2013-Issue 53—The release of the much anticipated final “repair” regulations (Treasury Decision 9636) in September probably stands as the most significant federal tax development of 2013. At over 200 pages in length, the regulations cover a gamut of capitalization questions that are expected to affect nearly every taxpayer.
As a new year approaches for calendar-year taxpayers, companies of all sizes should be reviewing their compliance policies and procedures to ensure that they are ready for the January 1, 2014 effective date.
While the basic structure and requirements within the 2011 temporary regulations remain intact, the final regulations refine and simplify some of the rules and create a number of new safe harbors. The stated purpose of the regulations was to reduce confusion, but the resulting regulations are inherently complex because of the broad range of areas they cover, added compliance requirements and the already heavy burden of properly accounting for fixed assets. The following discussion provides a brief summary of the major aspects of the final regulations as well as a compliance checklist to prepare for the impending changes.
The final regulations follow the basic outline of the proposed and temporary regulations, with changes made in each of the following five areas:
- De minimis safe harbor election;
- Routine maintenance safe harbor (for the improvement of tangible property);
- Materials and supplies;
- Dispositions; and
- Effective dates.
The following discussion summarizes the major changes in each of these areas, as well as key compliance considerations.
De Minimis Safe Harbor (Reg. 1.263(a)-1(f))
One of the more notable provisions in the regulations is the de minimis safe harbor permitting taxpayers to deduct certain amounts paid for tangible property. The final regulations replace the ceiling amount from the temporary regulations with a new safe harbor determined at the invoice or item level. A taxpayer with an applicable financial statement (AFS) may rely on the safe harbor if the amount paid for the item or invoice does not exceed $5,000. The final regulations clarify that the $5,000 must include transaction and additional costs included on the invoice that are part of the cost of property (e.g., shipping or installation). It should be noted that the $5,000 amount is only a safe harbor, so it may be higher in certain circumstances if consistent with a taxpayer’s AFS.
This provision should generally be beneficial to all taxpayers since it now formalizes the unwritten rule of deducting lower-dollar tangible property. However, the processes required to implement this change on an item basis are likely to be time-consuming.
Key compliance considerations:
- Taxpayers must have a written policy in place at the beginning of the taxable year (note: the written policy must be in place by year-end, so as of December 31, 2013 for calendar-year taxpayers).
- The written policy must be consistent with expensing in applicable financial statements.
- An irrevocable election to apply the de minimis safe harbor must be made annually on a timely filed tax return (including extensions).
- The amount paid for the property must not exceed $5,000 per item on an invoice (if substantiated by item on the invoice).
- Taxpayers may amend for 2012 and 2013 if a written policy was in place.
To take advantage of the de minimis safe harbor, taxpayers must establish a written expense policy for both book AND tax purposes by the beginning of their financial year in order to be able to claim the deduction on a current-year tax return. This threshold applies per invoice (or separately stated items on an invoice), meaning taxpayers will need to be able to substantiate each expensed item via supporting purchasing documents, invoices, general ledger detail or other relevant information. Taxpayers without applicable financial statements may deduct up to $500 per item if a written policy is in place.
Routine Maintenance Safe Harbor
Another significant change was made to the final regulations for amounts paid for the improvement of tangible property. In particular, the routine maintenance safe harbor was extended to include real property (buildings and building systems) as requested by many commentators. The final regulations use 10 years as the period of time in which a taxpayer must reasonably expect, at the time the property is placed in service, to perform more than once the relevant maintenance activities.
The final repair regulations also provide that the “unit of property” (UOP) standard must now be applied to both a building and its specified systems. This “componentization” of a building into multiple units of property generally requires that the improvement standards be applied separately to each specifically defined building system.
Amounts incurred for activities that do not meet the routine maintenance safe harbor are subject to analysis under the general rules for improvements. The final repair regulations require taxpayers to capitalize amounts paid to improve a unit of property that meet any of three classifications: a “betterment,” a “restoration” or an “adaptation” of existing property to a new or different use.
- A “betterment” is an expenditure that improves a previously existing material condition or defect, a material addition or increase in capacity, or a cost that is reasonably expected to increase productivity, efficiency, quality, strength or output.
- A “restoration” is rebuilding a unit of property to a like-new state. If the repairs are due to a unit of property being damaged in a casualty, costs should be capitalized up to the adjusted basis of the property, allowing for additional costs to be deducted if they can be treated as repair costs.
- An “adaptation” is when a taxpayer adapts a UOP to a new or different use other than the ordinary intended use at the time the UOP was placed in service.
The routine maintenance safe harbor also does not apply to network assets or certain rotable spare parts. While the repair standards apply separately to each UOP, the final regulations provide that taxpayers may make an election to capitalize repair costs that are capitalized on their books and records.
Key compliance considerations:
- Taxpayers should determine how they will identify and separate a “building” from its separable UOP subsystems based on their books and records. For example, taxpayers must review non-building property for functional interdependence, components that perform a “discrete and major” function, and other facts and circumstances that may be applicable to determining whether property placed in service is a major component or a substantial structural part.
- Taxpayers must consider how the acceleration of expenditures will impact other aspects of their tax return.
- Taxpayers should consider whether to elect to conform to their books and records regarding the capitalization of amounts paid for repair and maintenance costs. This is an annual election that is irrevocable. It applies to all amounts paid for repair and maintenance that are capitalized for book purposes. This election may be made back to 2012 through amended returns.
The UOP definition is complex. An upcoming edition of Tax Advisor Weekly will be dedicated to analyzing the UOP concept and its practical application based on the final regulations.
Materials and Supplies (Reg. Sec. 162-3)
The final regulations expand the definition of materials and supplies (M&S) to include property that has an acquisition cost of $200 or less. This is an increase over the $100 in the temporary regulations. Incidental M&S are deductible when paid or incurred, while non-incidental materials and supplies are deductible in the tax year they are first used or consumed. Additional characteristics of M&S are further clarified to be non-inventory tangible property used or consumed in the taxpayer’s operations that:
- Has a useful life of 12 months or less;
- Costs less than $200;
- Consists of fuel, lubricants, water and similar items; or
- Is previously identified by the IRS in a published guidance.
The final regulations also more clearly coordinate the general de minimis safe harbor rule (discussed above) and the de minimis safe harbor for materials and supplies. To simplify the application of the de minimis safe harbor rules, the final regulations require that the general de minimis safe harbor be applied to all materials and supplies if the taxpayer elects the de minimis safe harbor election under 1.263(a)-1(f)). However, the final regulations limit how this provision is applied to certain rotable, temporary or standby emergency spare parts.
Key compliance considerations:
- A taxpayer that made an election to capitalize certain materials and supplies (rotable spare parts, temporary spare parts or standby emergency spare parts) under prior guidance must obtain IRS consent to revoke that election before it may dispose of the property by transferring it to a supplies account.
- If a taxpayer elects the general de minimis safe harbor, it automatically is applied to materials and supplies as well. Supplies that fit under the de minimis rule must be accounted under that rule.
- The amount paid for the property must not exceed $200 per item on an invoice (if substantiated by item on the invoice).
- Taxpayers may amend for 2012 and 2013 if a written policy was in place.
In addition to the final repair regulations, the IRS also released a new set of proposed regulations surrounding the disposition of various classifications of property. These 2013 proposed regulations provide for significant changes relating to determining the treatment of dispositions of buildings and structural components. Because of their far-reaching impact, the proposed regulations could affect all taxpayers that dispose of MACRS property. A building (not a structural component) is treated as an asset for disposition purposes. Under the proposed regulations, taxpayers may elect to apply the partial disposition rule to achieve more flexibility in claiming a loss on a partial disposition.
Perhaps the most significant changes in the proposed regulations are the new rules related to partial dispositions of assets included in a single-asset account, in a multiple-asset account or in a general-asset account (GAA). The partial disposition rules would generally be elective except for certain specified rules. The disposition rules also apply to a partial disposition of an asset included in a GAA.
In an effort to relieve some of the burden associated with the disposition process, taxpayers may make a GAA election. Such an election allows a taxpayer to place similar assets into a GAA, effectively treating the GAA as an asset. However, under the GAA, no loss on disposition is recognized until all assets in the GAA have been disposed of. The definition for qualifying dispositions is now more restrictive under the proposed regulations, so taxpayers should carefully consider whether to make a GAA election if the goal is to claim losses of partial replacements.
Key compliance considerations:
- Forthcoming IRS revenue procedures should clarify whether the IRS would permit a taxpayer to revoke GAA elections made under prior guidance (e.g., Rev. Proc. 2012-20).
- Taxpayers should consider going forward as to whether GAA elections make sense given the restrictive nature of the definition of qualifying dispositions under the 2013 proposed regulations.
- A taxpayer that made an election to capitalize certain materials and supplies (rotable spare parts, temporary spare parts or standby emergency spare parts) must obtain IRS consent to revoke that election before it may dispose of the property by transferring it to a supplies account.
The final regulations are generally effective for taxable years beginning on or after January 1, 2014. Taxpayers must choose whether they want to early adopt the final regulations for tax years beginning on or after January 1, 2012. If they choose to early adopt the regulations with transitional relief, an amended federal tax return for 2012 or 2013 must be filed on or before 180 days from the extended due date of the taxpayer’s federal tax return for such year. Taxpayers also have the option to early adopt the temporary regulations for the same years, so a decision must be made as to which set of regulations is more effective.
Preparing for the Changes
Given the late-year release of the final repair regulations, taxpayers have been left scrambling to identify areas of primary relevance. Promised IRS guidance on the impact of accounting methods is still pending as of the date of this article and is expected in January 2014. The following are some of the key considerations taxpayers should be looking at now:
- What is the impact of the final regulations for 2014 and future years? Financial statement auditors will likely require an analysis of the impact.
- What is the impact of early adoption of temporary or final regulations for tax years 2012 and 2013? Which set of regulations are more beneficial?
- How will the changes to the UOP definitions impact the imposition of a Section 481(a) adjustment to conform to the final repair regulations?
- What book policies or procedures are already in place for expensing purchased property up to a specified dollar amount?
- What kind of impact would an increase to an expense policy limitation for tax (i.e., up to the $5,000 de minimis rule) have on the financial statements (e.g., an increase from $2,000 to $5,000)?
- Do the benefits of a full $5,000 policy under the final repair regulations outweigh any lost benefits from a financial statement perspective? Keep in mind that any changes to existing policies for financial statement purposes will most likely require coordination between members of the taxpayer’s internal financial reporting personnel and the external auditors.
- Will a reduction in taxable income due to adopting the final regulations affect permanent items in a taxpayer’s return (e.g., the taxable income limitation for the Section 199 deduction)?
- Does this potential loss in other deductions or increases to revenue recognition make the election to follow book capitalization more appealing?
- How will these adjustments affect a taxpayer’s corporate effective tax rate (ETR) as referenced above, for example, with respect to the impact on Section 199?
- What kind of disclosures should be made from a financial statement perspective?
- What elections should be made on (and statements filed with) the tax return?
Taxpayers should also conduct a state-by-state analysis of the impact of the final regulations. State taxable income is generally tied to federal taxable income, so a state’s conformity to the IRC and related regulations determines whether a new federal law or regulation is adopted by the state. State conformity can be based on a fixed date, rolling dates or selected adoption of provisions. To the extent the final regulations are not adopted (or only partially adopted) by a particular state, a taxpayer will have to address a variety of issues, including basis discrepancies and financial statement implications related to state income tax obligations.
Alvarez & Marsal Taxand Says:
The final regulations address a broad range of capitalization and deduction issues related to tangible property and may likely affect taxpayers in all industries. Although compliance with the final regulations is not required until tax years beginning January 1, 2014 or after, taxpayers should review the impact of the regulations for financial reporting purposes and to ensure that procedures are in place to appropriately track compliance on a going forward basis.
Taxpayers also should be reviewing their tax situation to determine whether they should early adopt provisions of the regulations or otherwise use the inherent flexibility of the regulations to accelerate or slow deductions for planning purposes. The final regulations have a number of elections that must be made annually on an original tax return, so taxpayers should undertake a thorough analysis of the impact on their tax filing position. As the new year begins, now is the time to ensure that the appropriate process changes are made and that the impact of the regulatory changes on the tax provision is well understood.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.