and depreciation or recognition of gain or loss on the disposition of property affected by the so-called "tangibles" regulations. In addition, the Institute's comments on transitional guidance on changes in accounting methods provided in Revenue Procedures 2011-19 and 2011-20. TEI's comments were prepared under the aegis of the Institute's Federal Tax Committee, whose chair is Robert L. Howren of BlueLinx Corporation. Contributing to the development of TEI's comments were Richard A. Brandenburg of The Goodyear Tire & Rubber Company; Katherine C. Castillo of Guardian Industries Corporation; Sandhya K. Edupuganty of Texas Instruments Incorporated; Thomas L. Leffelman of the Bway Corporation; Charles N. (Sandy) Macfarlane of Chevron Corporation; John A. Mann of Walgreen Co.; and Madeline R. Schneider of Brunswick Corporation. Jeffery P. Rasmussen, TEI Senior Tax Counsel, serves as staff liaison to Federal Tax Committee and coordinated the preparation of the Institute's comments.

On December 23, 2011, the Internal Revenue Service and U.S. Department of Treasury issued temporary regulations under sections 162(a) and 263(a) of the Internal Revenue Code, relating to amounts paid to acquire, produce, or improve tangible property. The temporary regulations clarify and expand the standards in the current regulations concerning whether amounts must be capitalized or deducted currently and also revise the depreciation rules under the modified accelerated cost recovery system (MACRS) of section 168. The temporary regulations, which serve as the text of proposed regulations, were published in the December 27, 2011, issue of the Federal Register (76 Fed. Reg. 81060), and the April 2, 2012, issue of the Internal Revenue Bulletin (2012-14 I.R.B. 614). A hearing is scheduled for May 9, 2012.


Tax Executives Institute is the preeminent association of in-house business tax executives in North America. Our nearly 7,000 members represent 3,000 of the leading corporations worldwide. TEI represents a cross-section of the business community, and is dedicated to developing and effectively implementing 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 in a cost-efficient manner.

Members of TEI 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 a balanced and practical perspective to the issues raised by the temporary regulations.


The temporary regulations represent the culmination of an eight-year effort corn mencing with the announcement in Notice 2004-6 (1) that the IRS and Treasury Department intended to provide comprehensive guidance on whether amounts paid to restore or improve property are capital expenditures or deductible as ordinary and necessary business expenses. A comprehensive set of proposed regulations were issued in 2006 (2) and subsequently withdrawn and reproposed in 2008. (3) Many of the provisions from the 2008 proposed regulations have been retained in the temporary regulations and the rules generally follow the format of the 2006 and 2008 proposed regulations. Hence, the temporary regulations provide guidance on whether amounts paid should be treated as (i) materials and supplies under Temp. Reg. [section] 1.162-3T; (ii) costs to acquire (or produce) tangible property under Temp. Reg. [section] 1.263(a)-2T; or (iii) costs to improve tangible property under Temp. Reg. [section] 1.263(a)-3T. In addition to providing a comprehensive framework for the tax treatment of costs incurred to acquire, produce, improve, or repair tangible personal property, the temporary regulations significantly revise the accounting treatment for assets subject to the modified accelerated cost recovery system (MACRS) of section 168, especially those relating to determining gain or loss on the disposition of MACRS property. The Preamble to the temporary regulations raises several questions about the definitions and operation of the rules and invites comments on issues that are not addressed. Finally, since the new rules will require nearly all taxpayers to make changes in their accounting methods, transitional guidance to facilitate such changes has been issued in Revenue Procedures 2012-19 and 2012-20. (4)

In general, TEI believes that the temporary regulations represent a significant refinement of the previously proposed rules and should help resolve decades of thorny issues surrounding the treatment of tangible property, including the capitalization or deduction of the costs of property, incidental costs, repairs, and improvements. In many cases, the temporary regulations follow prior capitalization and deduction standards or adapt and clarify longstanding judicial interpretations of those rules. For example, Temp. Reg. [section] 1.263(a)-3T(h)(3) (iii) adopts the Plainfield-Union test (5) as the "appropriate comparison" for determining whether a repair required by an "event" (including normal wear and tear) constitutes an improvement or betterment. As another example, the judicially created plan of rehabilitation doctrine has been explicitly rejected as a capitalization rule. Moreover, Examples 11 and 12 of Temp. Reg. [section] 1.263(a)-3T(h)(4) seemingly reject the notion that repairs undertaken to comply with federal, state, or local requirements create a per se capitalization requirement; rather the nature of the work performed and whether it results in a material addition or material increase in capacity, productivity, etc., are deemed to be the determining factors in the analysis. In addition, several new rules have been added--such as the expansion of the definition of dispositions to include retirements of structural components of a building--that will improve current law.

Regrettably, in other areas the temporary regulations impose administrative burdens that impede the simplification that the rules would otherwise achieve. Moreover, in some cases the temporary regulations re verse longstanding rules or step back from the certainty that the bright lines in the 2008 proposed regulations would have promoted, thereby creating new ambiguities and compliance challenges for taxpayers or shifting the focus of disputes between taxpayers and the IRS. To improve the regulations, we offer the following comments.

Captilization Threshold De Minimis Accounts

Temp. Reg. [section] 1.263(a)-2T(g)(1) permits taxpayers to deduct amounts paid for the acquisition or production of property where the taxpayer (i) has an applicable financial statement (AFS), (ii) has at the beginning of the tax year written accounting procedures treating the amounts paid costing less than a certain dollar amount as an expense for non-tax purposes, and (iii) treats such amounts as an expense on its AFS in accordance with its written procedures. Under subparagraph (iv) of Temp. Reg. [section] 1.263(a)2T(g)(1) the total aggregate amounts deducted under this section and Temp. Reg. [section] 1.162-3T(f) (materials and supplies) for the taxable year must be less than or equal to the greater of (1) 0.1 percent of the taxpayer's gross receipts for the taxable year as determined for federal income tax purposes, or (2) 2 percent of the taxpayer's total depreciation and amortization expense for the taxable year as determined in its AFS. The provision eliminates the "no distortion of taxable income" requirement set forth in the 2008 de minimis property rule, but converts the rule in the temporary regulations to an absolute "ceiling" limiting annual deductions of de minimis property.

TEI has long supported the establishment of a de minimis rule for purchases of non-inventory tangible personal property because it strikes an appropriate balance between the requirements of the clear reflection of income standard of the Code and the costs and burdens of complying with and administering the tax laws. By creating a formal rule permitting deductions of de minimis property amounts, the regulations acknowledge longstanding IRS examination practices of acquiescing to taxpayers' deductions of amounts less than a de minimis dollar threshold. Those examination practices conserved IRS resources for more significant issues and we applaud the inclusion of a de minimis property rule in the temporary regulations. The ceiling rule, however, imposes a requirement to -or presupposes that taxpayers already -track and account for de minimis property purchases. Such a requirement is contrary to general practice, severely undermines the goal of administrative convenience, and imposes considerable burdens on taxpayers as well as the IRS. Thus, we have the following comments and recommendations about the ceiling rule.

A. Abandon the Ceiling Rule

Even though the measurement and reporting of net income for financial and tax accounting purposes are guided by differing objectives, both are tempered by practical constraints. Indeed, the statutory requirement in section 446(a) that "taxable income ... be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books" is premised on the realization that in determining taxable income it is appropriate, convenient, and, most important, cost-effective to adhere as often and as closely as possible (within the different objectives of the two systems) to the method employed for financial accounting purposes. The section 446(a) requirement also generally produces the easiest means for the IRS to verify a taxpayer's income. Indeed, the objectives of financial and tax reporting will be best served in this instance by following the same practice.

Despite the lack of a formal rule permitting deductions for de minimis purchases of tangible personal property, most taxpayers have long followed their AFS capitalization threshold for tax purposes. Moreover, as the Preamble to the temporary regulations helpfully acknowledges, IRS examiners, especially in the Large Business & International Division (and its predecessor organizational structures), have long employed risk analysis and materiality factors to determine what level of expenditure to review. As IRS examiners well know, once an asset is expensed for financial statement purposes, few taxpayers have a process to track the property. The proposed ceiling rule, however, assumes that taxpayers currently track the cost of each acquired asset regardless of the asset's treatment for financial statement purposes. (6) Moreover, de minimis property and materials and supplies are accounted for in multiple accounts in multiple cost centers across multiple lines of business within a single taxpayer. Hence, it will be extremely burdensome to identify all the accounts where such costs are expensed and deducted and establish the necessary controls and procedures to aggregate those costs to comply with the ceiling rule. (7) As important, it will be time consuming for IRS agents to review and analyze taxpayers' procedures for complying with the ceiling rule. Hence, TEI recommends abandoning the ceiling rule.

Business taxpayers make prudent judgments about which assets to track--and which to expense--and we believe that the materiality thresholds set for financial accounting purposes, which are reviewed by financial statement auditors as well as IRS agents, provide sufficient safeguards against distortion of taxable income,s Nearly all taxpayers that adopt a de minimis rule for financial statement purposes also adopt written rules or procedures to guard against the distortion of their financial statement income (and evasion of internal controls) that might arise through fragmentation of mass or bulk asset purchases. (9) So long as the taxpayer complies with its capitalization accounting policies in all material transactions, the IRS should not prescribe additional rules undermining the administrative convenience that a de minimis property deduction affords.

In the event the ceiling rule is retained, we have the following additional recommendations to mitigate the burdens it will impose.

B. Increase the De Minimis Ceiling

In setting a threshold for de minimis property for AFS purposes, there is a tension between the administrative convenience of expensing the asset and thus not having to track its depreciation or eventual disposition or retirement, and setting the threshold amount too high and thus reducing publicly reported earnings and potentially losing control over significant assets. If the government determines that a ceiling rule is necessary, TEI recommends increasing the ceiling to the greater of 0.5 percent of gross receipts reported on the federal tax return or 5 percent of depreciation and amortization expense reflected in the AFS. The limits of 0.1 percent of gross receipts or 2 percent of depreciation and amortization expense, which were specified in the 2008 proposed regulations, were not increased when the rule was converted from a safe harbor to a ceiling rule. While the amounts may have been appropriate for a safe harbor, they are too low for a ceiling rule. A higher limit will be especially important for taxpayers making the election under Temp Reg. [section] 1.162-3T to treat certain materials and supplies as de minimis property.

C. Encourage Agents to Reach Agreements with Taxpayers for Higher Thresholds Where the Higher Threshold Clearly Reflects Income

The Preamble to the temporary regulations helpfully notes that the de minimis threshold is not intended to prevent a taxpayer from reaching an agreement with its examining agents that, as an administrative matter and based on risk analysis or materiality, agents will not review certain items:

[I]t is not intended that examining agents must now revise their materiality thresholds in accordance with the de minimis rule ceiling. Thus, if examining agents and a taxpayer agree that certain amounts in excess of the de minimis rule ceiling are immaterial and should not be subject to review, that agreement should be respected, notwithstanding the requirements of the de minimis rule in the temporary regulations.

TEI welcomes the Preamble's acknowledgement and urges the IRS to issue guidance to agents instructing them, consistent with a proper risk analysis, to maintain or consider increasing materiality levels as necessary for the examination of de minimis property purchases. By doing so, the IRS will maintain the flexibility of a safe harbor approach and mitigate the administrative burdens that a too-low ceiling rule would otherwise impose.

Given the lack of formal guidance about the accepted administrative practice of deducting de minimis property before the release of the 2008 proposed regulations, it is unclear what evidence taxpayers must provide to establish an "agreement" that amounts higher than the ceiling rule should not be reviewed. At one end of the spectrum, taxpayers may have conducted significant studies to determine the amount of deductible annual repairs or capitalized expenses for building structures or plant property and such studies may have been reviewed by agents or incorporated in a prefiling agreement. In other cases, taxpayers may have reached closing agreements with Appeals officers permitting certain expenditures or percentages of certain expenditures to be deducted. We encourage the IRS to leave all formal agreements undisturbed. We also urge it to continue to accept previously reviewed repair studies.

In many cases, however, the only "agreement" with taxpayers will be the taxpayer's AFS policy or, in some cases, an agreed dollar amount in information document requests (whether in a coordinating agent's IDR or a computer audit specialist's statistical sampling deck) seeking detailed support for expenditures in various accounts in excess of a stated dollar amount. We encourage the IRS to build on its past administrative practice of accepting a taxpayer's AFS policy and prior IDRs to develop formal agreements and practices that are consistent with the statements in the Preamble. By doing so, the IRS will mitigate the administrative burden that an otherwise too-low ceiling rule would impose.

D. Provide Election to Apply the Ceiling Rule at the AFS Level

Temp. Reg. [section] 1.263(a)-2T(g)(7) states that if the financial results of a consolidated group member are reported on an AFS for the consolidated group, then, for purposes of the de minimis rule, the written accounting procedures utilized for the group's AFS may be treated as the written accounting procedures of the member. The Preamble to the temporary regulations invites comments on the manner in which the de minimis rule, including the limitations, may be applied to a consolidated group.

In the event the ceiling rule is maintained, TEI recommends affording taxpayers an election to determine the ceiling amount based on the AFS for the worldwide group. The requirement to compute a separate ceiling for each member of the group is burden some and should be avoided by permitting taxpayers to use their AFS for the group in determining the ceiling amount. (10) At a minimum, the election should permit taxpayers to compute the ceiling no lower than at the level of the U.S. consolidated group amounts for gross receipts and the related AFS depreciation and amortization expense for such members. Taxpayers should not be required to compute the ceiling amount for each member of the group, compare each member's de minimis property purchases to that separate limit, and then aggregate its actual or ceiling-limited amounts for each member to determine the total for the group. Applying the ceiling rule at the member level is contrary to the purpose of having the de minimis rule, which is to ease taxpayers' administrative burdens. Moreover, in many affiliated groups, assets may be concentrated in one or a few members (and thus depreciation expense and noninventory property purchases concentrated in such members) whereas sales, rental income, interest income (or other activities generating gross receipts) are concentrated in other entities. A member-by-member ceiling limit may produce traps, even for well-informed taxpayers.

E. Ameliorate the Practical Challenge of Determining the Ceiling Amount and its Burdens by Providing Elections for (1) Computing the Ceiling Amount on a Look-Back Basis and (2) Capitalizing and Depreciating a "Ceiling Rule Vintage" Asset

Another impractical element of the ceiling rule is the challenge of comparing, on a real-time basis during the taxable year, the current year gross receipts and depreciation and amortization expense with the cumulative year-to-date purchases of de minimis property (and materials and supplies). A lack of complete current year data for the ceiling amount or purchases of property, materials, and supplies will lead to under- or over-stated estimated tax payments as well as tax accounting errors. Moreover, although taxpayers may elect under Temp. Reg. [section] 1.263(a)-2T(g)(4) not to apply the de minimis rule to amounts that exceed the ceiling amount, the election "out" must be made on a timely filed original return. The determination of the proper amount of de minimis purchases to capitalize under the election is critical because a deduction of one dollar in excess of the ceiling amount (without a qualified election identifying the property to which the election applies) seemingly requires a taxpayer to capitalize the entire amount of its de minimis purchases. To the extent taxpayers are able to track for tax purposes amounts expensed for book purposes--which candidly few will be able to do--a miscalculation of either the property amounts deducted or the ceiling amount may produce a draconian result. (11)

To ameliorate the burden of potential miscalculations (or the effect of IRS audit adjustments on the amount of de minimis purchases or the ceiling limits), TEI has two recommendations. First, taxpayers should be permitted to elect to use either (1) prior year gross receipts and depreciation and amortization expense or (2) a three-year rolling average of those amounts as a safe harbor alternative for determining the ceiling amount. Second, taxpayers should be permitted to deduct the full amount up to the ceiling rule and then elect to capitalize (possibly as a protective election) the amount of de minimis purchases determined to be in excess of each year's ceiling amount without specifically identifying the items, unit of property (UOP), or amount subject to the election.

Under the first election, taxpayers would be permitted to look back either one year or three years for determining the ceiling amount. Such a rule would permit taxpayers to compute the annual ceiling amounts in advance of their purchases of de minimis property. Under the second election, taxpayers should be permitted to (1) deduct the full ceiling amount for the year and (2) automatically treat all de minimis property exceeding the ceiling amount for the year as a single mass asset and depreciate that amount using a three-year MACRS life. In other words, when taxpayers determine, whether before or after filing their return (including during examinations), that they have acquired de minimis property in excess of the ceiling amount, they should be permitted to deduct the ceiling amount and create a "vintage" account or "ceiling rule asset" for each year's excess amount without specifically identifying the amount. (12) In respect of TEI's recommendation to use three-year MACRS depreciation to recover the cost of the "ceiling rule asset," although some assets in each year's ceiling rule vintage account may have a longer class life than permitted for three-year MACRS depreciation, the bulk of the de minimis property will on average--including the materials and supplies deducted as a result of an election in Temp. Reg. [section] 1.162-3T(f)--be short lived. Finally, because of the short life and the treatment of individual items as part of a single mass asset, dispositions or retirements would not be accounted for, but any proceeds received on disposition of such items should be recognized as ordinary income.

F. "Adoption of" or "Changes to" a Taxpayer's AFS De Minimis Threshold Policy

Neither the 2008 proposed regulations nor the temporary regulations directly address whether (1) the adoption of an AFS de minimis threshold constitutes a method of accounting or (2) changes to the AFS dollar threshold are treated as changes in a taxpayer's method of accounting. Moreover, the Code and prior regulations are silent on the issue. In previous comments, TEI has argued that the deduction of de minimis property is a rule of administrative convenience and not a method of accounting and, thus, any changes in the AFS policy should not require taxpayers to file requests for changes in method. (13) Even though it remains unclear whether a taxpayer's practice of deducting de minimis property of less than a certain dollar threshold on its tax return in conformity with a taxpayer's AFS policy before January 1, 2012, is a method of accounting, section 4.17 of Rev. Proc. 2012-19 states that "a taxpayer that wants to change its method of accounting.., to the method of applying the de minimis rule under [section] 1.263(a)-2T(g) ... "must comply with the requirements of the procedure to obtain automatic consent for the "change." (14) Hence, all taxpayers are seemingly required to file Form 3115 (Application for Change in Accounting Method) for their first taxable year that includes January 1, 2012, in order to continue deducting the same dollar amount of de minimis property under a pre-existing AFS policy and tax accounting "practice" or "method."

Given (1) the conflicting authorities (15) in respect of whether taxpayer's could properly deduct de minimis property and (2) the Preamble's acknowledgement of the widespread taxpayer practice of deducting de minimis property before January 1, 2012, the IRS should clarify whether every taxpayer that expects to maintain its practice of deducting de minimis property after December 31, 2011, in accord with a pre-existing AFS policy should file a Form 3115 within two years* From many taxpayer's tax and financial accounting and reporting perspectives, nothing changed on January 1, 2012.

In addition, under the broad language of section 4.17 of Rev. Proc. 2012-19, taxpayers deducting de minimis property in accord with their AFS policy after December 31, 2011, will seemingly be required to file a Form 3115 whenever any aspect of the AFS policy or procedures changes, including increases in the dollar threshold. Although we believe that changes in a taxpayer's AFS policy for de minimis property threshold are generally attributable to changes in the underlying facts (e.g., because of inflation in property prices, growth, or changes in the taxpayer's underlying business)--and thus should not be subject to the change in accounting method rules--TEI welcomes the decision to permit taxpayers to make such changes by means of the automatic consent procedures implemented via the cut-off method. We question, however, whether changes to a taxpayer's AFS policy or procedures other than the dollar threshold should require IRS consent. We recommend that the IRS clarify that only changes to adopt an AFS de minimis property policy or to increase the de minimis property threshold amount are subject to the automatic or advance consent requirements. A taxpayer's AFS policy and procedures may prescribe other practices or requirements that have no bearing on the deduction of de minimis property.

Betterments, Restoration, or Adaption--Bright-Line Rules vs. Facts and Circumstances Tests

A. Definition of Material "Defect," "Addition," "Capacity," etc.

To distinguish repairs from "betterments," Temp. Reg. [section] 1.263(a)-3T(h)(1) provides that an "amount paid results in a betterment of a unit of property only if it (i) ameliorates a material condition or defect ... ;(ii) results in a material addition ... to the unit of property; or (iii) results in a material increase in capacity ... productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property." (16) The rules, however, provide no guidance on the interpretation of the term "material" and omit any bright line test of materiality. Example 1 of the section concludes that remediation of contaminated soil results in the amelioration of a material defect but Example 2 concludes that the removal of asbestos from a building does not correct a material pre-existing defect or condition. The examples omit any facts about the amounts paid to correct either condition and there seems to be little to explain or distinguish the conclusions. (17)

To diminish controversy and promote certainty of treatment, TEI recommends that the IRS provide guidance in the form of a series of rebuttable presumptions -perhaps as a sliding scale of a percentage of original cost or the physical structure affected--within which expenditures would be considered a "material" addition (or alternatively a deductible repair) or betterment. To illustrate the concept, for a unit of property (UOP) with an original cost of up to $100,000, any expenditure in excess of $50,000 or affecting more than 50 percent of the physical structure of the UOP might be presumed a material addition or increase. For a UOP costing $100,000 or more but less than $1 million any expenditure in excess of 35 percent of the cost or affecting in excess of 35 percent of the physical structure of the UOP might be presumed to be a betterment. For a UOP costing $1 million or more, but less than $5 million expenditures in excess of 20 percent of cost or affecting in excess of 20 percent of the physical structure might be presumed a betterment* For a UOP costing $5 million or more, expenditures in excess of 10 percent of the cost or in excess of 10 percent of the physical structure might be presumed to be a betterment. (18) In all cases, the taxpayers should be permitted to rebut the presumption of a betterment with additional facts and circumstances*

B. Restoration of"Major" Components

The 2008 proposed regulations pro vided that a taxpayer did not have to capitalize, or treat as an improvement, amounts paid to replace a major component or substantial structural part of a unit of property unless those amounts were paid after the recovery period for the property, and either (1) the replacement cost comprised 50 percent or more of the replacement cost of the entire unit of property, or (2) the replacement parts comprised 50 percent or more of the physical structure of the unit of property ("the 50-percent thresholds"). Thus, capitalization under the major component rule was required only where the property was fully depreciated and either 50-percent threshold was exceeded. The temporary regulations eliminate the 50-percent thresholds for determining when the replacement of a "major component" requires capitalization as a restoration, adopt new rules for capitalizing repairs to "building systems," and generally fall back on a facts and circumstances test to determine when repairs to a structural component should be capitalized as a restoration.

TEI regrets the elimination of the brightline tests for the determination of a restoration because bright-line rules mitigate the administrative burdens of a facts and circumstances analysis. TEI urges the IRS and Treasury Department to consider restoring the bright-line tests to the regulations. As recommended in section A above, the IRS should consider providing guidance in the form of a series of rebuttable presumptions--perhaps as a sliding scale of a percentage of original cost or the physical structure affected--in excess of which expenditures would be considered a restoration of a major component.

Guidance Needed for "Discrete or Major" Function Test for Plant Property

The 2008 proposed regulations defined a UOP for "plant" property as consisting of all the components within a plant that performs a "discrete or major" function or operation for functionally interdependent machinery or equipment. Temp Reg. [section] 1.263(a)-3T(e)(3)(ii)(B) retains this test for repairs of units of "plant property."

The functional interdependence test is extremely broad. Hence, the "plant property" rule limits the scope of machinery and equipment that is considered functionally interdependent to some amount less than all property at a single location. By limiting the size of the UOP (or breaking a large UOP into more granular components), an expenditure is more likely to be capitalized as a betterment, adaptation, or restoration rather than deducted as a repair. Regrettably, the "discrete and major" component test is a new facts and circumstances test and there are only two examples in the temporary regulations and few or no court decisions to determine what constitutes a "discrete and major" function for "plant property." To minimize controversy, we recommend that the IRS provide more examples or further delineation of what constitutes a "discrete or major" function where multiple pieces of equipment or UOPs operate at a single physical location. (19)

Dispositions of Building Components

Temp. Reg. [section][section] 1.168(i)-8T(a) through (i) provide new rules relating to dispositions of MACRS assets. Specifically, Temp. Reg. [section] 1.168(i)-8T(b)(1) expands the definition of dispositions to include the retirement of a structural component of a building. The Preamble explains that--

This change allows a taxpayer to recognize a loss on the disposition of a structural component of a building before the disposition of the entire building, so that a taxpayer will not have to continue to depreciate amounts allocable to structural components that are no longer in service. Thus, under the temporary regulations, a taxpayer is not required to capitalize and depreciate simultaneously amounts paid for both the removed and the replacement properties. (20)

The expansion of the definition of dispositions to include a retirement of structural components is a welcome change. Since there was no previous tax rule or business reason to identify and maintain the basis of structural components when the components were first placed in service, the Preamble acknowledges the challenge that taxpayers may have in determining the amount of adjusted basis of the property allocable to the retired component and invites comments on safe harbors or computational methodologies taxpayers may use to simplify the determination.

Many taxpayers have used cost segregation studies to segregate and allocate basis for section 1245 and section 1250 property. The IRS has also accepted well documented and reasoned studies performed by the taxpayer or qualified third-party professionals. We recommend that taxpayers be permitted to continue such practices to allocate the basis of section 1250 property to components of the structure. Specifically, we recommend permitting taxpayers to use third-party construction estimating and valuation services, software, and similar tools to estimate the original cost of a component at the time of its installation. Upon making a reasonable determination of the current age of the retired components and its estimated replacement cost, the taxpayer can then estimate the amount of remaining basis to retire. We do not believe, however, that taxpayers should be required to undertake expensive studies to determine the basis allocable to building components. Rather, a simplified method of allocating basis to the structural components of a building (perhaps by the use of safe harbor percentages of structural components) should be developed to make appropriate use of the revised disposition and general asset account rules.

Casualty Loss Rule

The 2008 proposed regulations provided that an amount is paid to restore a unit of property (and thus subject to capitalization) if it repairs damage to a unit of property for which the taxpayer had properly taken a basis adjustment as a result of a casualty loss under section 165 (hereinafter the "casualty loss rule"). The temporary regulations retain the casualty loss rule, with the Preamble's explanation that "the rule is consistent with the fundamental principle that a taxpayer must capitalize the cost of acquiring new property." (21) Thus, the rule prevents "the acceleration of deductions for both the casualty loss and the costs of restoring the property." (22) In effect, the temporary regulations adopt a per se rule that any repair to property for which a taxpayer has taken a basis adjustment as a result of casualty loss under section 165, or relating to a casualty event described in section 165, is a restoration requiring capitalization.

TEI believes that the casualty loss deduction under section 165 and the analysis of whether an expenditure is for a repair under section 162 or a betterment under section 263(a) should not be conflated. Case law confirms that sections 162 and 165 provide independent deductions and an independent analysis should be made of the repair expenditure. See R. R. Hensler, Inc. v. Commissioner, 73 T.C. 168 (1979), acq., 1980-2 C.B. 1; and Louisville & Nashville R.R. Co. v. Commissioner, T.C. Memo 1987-616. We urge the IRS and Treasury Department to abandon the temporary regulation's presumption that a repair of property for which a casualty loss is claimed or basis is reduced is a per se restoration requiring capitalization of the attendant repair costs.

Miscellaneous Comments

A. Routine Maintenance Safe Harbor

Temp. Reg. [section] 1.263(a)-3T(g) prescribes a safe harbor for routine maintenance expenses for property other than buildings. The rules are generally workable and TEI applauds adoption of the safe harbor. (23)

Regrettably, the Preamble to the temporary regulations rejects the application of the routine maintenance safe harbor to buildings, stating that, in addition to the long class life for buildings, "the courts have held that amounts paid for replacements of major components or substantial structural parts of buildings and their structural components are capital expenditures." (24) The explanation, however, seems hollow, especially since the same rationale is used to justify the creation of eight new building "systems" for purposes of testing whether expenditures must be capitalized as a betterment, adaptation, or restoration (BAR). By carving off building "systems" as separate UOPs from "buildings and structural components," the temporary regulations create a bias in favor of capitalizing building maintenance costs as restorations. Adding an explicit safe harbor for building maintenance costs would, we believe, restore balance to the regulations.

Indeed, the Examples in Temp. Reg. [section] 1.263(a)-3T(i)(5) (restorations) implicitly provide practical guidance for a safe harbor rule. In Example 17, the replacement of 2 of 10 roof-mounted chillers (i.e., 20 percent of similar structural units) in a building's HVAC system is not considered a restoration because by themselves the chillers are "not a large portion of the physical structure of the HVAC system" and do not "perform a discrete and critical function in the operation of the system." (25) Similarly, the replacement of 3 of 20 sinks (i.e., 15 percent of similar components within the structure) in Example 21 is considered a repair rather than a restoration of a major component or substantial structural part of the building system whereas in Example 20 when all the sinks on all floors are replaced, the result is a restoration. (26) Based on the examples, the IRS and Treasury seemingly accept that up to 20 percent of similar structural components of a building (e.g., up to 20 percent of the foundation, the walls, partitions, roof, or windows tested as separate UOPs) or up to 20 percent of a building's "systems" (e.g., plumbing, electrical, fire protection and alarm system, HVAC, elevators, or escalators--again tested as separate UOPs) can be replaced or repaired before a restoration has occurred. We urge the IRS and Treasury to consider adding a safe harbor for routine building maintenance.

B. Materials and Supplies

Temp. Reg. [section] 1.162-3T(c)(1) provides a new definition of materials and supplies, which consists of property that is (1) not inventory and (2) falls into one of the following categories: (i) components acquired to maintain, repair, or improve a unit of tangible property; (ii) fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less; (iii) has an economic useful life of 12 months or less; (iv) has an acquisition or production cost of $100 or less (or other amount identified in future IRS guidance); or (v) is identified in future IRS guidance as materials and supplies. Hence, materials and supplies with a life in excess of 12 months or costing in excess of $100, which many taxpayers would have considered deductible materials and supplies or classified as de minimis property for AFS purposes and deducted, must be capitalized for tax purposes. To mitigate the effect of the capitalization requirement, Temp. Reg. [section] 1.162-3T(f) affords an election to apply the de minimis property election of Temp. Reg. [section] 1.263(a)-2T(g) to non-incidental materials and supplies. To avail themselves of the rule, taxpayers must institute processes to account for property costing as little as $100 per item (or less in case of nonincidental materials and supplies) in order to comply with the ceiling rule.

We have several comments and recommendations in respect of the definition of materials and supplies. First, it is unclear why the definition is so restrictive and, especially why taxpayers must await additional IRS guidance before treating additional items as materials and supplies. The regulations should adopt a definition that permits taxpayers to determine what a "material and supply" is for their business. Otherwise, the scope of deductions for materials and supplies will be too rigid.

Second, notwithstanding the Preamble's rejection of a threshold higher than $100 for materials and supplies (as well as the seeming rejection of a threshold indexed for inflation), TEI believes the thresholds for the definition of materials and supplies in Temp. Reg. [section][section] 1.162-3T(c)(1)(iii) and (iv) should be increased. Specifically, the dollar amount should be increased to $500 and indexed for inflation. A threshold higher than $100 will not distort the taxable income of large business taxpayers.

Finally, under pre-January 1, 2012, guidance (including the 2008 proposed regulations), all tangible property with a useful life of 12 months or less could be deducted when purchased. (27) In contrast, under the temporary regulations, unless a taxpayer elects to deduct (subject to the ceiling rule) materials and supplies as de minimis property under Temp. Reg. [section] 1.162-3T(f), nonincidental materials and supplies can only be deducted when consumed. Thus, in addition to creating a burdensome tracking requirement for short-lived property, the temporary regulation is at odds with the rule for the treatment of intangible property with a useful life of 12 months or less. Under Treas. Reg. [section] 1.263(a)-4(f), taxpayers are not required to capitalize (or track or otherwise account for) amounts paid for intangible assets with a useful life of less than 12 months. It is unclear why the rule for non-incidental materials and supplies with a life of less than 12 months should be more stringent than for intangible property purchases. TEI recommends making the treatment of tangible and intangible property with a life of 12 months or less consistent, with the amounts deductible when incurred unless the taxpayer elects otherwise. 28

C. Allocation of Facilitative Costs to Acquire Specific Assets

Temp. Reg. [section] 1.263(a)-2T(f)(4), Example 6, indicates that amounts paid by a retailer to an architect to perform a study evaluating the suitability of a site for construction of the type of distribution facility the retailer wishes to build are required to be capitalized to the land rather than the facility because the amounts are inherently facilitative for the acquisition of the land. The costs for the architect, however, are arguably necessary to build the facility rather than acquire the land. Under a section 263A analysis (as is applied in the immediately succeeding Example 7 of the temporary regulation), the costs would seemingly be allocated to the building and thus be depreciable. We recommend deleting Example 6 or clarifying the analysis of why the section 263A rules should not be applied.

Transitional Guidance

Temp. Reg. [section] 1.162-3T is generally effective for amounts paid or incurred (to acquire or produce property) in taxable years beginning on or after January 1, 2012, except for [section] 1.162-3T(e), which is effective for taxable years beginning on or after January 1, 2012. Similarly, Temp. Reg. [section][section] 1.167(a)-4, 1.167(a)-7T, 1.167(a)-ST, 1.168(i)-1T, 1.168(i)-7T, 1.168(i)-8T, 1.263(a)-1T, 1.263(a)-2T, 1.263(a)-3T, 1.263(a)-6T, and 1.1016-3T are effective for taxable years beginning on or after January 1, 2012, except for Temp. Reg. [section][section] 1.263(a)-2T(f)(2)(iii), (f) (2)(iv), (f)(3)(ii), and (g), which are effective for amounts paid or incurred (to acquire or produce property) in taxable years beginning on or after January 1, 2012. Rev. Proc. 2012-19 and 2012-20 have been issued to prescribe the conditions under which taxpayers may obtain automatic consent to change to a method of accounting provided in the temporary regulations and prescribe whether the change is to be implemented on a cut-off basis or with a section 481(a) adjustment. Finally, the IRS Large Business & International Division has issued a directive (LB&I-4-0312-004, March 15, 2012) limiting IRS examination activity on costs to repair or improve property and dispositions for tax years before January 1, 2012, and for the first two taxable years beginning on or before January 1, 2014.

The transitional guidance--including the two-year period for implementing automatic changes in accounting methods under the revenue procedures, the relaxation of the scope limitations for changes in method, and the LB&I "stand down" directive for audit activity relating to repairs or improvements and dispositions for two years--is generally helpful and appropriate. We believe, however, that the guidance relating to statistical sampling should be clarified.

For purposes of computing the section 481(a) catch-up adjustments required to change accounting methods and comply with the temporary regulations, the revenue procedures state repeatedly that "sampling methods not prescribed in Rev. Proc. 2011-42 are not permitted." We submit that the procedures are too restrictive, especially since prior to Rev. Proc. 2011-42 taxpayers would have followed other guidance on statistical sampling. (29) More important, Rev. Proc. 2011-42 itself states that "if a taxpayer employed a probability sample or method not covered by this revenue procedure, then the estimate may be referred to a Statistical Sampling Coordinator for resolution or issue development." (30) Hence, we recommend that the IRS clarify that, while Rev. Proc. 2011-42 sets forth the preferred statistical sampling methodology, other statistical sampling techniques may be employed. Moreover, the IRS should confirm that the results of repair, cost segregation, or similar studies undertaken prior to the announcement of the temporary regulations may be relied upon and used to compute the catch-up adjustments necessary to comply with the temporary regulations. Taxpayers should not be burdened with a requirement to disregard prior studies because of heightened statistical sampling requirements issued after undertaking previously valid studies.

In addition, the revenue procedures make no mention of taxpayers' using extrapolation techniques to estimate cumulative catch-up adjustments based on studies of either current year data or a limited number of open tax years, say three, for which data may be readily available. Rev. Proc. 2011-43, for example, provides an extrapolation method permitting taxpayers to compute a safe harbor amount in determining whether expenditures to maintain, replace, or improve electric transmission and distribution property must be capitalized. (31) We urge the IRS to confirm that taxpayers may use extrapolation methods (1) to compute required section 481(a) catch-up adjustments under Rev. Procs. 2012-19 and 2012-20 and (2) determine on an ongoing basis the amount of expenditures that can be deducted as repairs.


Tax Executives Institute appreciates this opportunity to present its views on the temporary regulations under sections 162(a) and 263(a), relating to the capitalization of expenditures for tangible assets and repairs. If you have any questions, please do not hesitate to call Robert L. Howren, chair of TEI's Federal Tax Committee, at (770) 221-2731, or Jeffery P. Rasmussen of the Institute's legal staff at 202.638.5601 or

(1.) 2004-3 I.R.B. 308 (January 20, 2004).

(2.) 71 Federal Register 48590; 2006-39 I.R.B. 532 (September 25, 2006).

(3.) 73 Federal Register 12838; 2008-18 I.R.B. 871 (May 5, 2008).

(4.) Rev. Proc. 2012-19, 2012-14 I.R.B. 689 (April 2, 2012); Rev. Proc. 2012-20, 2012-14 I.R.B. 700 (April 2, 2012).

(5.) Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962), nonacq, on other grounds, 1964-2 C.B. 8.

(6.) See "IRS Aware De Minimis Cap Rules on Tangible Property Might Pose Burden," BNA DAILY TAX REPORT, G-3 (February 21, 2012). Because of the lack of a formal de minimis rule, "taxpayers were supposed to be tracking those costs previously and capitalizing them."

(7.) Most taxpayers have expressed significant skepticism about their ability to institute the necessary tracking and reporting changes in their enterprise resource planning systems. Even where taxpayers make the system changes (or pay the software vendor to make the changes), they may not be able to achieve full compliance because they may not be able to identify all the accounts in all the cost centers where property is acquired and thus either expensed or capitalized in accordance with the company's tax and financial reporting guidelines.

(8.) The attendant reduction in reported earnings will curb publicly traded companies from setting excessive thresholds.

(9.) For example, the purchase of 1,000 personal computers at the same time would likely require the amounts to be capitalized for financial statement purposes even though the cost of each computer might be less than the de minimis amount.

(10.) Presumably, the temporary rules apply to the determination of earnings and profits of controlled foreign corporations (CFCs) as well as to entities whose income is reported directly (e.g., as branch income) or indirectly (e.g., through a partner's distributive share of partnership income) on a U.S. tax return. Most taxpayers will adopt a uniform accounting policy that applies worldwide and it will be extremely burdensome for such taxpayers to comply with different book standards depending on whether the entity has reportable income (whether directly as taxable income on the U.S. tax return or indirectly as Subpart F income for the U.S. shareholder) or non-reportable income or is or is not an includible entity (e.g., a partnership). For example, a multinational U.S. corporation may have U.S. entities operating side by side with CFCs (or in joint ventures with CFCs of the taxpayer or other taxpayers) in foreign jurisdictions. In many cases, one person will be responsible for the accounting for the U.S. and foreign entities and it will be burdensome to apply different thresholds depending on whether the entity is a U.S. entity, CFC, controlled partnership, or non-controlled entity with U.S. partners.

(11.) If, contrary to TEI's recommendation, the ceiling rule is retained, most taxpayers will face a serious challenge in identifying and tracking "expensed" de minimis property that should be capitalized. The property may be accounted for in a single account for uniformly similar property, be in multiple accounts in different cost centers for uniformly similar property, be commingled in one account for different types of de minimis tangible or intangible property, materials and supplies, or miscellaneous services, or be commingled in multiple accounts for different items across multiple cost centers. The IRS will similarly be challenged in examining taxpayer accounting for de minimis items. Taxpayers should be permitted to make reasonable determinations of which accounts should be tracked and make reasonable estimates (based on extrapolations or simplified statistical samples) of the amounts of de minimis property that would have to be segregated from the book amounts and tracked as a depreciable asset (or non-incidental material and supply).

(12.) Thus, taxpayers should be permitted to revise--whether as a result of an amended return or an IRS examination--the amount of the "ceiling rule asset" subject to depreciation.

(13.) Tax Executives Institute, Comments on Proposed Regulations on Capitalization of Expenditures Related To Tangible Property, REG168745-03 (January 30, 2007).

(14.) 2012-14 I.R.B. 689, 695 (April 2, 2012) (emphasis added).

(15.) Compare Union Pacific R.R. Co. v. United States, 524 F. 2d 1343 (Ct. C1. 1975) and Cincinnati, N.O. & Tex. Pac. Ry. v. United States, 424 F. 2d 563 (Ct. C1. 1970) (permitting the taxpayers to use their $500 de minimis rule) with Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo 2001-149 (disallowing the taxpayer's use of a $500 de minimis rule).

(16.) 2012-14 I.R.B. 614, 675 (April 2, 2012) (emphasis added).

(17.) At a minimum, Example 2 should be clarified to state that asbestos insulation is not inherently defective and the fibers have not deteriorated to the point where its replacement is necessary to remedy a defective condition.

(18.) The ranges are intended to be illustrative of a safe harbor range of repairs rather than absolute rules for capitalization. Indeed, the ranges should be prefaced with a confirmation of pre-2012 law that the determination whether an expenditure is a repair or improvement is made based on all facts and circumstances and that there is no dollar amount beyond which the an expenditure must automatically be considered as a capital item rather than a deductible repair. Many taxpayers incur large expenditures in absolute dollar amounts that are still routine maintenance. For example, a lens used in a production line for the fabrication of silicon wafers into computer chips may cost upwards of $500,000, but the cost of the lens--a component--may be an insignificant part (i.e., less than 5 percent) of the overall cost of the production line that constitutes the UOP.

(19.) Consider the following as a contrasting example to Example 6 of Temp Reg. [section] (a)3T(e)(6). Assume that a production line consists of the following components: a Slitter (which cuts metal to a particular size or blank body); a Bodymaker (which rounds and welds the body blanks to a cylinder as a can body); a Cure System (which cures striping if the can requires it); a Flanger (which creates flanges on top and bottom of the can body in order to accept ends); a Bottom Seamer (which fastens a bottom to the flanged can body; a Top Seamer (which fastens a top to the flanged can body); and a Tester (which tests the completed can for leaks). If any one part of the production line malfunctions, the line must be shut down and the inoperable component replaced or repaired. On these facts and circumstances, the entire production line is functionally interdependent so the unit of property is the entire line. None of the individual pieces of equipment on the line constitutes a discrete and major function.

(20.) 2012-14 I.R.B. 614, 621 (April 2, 2012).

(21.) 2012-14 I.R.B. 614, 629 (April 2, 2012).

(22.) Id.

(23.) The Preamble to the 2008 proposed regulations includes the following statements about the routine maintenance safe harbor: The safe harbor is intended to operate only as a safe harbor in which qualifying costs will be deemed not to constitute an improvement. The IRS and Treasury Department recognize that many activities that do not qualify for the safe harbor nonetheless may be activities that do not give rise to capitalization of costs under section 263(a). Additionally, costs deductible under the maintenance safe harbor may be required to be capitalized under section 263A to other property produced or acquired for resale. (Emphasis added.) The Preamble to the 2011 temporary regulations omits this language. We agree with the italicized statement that expenditures that fall outside of a safe harbor range should not be presumed to be capitalized. To ensure that IRS agents do not make such presumptions, TEI recommends inserting the italicized statement in the Preamble to the final regulations.

(24.) 2012-14 I.R.B. 614,626 (April 2, 2012).

(25.) Id. at 680.

(26.) Also, compare Example 23, where replacement of 30 of 300 windows (10 percent of the structure's windows) is considered a repair, with Example 24, where the replacement of 200 of 300 windows (66 percent of the structure's windows) is considered a restoration.

(27.) See, e.g., Rev. Rul. 89-62, 1989-1 C.B. 78 (permitting deduction of videocassettes with a useful life of one year or less); Rev. Rul. 73-357, 1973-2 C.B. 40 (permitting a deduction for the cost of tires with an average life of less than one year).

(28.) Thus, the election accorded to taxpayers in Temp. Reg. [section] 1.162-3T(d) to capitalize and depreciate materials and supplies should be retained as a helpful alternative.

(29.) See generally, section 5 of Rev. Proc. 2011-42, 2011-37 I.R.B. 318, 320 (September 12, 2011). According to section 6, the procedure was generally effective for taxable years ending on or after August 19, 2011. With respect to the use of statistical sampling by a taxpayer for a taxable year ending before August 19, 2011, for which the applicable period of limitations had not expired, the IRS would permit, but would not require, application of Rev. Proc. 2011-42.

(30.) 2011-37 I.R.B. 318, 319 (September 12, 2011) (emphasis added).

(31.) 2011-37 I.R.B. 326 (September 12, 2011).
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