In March 2008, the Service released proposed regulations regarding the application of Section 263(a) to amounts paid to acquire, produce, or improve tangible property.1 As a general rule, these proposed regulations confirm that a taxpayer must capitalize the costs of acquiring or producing tangible property as well as certain costs that facilitate the acquisition. A taxpayer that incurs costs to repair an asset after it has been placed in service must determine the relevant unit of property and then allocate costs to the extent that the expenditures result in an improvement to that unit of property. Because the treatment of repair expenses is the most significant part of these regulations, they are known generally as the repair regulations.
The government has been hard at work revising these proposed regulations and they hope to issue a revised version of the regulations in the next several months. A number of issues are currently under consideration for inclusion in the upcoming regulations package. Some of these issues are summarized below; however, a number of issues were addressed more fully in a recent comment letter submitted by the American Bar Association, available at http://www.abanet.org/tax/pubpolicy/2010/082310comments.pdf.
By way of background, the proposed regulations provide a three-part test for distinguishing between deductible repair expenses and capital expenditures. Expenditures are capitalized to fixed assets if the costs result in: (i) a betterment; (ii) a restoration; or (iii) a new or different use with respect to the unit of property. The proposed regulations simplify the rules for determining a unit of property and provide guidance to simplify the determination of whether assets must be accounted for as materials and supplies.
The betterment standard in proposed regulation Section 1.263(a)-3(f) replaces the so-called "increase in value" test set forth in 2006 proposed regulations. Expenditures result in a betterment of a unit of property in three situations: (i) the remediation of a material defect that existed prior to the acquisition or that arose during production of the unit of property; (ii) a material addition to the unit, such as an enlargement, expansion, or extension; and (iii) a material increase in the capacity, productivity, efficiency, strength, quality, or output of the unit of property.
The restoration test under the proposed regulations continues to seek to identify those expenditures that materially prolong the useful life of an asset, relying on six objective standards: (i) replacement of a component of a unit of property when the taxpayer has properly deducted a loss for that component; (ii) replacement of a component when the taxpayer has taken into account the adjusted basis in realizing gain or loss on a sale or exchange of the component; (iii) repair of damage to a unit of property when the taxpayer has taken a basis adjustment as a result of a casualty event (whether or not a casualty loss is deducted); (iv) return of the unit of property to its ordinary efficient operating condition after it was in a state of disrepair and no longer functional, at any time in the property’s existence; (v) rebuilding of a unit of property to a like-new condition after the end of both its economic useful life to the taxpayer and the Section 168(c) recovery period that would apply to the property; (vi) replacement of a major component or substantial structural part of a unit of property after the end of its Section 168(c) recovery period.
Further, capitalization is required when a taxpayer incurs expenditures that change the taxpayer’s use of the property. A new or different use is one that is not consistent with the taxpayer’s intended ordinary use of the unit of property when the taxpayer originally placed it in service.
These proposed regulations address a number of concerns identified by taxpayers, commentators, and practitioners. A number of bright-line rules have been provided and certain critical terms used in this area have been defined, which may not only reduce the cost of recordkeeping and compliance burdens of taxpayers, but may also increase the efficient use of the government’s administrative resources.
Casualty Loss Rule
One of the most important issues to be resolved in the regulations package is the interaction of the casualty loss rules with the repair regulations. The proposed regulations provide that if a basis adjustment has been made as a result of either a casualty loss deduction or receipt of insurance proceeds for a casualty event, subsequent repairs to that property must be capitalized. Solely for purposes of property subject to a casualty loss, the cause of the expense determines whether the expense is deductible. In all other cases, the effect of the cost on the unit of property is the exclusive determinant of deductibility. Although the proposed regulations provide a uniform and consistent approach for determining whether a cost is properly treated as a deductible repair expense, a special rule was added for property subject to a casualty loss.
This approach appears to be based on the reasoning that, because casualty losses are extraordinary events, the response to them cannot be "ordinary" as required for deduction under Section 162. This conclusion is contrary to the conclusion of the Supreme Court that "once in a lifetime" events may be ordinary for purposes of Section 162.2 More importantly, the government appears to view taking these two deductions as a "double deduction" when in fact these amounts arise by operation of two separate Code provisions designed to operate concurrently. The provision eliminates deductions that a taxpayer is otherwise entitled to take. For this reason, we are hopeful that the government will reconsider its position when the package is finalized.
Transition Rules and Accounting Method Changes
The preamble to the proposed regulations notes that a change in the treatment of repair costs is a change in method of accounting, and requests comments regarding how to implement such accounting method changes. The proposed regulations provide that the rules are applicable to amounts paid or incurred in taxable years beginning on or after the date the final regulations are issued. However, the proposed regulations are interpretive regulations generally intended to clarify rather than change current law. For this reason, except with respect to any de minimis rules or safe harbor guidance, it is hoped that the regulations, when finalized, provide that taxpayers may rely on the principles of the final regulations in taxable years prior to their effective date.
There is some question whether the final regulations will allow a Section 481(a) adjustment for accounting method changes.3 When the government finalized regulation Sections 1.263(a)-4 and 1.263(a)-5 relating to intangible assets and transaction costs, accounting method changes were only available with a modified adjustment. However, because these changes would relate to currently held depreciable assets for which records likely would be available, it is recommended that adjustments be made available. Further, the government is also considering whether to include guidance regarding the computation of adjustments under Section 481(a), including that separate determinations of approach be permitted for differing items, and whether simplifying conventions should be made available, and whether taxpayers may be permitted to request a cut-off adjustment.
Expansion of the Special Exception for Transaction Costs to All Property Acquisitions
The proposed regulations include a special rule that allows taxpayers to deduct costs incurred to investigate whether to acquire real property and which real property to acquire. It has been suggested that the government consider whether to expand this exception to the acquisition of all property, both real and personal. Unless this rule is expanded, tangible personal property would be the only property for which pre-decisional investigatory costs are required to be capitalized in an acquisition context. The preamble indicates that the exclusion was added so that taxpayers would not be required to undertake complicated allocations of costs. Because taxpayers would still be required to capitalize costs to personal property, complicated allocations of investigatory costs would continue to be required with acquisitions involving both real and personal property and in acquisitions of various personal properties. Consequently, expansion of this exception to acquisitions of all tangible property would enhance the administerability of the rules.
Rule for Acquisitions
The proposed regulations include a de minimis rule that allows taxpayers to immediately deduct the costs of acquiring or producing property for tax purposes applying the de minimis standard adopted in its financial statements, provided that deducting these de minimis amounts does not result in a distortion of income. The regulations provide a quantitative safe harbor for when a de minimis standard is deemed not to distort income. Under the safe harbor, an amount deducted for financial purposes is not distortive if that amount, when added to the amounts deducted in the taxable year as materials and supplies for units of property costing $100 or less, is less than or equal to the lesser of (i) 0.1 percent of the taxpayer’s gross receipts for the taxable year, or (ii) 2 percent of the taxpayer’s total depreciation and amortization for the taxable year as determined in its applicable financial statements.4 As a result, to rely on the de minimis amount established for book purposes, a taxpayer must complete a complicated annual testing. The government is considering whether to eliminate the annual testing and also whether the de minimis standard should be extended to include standards used in IFRS and for taxpayers without applicable financial statements.
These proposed regulations clarify a number of complex and multi-faceted issues. It is anticipated that the regulations, when finalized, will achieve their goals of increasing certainty and reducing controversy consistent with the principles of current law. It is also anticipated that the government will revise some of the positions in the proposed regulations and possibly re-propose a portion of the regulations. Additionally, the government is also working on several projects to address the treatment of repair costs for specific industries. It is anticipated that additional guidance will be issued in the utilities and telecom industries prior to year-end as well. The government’s efforts on this project has been significant and will affect many taxpayers in a range of issues.