2012 - Issue 1 - Just in time for the holidays, the IRS released new temporary regulations addressing the treatment of expenditures for tangible property. The regulations provide some certainty and help with some administrative concerns, but generally, however, raise new questions and pump more complexity into the system. The changes in the new regulations from the prior versions are significant and will warrant consideration in your company's tax provision and uncertain tax position determinations in the quarter that includes the effective date of the new regulations (i.e., January 1, 2012).
De Minimis Rule
The temporary regulations change several aspects of the de minimis rule from the 2008 proposed regulations. The convoluted "no distortion requirement" is replaced with an overall ceiling that generally limits the total expenses taxpayers can deduct under the de minimis rule. The new "ceiling rule" provides that the aggregate of amounts paid and not capitalized under the de minimis rule for the taxable year must be less than or equal to the greater of (1) 0.1 percent of gross receipts for the taxable year, or (2) 2 percent of depreciation and amortization expense for the taxable year as determined in the taxpayer's applicable financial statement (AFS).
Under the new regulations, a taxpayer can elect not to apply the de minimis rule, and the exceptions from the proposed de minimus rule for property acquired for repairs and improvements are eliminated. However, the de minimis rule does not apply to amounts paid for labor and overhead incurred in repairing or improving property.
Another significant change is that a taxpayer that is without an AFS will be precluded from applying the de minimis rule. However, the temporary regulations provide some relief for a taxpayer without an AFS by providing a deduction for materials and supplies that cost $100 or less.
Additionally, there must be written accounting procedures as part of the AFS that allow for the expensing of items paid for tangible personal property below a certain threshold.
The IRS and the Treasury Department received one comment letter suggesting that the temporary regulations clarify the application of the de minimis rule to a member of a consolidated group. In response, the temporary regulations added a provision that permits a member to use the written accounting procedures provided on the AFS of its affiliated group. The IRS and the Treasury Department intend to give further consideration to the application of the de minimis rule in a consolidated group setting. In this regard, the IRS and the Treasury Department have requested additional comments on the manner in which the de minimis rule, including the de minimis rule limitations, may be applied to, and based on, the tax and financial results of a consolidated group.
Materials, Supplies and Spare Parts
There are some taxpayer-friendly changes included in the new regulations relating to the costs of acquiring materials, supplies and spare parts. Under the new regulations, taxpayers can elect to treat materials and supplies under the aforementioned de minimis rule, relieving taxpayers of a potentially significant record-keeping burden. A taxpayer makes the election by deducting the amounts paid to acquire or produce a material or supply in the taxable year that the amounts are paid and by complying with the requirements for applying the de minimis rule.
There are also new alternative optional methods to account for spare parts. The 2008 regulations required that the cost of spare parts be deducted in the taxable year the parts are disposed of. The new regulations provide for the deduction of the cost of the spare part when it's first installed. If the part is uninstalled and temporarily taken out of service, the fair market value of the part at that time must be included in ordinary income. A cost basis is assigned to the part equal to its fair market value, plus any reconditioning costs. The taxpayer deducts the basis in the taxable year it is re-installed. This cycle continues until the part is ultimately disposed of. The new regulations do not supersede Revenue Procedure 2007-48, so taxpayers can still rely on the depreciable asset safe harbor.
Amounts Paid to Produce Tangible Personal Property
The temporary regulations retained most of the provisions of the 2008 regulations related to amounts paid to produce tangible personal property. For example, the temporary regulations retain the bright-line rule that requires costs incurred for work performed on a unit of property prior to being placed in service be capitalized, dismissing the possibility that some work on property prior to its placed-in-service date may otherwise be a noncapital expenditure. With regard to the treatment of transaction costs, the temporary regulations added a "reasonable allocation" rule to assist taxpayers in making allocations of facilitative transaction costs among personal and real property acquired in a single transaction. Also, the de minimus rule was revised to eliminate the "no distortion" rule, as discussed above.
Amounts Paid to Improve Tangible Property
Most of the changes discussed previously are generally viewed as positive and helpful in relieving some administrative burden from taxpayers. The rest of our discussion highlights significant taxpayer-unfriendly changes that may require accounting method changes and related Section 481(a) adjustments.
One of the most significant areas of change introduced in the temporary regulations is the modification of the unit of property rules relating to a building and its structural components. While the temporary regulations retain the general rule that the unit of property for a building comprises the building and its structural components, the temporary regulations require the taxpayer to apply improvement standards separately to the primary components of the building, i.e., the building structure (e.g., walls, roof, etc.) and its specifically defined building systems (e.g., HVAC, plumbing, electrical, gas, etc.). Thus, a cost is treated as a capital expenditure if it results in an improvement to the building structure or to any of the specifically enumerated building systems.
The new regulations also eliminate the 50 percent threshold tests and recovery period limitation from the 2008 proposed regulations ---- a bright-line test that taxpayers have applied since the 2008 proposed regulations were published to help determine whether a replacement is a major part of the building structure. Taxpayers who applied the 50 percent threshold and therefore expensed amounts paid for structural components that were under 50 percent of the replacement cost of the entire building are likely not in compliance with the new regulations. The new regulations do, however, allow taxpayers to treat the retirement of a structural component of a building as a disposition, thereby allowing the recovery of the remaining basis of a structural component of a building that has been replaced prior to the disposition of the entire building.
As for property other than buildings, the temporary regulations retain the functional interdependence test as the general rule for determining the unit of property. However, the temporary regulations remove the rule requiring taxpayers to treat a functionally interdependent component as a separate unit of property if the taxpayer initially assigned a different economic useful life to the component for financial statement or regulatory purposes. The discrete and major function rule from the 2008 proposed regulations continues to define the unit of property for plant property. Determinations on the unit of property for network assets will be provided through tailored guidance through the Industry Issue Resolution (IIR) program.
The IRS has addressed amounts paid to improve leased property in the regulations for the first time by applying the functional interdependence test to real and personal leased property, other than buildings. One interesting twist in the new regulations is that an improvement of property by a lessor is not considered a unit of property separate from the property being improved, while an improvement by a lessee is considered a separate unit of property.
The IRS theorized that the lessor of property generally should be treated in the same manner as any other owner of property when it makes an improvement to its property. Treating the lessee's initial improvement as a separate unit of property, the IRS theorized, is based on the premise that, when making a leasehold improvement, the lessee should be treated as if it has acquired or produced new property. This new property interest is separate and distinguishable from the lessee's interest in the underlying property.
The new temporary regulations provide guidance on the treatment of improvements to leased property made by both lessees and lessors. The lessee must capitalize improvements except to the extent of any rental allowance under Section 110. The lessor must capitalize improvements paid directly or indirectly through a construction allowance and must also capitalize a lessee's payments for an improvement if such payments constitute a substitute for rent.
Other clarifications in the new regulations are that the leased property rules address both Section 1250 and Section 1245 property. In addition, the "book life consistency rule" was removed as a measure of a unit of property, but the depreciation consistency rule is retained for property, other than buildings. The temporary regulations added a second depreciation consistency rule that applies if a taxpayer or the IRS properly changes the Modified Accelerated Cost Recovery Systerm (MACRS) class or depreciation method for any type of property (for example, as a result of a cost segregation study or a change in the use of the property) in a taxable year after the year the property was initially placed in service.
Under this new rule, the taxpayer must change the unit of property determination for the effected property to be consistent with the change in treatment for depreciation purposes. Thus, for example, if a taxpayer performed a cost segregation study and changed the classification of components in a building from Section 1250 property to Section 1245 property, the taxpayer must use the same classifications to define the unit of property for capitalization purposes.
Costs Incurred During an Improvement
While the temporary regulations deem obsolete the "plan of rehabilitation" doctrine developed under common law, the new regulations retain the general rule from the 2008 proposed regulations for otherwise deductible indirect costs incurred during an improvement but clarify that all indirect costs, including repair and removal costs, are subject to the Section 263A standard. With regard to removal costs, the new regulations do not provide any bright-line test.
The IRS indicated that the costs of removing a component of a unit of property should be analyzed in the same manner as any other indirect cost incurred during an improvement to property. Thus, similar to the treatment of otherwise deductible repair and maintenance costs incurred during an improvement, the costs of removing a component of a unit of property must be capitalized if they directly benefit or are incurred by reason of an improvement to a unit of property.
The new regulations retain the safe harbor from the 2008 proposed regulations for routine maintenance; if repair and maintenance is expected to be done more than once during the IRS class life (not economic useful life) of the unit of property, then the item is considered a repair. The safe harbor under the new regulations applies to all tangible property except buildings. The treatment of maintenance performed on a building is determined using the general rules for improvements discussed above.
The temporary regulations retain the rules in the 2008 proposed regulations. Generally, if an amount paid ameliorates a pre-acquisition material condition or material defect, results in a material addition to the unit of property or results in a material increase in the capacity, productivity, efficiency, strength or quality of the unit of property, the expenditure results in an improvement. Several new examples were added to the temporary regulations to address questions about store refreshing and remodeling costs. The determination of whether such expenditures must be capitalized turns on an examination of all the facts and circumstances.
Another taxpayer-unfriendly development relates to the application of Section 165 casualty losses in conjunction with a Section 162 repair deduction. Consistent with the 2008 proposed regulations, if a casualty loss is taken, the subsequent repair and restoration work must be capitalized under Section 263, with recovery of such costs permitted through depreciation over the proper recovery period. The IRS has provided an "either or" approach. Under the temporary regulations, the taxpayer can elect to forgo the casualty loss in order to obtain Section 162 treatment on the repair and restoration work.
Multiple Asset Accounts
The IRS also addressed grouped assets and the accounting for MACRS assets in the new regulations. If an asset has a personal use component, it cannot be grouped with other like assets and must be accounted for separately. Additionally, to dispose of group assets, taxpayers can use FIFO, or any reasonable method approved by the Secretary of the Treasury. Taxpayers may not use LIFO to account for disposed group assets.
Multiple asset accounts do not need to have the same class but must include assets that have the same depreciation method, recovery period and convention, and that are placed in service in the same taxable year. This is consistent with the 2008 proposed regulations. The temporary regulations added the provision that the assets in the multiple asset account must also be eligible for the same bonus depreciation treatment. Also added in the new regulations is a provision to elect out of general asset account treatment in connection with most dispositions.
Complying with the New Temporary Regulations
A change to comply with the new temporary regulations will be considered a change in accounting method that will require a determination of the related Section 481(a) adjustment. The regulations are effective for tax years beginning on or after January 1, 2012. We expect the IRS will release revenue procedures in the near future that will provide automatic change procedures to comply with these regulations.
Alvarez & Marsal Taxand Says:
Much will be said about these new regulations over the forthcoming weeks, since they affect most business taxpayers. As further information and guidance surfaces, we will provide updates in subsequent editions of Tax Advisor Weekly. If your company or business has opted to conform to the 2008 proposed regulations, especially for expenditures for buildings and their structural components, a thorough review of your capitalization policy in light of these new temporary and proposed regulations is in order. A likely scenario could be that your company will be required to file for an accounting method change in order to comply with these new regulations. Additionally, you will need to be mindful of these regulations in completing your tax provision and uncertain tax position computations effective with the quarter that includes January 1, 2012. Happy New Year folks!