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Summary of Tangible Property Regulations

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Understanding the new Tangible Property Regulations

Understanding the new Tangible Property Regulations

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  • 1. Deconstructing the Tangible Property Temporary Regulations Understanding how the new guidance may affect your companyMarch 2012
  • 2. ContentsOverview 2Materials and Supplies 3Amounts Paid to Acquire or Produce Tangible Property 4Amounts Paid to Improve Tangible Property 6Dispositions of MACRS Property 12Transition Guidance – Revenue Procedures 2012-19 and 2012-20 15Large Business and International Division Directive 17Tangible Property Temporary Regulations Automatic Method ChangeGuidance Chart 18Contacts 23 Deconstructing the Tangible Property Temporary Regulations 1
  • 3. Overview Overview On December 27, 2011, the Treasury Department (―Treasury‖) and the Internal Revenue Service (―IRS‖) issued temporary 1 and proposed 2 regulations (―the Temporary Regulations‖) that provide guidance with respect to the treatment of materials and supplies, dispositions of MACRS property, capitalization of amounts paid to acquire or produce (or facilitate the acquisition or production of) tangible property, and the determination of whether an expenditure with respect to tangible property is a deductible repair or must capitalized. Thus, the Temporary Regulations address a broad range of capitalization and deduction issues for expenditures related to tangible property and may likely impact taxpayers in all industries.The Temporary Regulations are generally effective for taxable years beginning on or after January1, 2012; however, a number of provisions are effective for amounts paid or incurred in taxable yearsbeginning on or after January 1, 2012. Early adoption of the Temporary Regulations is not allowed.Changes to comply with or adopt the provisions in the Temporary Regulations generally will bemade through an accounting method change, most of which require the computation of anIRC § 481(a) adjustment. Rev. Proc. 2012-19 and Rev. Proc. 2012-20 provide guidance onimplementing the Temporary Regulations.The Temporary Regulations retain many of the provisions included in the proposed regulationsissued in 2008 (―2008 Proposed Regulations‖ 3); however, there are a number of new provisions andchanges from the 2008 Proposed Regulations as well as changes to pre-January 1, 2012 law. Themajor changes include: Disposition of structural components of a building Rules for determining whether there is an improvement to a unit of property, including the replacement of a major component or substantial structural part of a unit of property Expansion of the definition of ―materials and supplies‖ Revision of the proposed de minimis rule allowing taxpayers to deduct certain amounts that cost less than a minimum threshold amount Numerous examples analyzing a variety of costs incurred to remodel or refresh stores Simplifying conventions for amounts paid that facilitate the acquisition of certain tangible property Replacement of the ―plan of rehabilitation‖ doctrine with a ―benefit or incurred by reason of‖ standard from IRC § 263A Various elections, including general asset account elections that interact with the rules for restorations Material changes to the routine maintenance safe harborThe Temporary Regulations withdraw the 2008 Proposed Regulations and serve as the text of thecurrent proposed regulations. Treasury and the IRS have requested comments on the proposedregulations by April 17, 2012, in advance of the public hearing on the regulations scheduled for May9, 2012.1 T.D. 95642 REG 168745-03 Deconstructing the Tangible Property Temporary Regulations 23 73 FR 47 12838-01
  • 4. Materials and SuppliesMaterials and Supplies As under pre-January 1, 2012 law, incidental materials and supplies (i.e., materials and supplies for which the taxpayer does not maintain a record of consumption or take physical inventories at year end) are deductible when purchased. Non-incidental materials and supplies are deductible when used or consumed. In response to comments received with respect to the 2008 Proposed Regulations, Treasury and the IRS clarify and expand the definition of materials and supplies in the Temporary Regulations by eliminating the requirement that such property not be a unit of property and including a new category of qualifying property. Accordingly, the Temporary Regulations define a material and supply as tangible property used or consumed in the taxpayer’s operations that is not inventory and is: A component acquired to maintain, repair, or improve a unit of tangible property (includes rotable and temporary spare parts); Fuel, lubricants, water, or similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in taxpayer’s operations (new category); A unit of property that has an economic useful life of 12 months or less; A unit of property with an acquisition or production cost of $100 or less; or Property identified in future published guidance.A taxpayer may elect to capitalize and depreciate each material or supply. A taxpayer makes theelection annually by capitalizing the particular material or supply in the taxable year the amounts arepaid and by beginning to recover the costs on its timely filed original federal income tax return(including extensions) for the taxable year the asset is placed in service. A taxpayer may also electannually to treat each material or supply under the de minimis rule (discussed below), provided allrequirements under such rule are met for such material or supply.The Temporary Regulations include special rules for rotable and temporary spare parts (―rotables‖).The default treatment is to deduct rotables when used or consumed (i.e., when disposed of);however, a taxpayer may elect to capitalize and depreciate rotables or elect an optional methodtreatment. Under the optional method, the taxpayer deducts its basis in the rotable in the year it isplaced in service, recognizes income when the rotable is removed, capitalizes costs to fix therotable, and then claims a deduction for such basis when the rotable is once again placed in service.Additionally, otherwise deductible materials and supplies may be subject to capitalization underIRC § 263A, or as an improvement under Temp. Reg. § 1.263(a)-3T. Deconstructing the Tangible Property Temporary Regulations 3
  • 5. Amounts Paid to Acquire or Produce Tangible PropertyAmounts Paid to Acquire orProduce Tangible PropertyAmounts paid to acquire or produce tangible property or to defend or perfect title to such propertymust be capitalized. In addition, a taxpayer must capitalize amounts paid to facilitate the acquisitionor production of tangible property. The determination of whether costs associated with activities arefacilitative is based on facts and circumstances. However, the Temporary Regulations provide a listof inherently facilitative activities that is similar to the list in Treas. Reg. § 1.263(a)-5, and includebidding costs, finders’ fees or brokers’ commissions, and securing an appraisal, among otheractivities.Facilitative CostsUnder the Temporary Regulations non-inherently facilitative pre-decisional investigatory costs paidin pursuing the acquisition of real property are not considered facilitative, and therefore are notrequired to be capitalized, if paid for activities performed in the process of determining whether andwhich real property to acquire. Because this special rule only applies to the acquisition of realproperty, an allocation of facilitative costs between real and tangible personal properties may berequired if both real and tangible personal properties are acquired in a single transaction. Theamount of non-inherently facilitative pre-decisional investigatory costs reasonably allocated to thereal property can be deducted, while costs reasonably allocated to the acquisition of personalproperty must be capitalized.The Temporary Regulations also provide that employee compensation and overhead costs relatedto the acquisition of tangible property are not subject to capitalization under IRC § 263(a); however,such costs may be required to be capitalized under IRC § 263A.De Minimis RuleThe de minimis rule provided in the Temporary Regulations permits a taxpayer to deduct certainexpenditures consistent with the treatment on its applicable financial statement (―AFS‖) subject to aceiling. An AFS is a financial statement provided to the Securities and Exchange Commission(―SEC‖), an audited financial statement used for creditors or other non-tax purpose, or a financialstatement provided to a governmental agency other than the IRS or SEC. To be eligible for the deminimis rule, the taxpayer must have in place at the beginning of the year, a written financialaccounting policy to deduct amounts below a certain dollar threshold and expense amounts on itsAFS consistent with the written policy.The ceiling amount (i.e., the maximum deduction under the de minimis rule) is equal to the greaterof: 0.1% of the taxpayer’s gross receipts for federal income tax purposes, or 2% of the taxpayer’s total depreciation and amortization expense for the tax year reflected on its AFSIf the amount expensed pursuant to the taxpayer’s AFS minimum capitalization threshold exceedsthe ceiling, then no amount is deductible under the de minimis rule. However, the taxpayer may Deconstructing the Tangible Property Temporary Regulations 4
  • 6. Amounts Paid to Acquire or Produce Tangible Propertyelect to capitalize a portion of the amounts expensed under its AFS capitalization threshold so as toallow it to deduct the ceiling amount.For consolidated groups, the determination of whether the taxpayer has an AFS and a written policyto expense amounts below a certain threshold can be made at the consolidated group level. Thedetermination and application of the ceiling amount is made separately for each consolidated groupmember.As noted above, amounts deducted as materials and supplies (discussed above) are not included inthe ceiling computation unless the taxpayer so elects.Practice ConsiderationThe favorable de minimis rule likely comes with an additional compliance burden for taxpayers.Specifically, many taxpayers do not currently track the total amount expensed under theircapitalization threshold. The revised ceiling test, and the flexibility afforded taxpayers in the formof elections, requires that taxpayers track the total amount deducted under the de minimis rule.The preamble to the Temporary Regulations indicates that the issuance of the regulations is notintended to disturb the treatment of minimum capitalization threshold agreements betweenexaminers and taxpayers, provided such agreements clearly reflect income. There is speculationthat the IRS will view the ceiling in the Temporary Regulations as the test in determining whetherthe previously agreed upon minimum capitalization threshold clearly reflects income. Taxpayersshould consider evaluating whether they are capable of capturing the information necessary toapply the de minimis rule and whether amounts deducted pursuant to their present capitalizationpolicies exceed the ceiling.ExampleAssume the taxpayer is a member of a consolidated group that has an AFS and a written policy atthe beginning of Year 1, under which it expenses amounts paid for property costing less than$500. In Year 1, the taxpayer pays $160,000 to purchase 400 computers at $400 each. Eachcomputer is a unit of property, is not a material or supply, and the taxpayer intends to treat the costof only the computers as de minimis. Assume that for its Year 1 taxable year, the taxpayer has taxgross receipts of $125M and book depreciation/amortization of $7M. To be eligible for the de minimis rule, the total aggregate amounts paid and not capitalized by the taxpayer must be less than or equal to the greater of $125,000 (0.1 % of its total tax gross receipts of $125M) or $140,000 (2% of its total book depreciation/amortization of $7M). Because the taxpayer pays $160,000 for the computers and this amount exceeds $140,000, it may not apply the de minimis rule to the total amounts paid for the 400 computers.However, if the taxpayer makes an election to capitalize $20,000 (the amounts paid to acquire 50of the 400 computers purchased in Year 1), it would not be required to capitalize the amounts paidto acquire the 350 computers in Year 1. Deconstructing the Tangible Property Temporary Regulations 5
  • 7. Amounts Paid to Improve Tangible PropertyAmounts Paid to Improve TangiblePropertyFor many taxpayers, the more significant aspects of the Temporary Regulations are the provisionsaddressing the treatment of amounts paid to improve tangible property (i.e., the so-called ―repair‖regulations). The Temporary Regulations generally provide that amounts paid to improve a unit ofreal or personal tangible property must be capitalized. An amount is considered paid to improve aunit of property (―UoP‖) if it results in: (i) a betterment of the UoP, (ii) a restoration of the UoP, or (iii)an adaptation of the UoP to a new or different use.If a type of maintenance is a recurring activity that the taxpayer reasonably expects to perform as aresult of the taxpayer’s use of the UoP (other than a building or structural component of a building)to keep the UoP in its ordinarily efficient operating condition, then the amount paid may qualify forthe routine maintenance safe harbor (discussed below).Definition of Unit of PropertyThe Temporary Regulations provide that unless otherwise specified, the UoP is determined using afunctional interdependence standard, under which the placing in service of one component by thetaxpayer depends on the placing in service of the other component by the taxpayer. Special UoPrules are provided for buildings, leased property, plant property, and network assets.The Temporary Regulations also provide that a component of a UoP must be treated as a separateUoP if that component (i) is properly treated as being within a different MACRS class (as determinedunder IRC § 168(e)) than the class of the larger UoP, or (ii) has been properly depreciated using adifferent depreciation method. This MACRS consistency rule applies during the placed in serviceyear of the asset and in future years (e.g., if the taxpayer completes a cost segregation study).Building and its Structural ComponentsThe Temporary Regulations define a building and its structural components as a single UoP, butrequire that the improvement standards be applied separately to the building structure and thefollowing building systems: Heating, ventilation, and air conditioning systems (HVAC); Plumbing systems; Electrical systems; All escalators; All elevators; Fire protection and alarm systems; Security systems; Gas distribution systems; and Any other structural component identified in published guidance. Deconstructing the Tangible Property Temporary Regulations 6
  • 8. Amounts Paid to Improve Tangible PropertyPractice ConsiderationRoof replacements are a common example used to illustrate the operation of the building UoPrules. The work performed on the roof must be measured against the building structure (definedas the building and its structural components, other than the building systems above) to determinewhether an improvement to the UoP occurs.The requirement to apply the improvement standards to the building structure and buildingsystems is a significant change that will likely result in additional capitalizable improvements.Taxpayers that previously categorized repair expenditures as deductible or capitalizable bycomparing work performed to the entire building should consider changing their method ofaccounting to comply with the Temporary Regulations.Plant PropertyPlant property is "functionally interdependent machinery or equipment, other than network assets,used to perform an industrial process, such as manufacturing, generation, warehousing, distribution,automated materials handling in service industries, or similar activities."The UoP for plant property is initially determined based on the functional interdependence standard.However, the Temporary Regulations provide that functionally interdependent plant property isfurther divided into smaller UoPs based on a component or a group of components that perform adiscrete and major function or operation.The preamble to the Temporary Regulations states, ―The discrete and major function rule provides areasonable and administrable limitation on the functional interdependence standard, whichotherwise could be overly broad in its application to industrial equipment.‖Practice ConsiderationThe discrete and major function standard often results in a UoP smaller than the taxpayer’s UoPunder its present method of accounting. This is particularly relevant for taxpayers whose―industrial process‖ requires that a product move uninterrupted from one end of the production lineto another to produce a salable product. Taxpayers with functionally interdependent productionlines (e.g., aluminum milling or certain chemical manufacturers) often defined the entire line as theUoP under prior law. Taxpayers with plant property that previously categorized repairexpenditures as deductible or capitalizable by comparing work performed to the entire productionline should consider changing their method of accounting to comply with the TemporaryRegulations.ExamplesTaxpayer uses many different machines in an assembly-line like process to treat, launder andprepare linens. Because this equipment is plant property used in an industrial process, each sorter,boiler, washer, dryer, etc. must be treated as a separate UoP.Taxpayer, a restaurant, serves food to customers on its premises. The restaurant employsequipment in an assembly-line like process to prepare and cook tortillas. Contrary to the exampleabove, because this equipment is property that is not used in an industrial process (i.e., it performsa small-scale function in a restaurant), the UoP in this example is the tortilla making equipmentapparatus as a whole. Deconstructing the Tangible Property Temporary Regulations 7
  • 9. Amounts Paid to Improve Tangible Property Network Assets The Temporary Regulations provide that the UoP for network assets is determined by the taxpayer’s particular facts and circumstances or as provided in published guidance (see e.g., Rev. Proc. 2011-27 for wireline network assets, Rev. Proc. 2011-28 for wireless networks assets and Rev. Proc. 2011-43 for electric transmission and distribution property). It is anticipated that the IRS will issue similar guidance for other industries with network assets (e.g., gas transmission and distribution) in the coming year.Leased PropertyA taxpayer that is a lessor of a building or other non-building property applies the general rule fordetermining the UoP and improvements. For a taxpayer that is a lessee of all or a portion of one ormore buildings, the UoP is each building and its structural components associated with the leasedportion of the building. Accordingly, a taxpayer-lessee must apply the improvement standards (asdiscussed below) to the leased building or leased portion of the building and the related buildingsystems. Lessee improvement made to a unit of leased property is a separate UoP. For non-building leased property, the general functional interdependence test applies except that the UoPmay not be larger than the unit of leased property.Practice ConsiderationThe Temporary Regulations provide, for the first time, guidance for units of leased property.ExampleTaxpayer leases two office spaces in the same building under separate agreements. Each officespace contains a separate HVAC unit. The taxpayer must treat the HVAC unit associated with oneleased office space as a building system of that leased space and the HVAC unit associated withthe second leased office space as a building system of that second leased space.Improvement StandardsOnce a taxpayer has determined the appropriate UoP, the next step is to assess whether theexpenditure is an improvement to the UoP resulting in capitalization. As discussed above, anamount is considered paid to improve a UoP if it results in: (i) a betterment of the UoP, (ii) arestoration of the UoP, or (iii) an adaptation of the UoP to a new or different use. The TemporaryRegulations generally require a facts and circumstances analysis to determine whether anexpenditure is an improvement; however, the Temporary Regulations provide a conceptualframework in applying the improvement standards including numerous examples. In applying thestandards, the Temporary Regulations provide that an amount is not necessarily deductible solelybecause the repair is required to comply with regulatory requirements. Additionally, the TemporaryRegulations effectively replace the ―plan of rehabilitation doctrine‖ with the IRC § 263A ―directlybenefit or are incurred by reason of‖ standard.BettermentThe Temporary Regulations provide that, in general, an amount paid results in a betterment of aUoP if it: Corrects a material condition or defect existing prior to the taxpayer’s acquisition of the UoP or one that arose during the production of the UoP, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production; Results in a material addition to the UoP; or Deconstructing the Tangible Property Temporary Regulations 8
  • 10. Amounts Paid to Improve Tangible Property Results in a material increase in capacity, productivity, efficiency, strength or quality of the UoP.The Temporary Regulations provide an appropriate comparison rule instructing taxpayers how toapply the betterment analysis. When a particular event necessitates the expenditure, the analysis isperformed by comparing the condition of the property after the expenditure with the condition of theproperty immediately before the event. If an expenditure is necessitated by normal wear and tear,the condition of the property after the expenditure is compared with the condition of the propertyimmediately after the last time the taxpayer corrected the effects of wear and tear.In determining whether an expenditure results in a betterment, the purpose of the expenditure, thephysical nature of the work performed, the effect of the expenditure on the UoP, and the taxpayer’streatment of the expenditure on its AFS are all considered.Practice ConsiderationThe betterment standard is highly factual, and combined with the revisions to certain UoPdefinitions (discussed above), requires taxpayers to compare the repair cost against the UoP todetermine whether an amount paid results in a betterment to that UoP.Three sequential examples in the Temporary Regulations (as summarized below) illustrate thebetterment standard, including the interplay of IRC § 263A (otherwise deductible amounts must becapitalized if they directly benefit or are incurred by reason of an improvement to a UoP) byanalyzing the refresh and remodel of a chain of retail stores. In relevant part, the examplesconclude that the replacement of bathroom fixtures (e.g., sinks, toilets, etc.) results in acapitalizable betterment to the plumbing system because the replacements result in materialincrease in quality to the plumbing system.ExamplesTaxpayer owns a retail store and periodically refreshes the appearance and layout of its store byreplacing and reconfiguring a small number of display tables and racks, relocating lighting,repairing floors, moving one wall to accommodate the reconfiguration of tables and racks andrepainting the interior structure. Assuming the work does not ameliorate any pre-existing materialconditions or defects, the amounts paid for the refresh of the building are not consideredbetterments because they do not result in material increases in capacity, productivity, efficiency,strength or quality of the building’s structure or building system compared to the condition beforethe refresh. However, amounts paid to acquire and install each display table and rack (i.e. tangiblepersonal property) must be capitalized.In the course of the store refresh, the taxpayer decides to update all the restroom facilities in thebuilding by removing the bathroom fixtures and replacing them with updated ones. The taxpayeralso pays amounts to replace floor and wall tiles that were damaged as a result of the installationof the bathroom fixtures. Because the updated fixtures materially increase the quality of theplumbing system of the building, the amounts paid to replace the fixtures are consideredbetterments and must be capitalized. The replacement of floor and wall tiles must also becapitalized because they directly benefit and are incurred by reason of the improvement to theplumbing system.If the taxpayer decides to substantially remodel the retail store by performing significant additionalwork to alter the appearance and layout of its stores in order to increase customer traffic and salesvolume, then the amounts paid for the remodel result in betterments to the building’s structure andsystem due to the increased efficiency as a result. In addition, the amounts paid to refresh theappearance of the store (above) must also be capitalized because they directly benefit and areincurred by reason of the remodel. Deconstructing the Tangible Property Temporary Regulations 9
  • 11. Amounts Paid to Improve Tangible PropertyRestoration of PropertyIn general, the Temporary Regulations require the capitalization of amounts paid to restore a UoP.For these purposes, restoration includes: Replacing a component of a UoP if the taxpayer has properly deducted a loss for that component (other than a casualty loss under Treas. Reg. § 1.165-7); Replacing a component of a UoP if the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss from the sale or exchange of the component; Repairing damage to a UoP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under IRC § 165, or relating to a casualty event described in IRC § 165; Returning a property to its ordinarily efficient operating condition from a state of nonfunctional disrepair; Rebuilding the property to a like-new condition after the end of its class life; Replacing a major component or substantial structural part of a UoP (where a major component or substantial structural part includes a part or combination of parts that comprise a large portion of the physical structure of the UoP or that perform a discrete and critical function in operation of the UoP).Practice ConsiderationBasis recovery on the disposition of property is a critical component of the restoration improvementstandard. As a result, understanding the disposition rules (discussed below) is important formaking the appropriate asset account elections to maintain flexibility in determining whether toclaim a deduction for a retirement or for a repair.Capitalizable restorations include an otherwise deductible repair when the taxpayer recoversadjusted basis on the disposition of a replaced component or part. If a taxpayer has properly takena basis adjustment as a result of a casualty loss, or relating to a casualty event under IRC § 165,then an amount paid to restore the damaged UoP is a capital expenditure. The impact of therestoration improvement standard and the new disposition rules on casualty losses are furtherdiscussed the disposition and General Asset Account section below.ExamplesAssume a taxpayer decides to replace several non-functional components of its walk-in freezer.The taxpayer abandons the old freezer components and properly recognizes a loss from theabandonment of the components. The taxpayer replaces the abandoned freezer components withnew components and incurs costs to acquire and install the new components. The costs toacquire and install the replacement components are capitalized as a restoration because thetaxpayer replaced components for which it had properly deducted a loss.Taxpayer owns an office building which has a HVAC system containing ten roof-mounted units,controls and air ducts. Due to malfunction, the taxpayer replaces two of the roof-mounted units.The two units do not comprise a large portion of the physical structure of the HVAC system orperform a discrete and critical function in the operation of the system and therefore do notconstitute a major component or substantial structural part of the building system. The taxpayerdoes not recover basis on the retirement of the two roof-mounted units. Accordingly, the taxpayeris not required to treat the amount paid to replace the two units as a restoration of a buildingsystem. Deconstructing the Tangible Property Temporary Regulations 10
  • 12. Amounts Paid to Improve Tangible PropertyAdaption to New or Different UseIn general, a taxpayer must capitalize amounts paid to adapt a UoP to a new or different use. Anamount paid is considered for a new or different use if the adaptation is not consistent with thetaxpayer’s intended ordinary use of the UoP at the time originally placed in service by the taxpayer.For example, the Temporary Regulations provide that in the case of a building, an amount is paid toadapt the UoP to a new or different use if it adapts to a new or different use any of the propertiesspecifically designated in the Temporary Regulations (i.e., buildings, condominiums, cooperativesand leased buildings).Routine Maintenance Safe HarborA routine maintenance safe harbor is provided for routine and recurring activities that a taxpayerexpects to perform as a result of a taxpayer’s use of the property. The safe harbor is not applicableto a building or its structural components or to certain rotables. An activity is considered recurringonly if at the time the property is placed in service the taxpayer reasonably expects to perform theactivity more than once during the Alternative Depreciation System (―ADS‖) class life of the UoP.A taxpayer must take into consideration the recurring nature of the activity, industry practice,manufacturers’ recommendations, the taxpayer’s experience and the taxpayer’s treatment of theactivity on its AFS when determining whether activities are considered routine maintenance. Anactivity is not considered routine and recurring if it results in a betterment or adaptation, is performedon property where a taxpayer has taken into account the adjusted basis of the property (e.g. byclaiming a loss), or if the property is in a state of nonfunctional disrepair prior to the expenditure.Practice ConsiderationThe routine maintenance safe harbor effectively offers relief for certain expenditures that areotherwise capitalizable as restorations. Thus, for example, the routine maintenance safe harbormay allow a deductible repair for what was otherwise a replacement of a major component orsubstantial structural part of a UoP (see definition of restoration above).ExamplesAircraft engines undergo engine shop visits (―ESV‖) on a regular basis. Taxpayer performs ESVduring and after the class life of the aircraft. The costs associated with the ESV are deemed not toimprove the aircraft under the safe-harbor for routine maintenance because the ESV involved thesame routine maintenance activities (that also qualified under the safe harbor) that were performedon the same aircraft engines during their class life.Taxpayer replaced the lining of a container that constitutes 60% of the physical structure of thecontainer. These replacements occur on a regular basis throughout the life of the container.Notwithstanding the substantial nature of the replacement, the costs qualify as repairs activitiesunder the routine maintenance safe harbor. Deconstructing the Tangible Property Temporary Regulations 11
  • 13. Dispositions of MACRS PropertyDispositions of MACRS PropertyUnder the Temporary Regulations, a disposition occurs when ownership of the asset is transferredor when the asset is permanently withdrawn from use. A disposition includes the sale, exchange,retirement, physical abandonment, destruction of an asset or transfers of an asset to a supplies,scrap, or similar account. In a significant change from prior law, the Temporary Regulations providethat the retirement of a structural component of a building is a disposition of MACRS property.Accordingly, the rules for accounting for assets to which IRC § 168 applies and determining the gainor loss upon the disposition of the MACRS property are outlined in the Temporary Regulations.Disposition of an AssetThe Temporary Regulations provide that the facts and circumstances of each disposition areconsidered in determining the appropriate asset disposed. In general, the asset for dispositionpurposes cannot be larger than the UoP. A taxpayer may generally use any reasonable, consistentmethod to treat each of an asset’s components as the asset for disposition purposes unlessspecifically described otherwise.To maintain consistency with the UoP under the improvement standards, each structural componentof a building is the asset for disposition purposes. Under prior law, a taxpayer was precluded fromrecovering basis on the disposal of a component of the building, yet was required to capitalize thecost of the new replacement component. The new disposition rules work with the new restorationrules to provide a more balanced approach. Under the Temporary Regulations, a taxpayergenerally recovers the adjusted basis of the disposed component, but must capitalize repair costsfor which the taxpayer has recovered the basis on the component of the UoP removed during therepair. Deconstructing the Tangible Property Temporary Regulations 12
  • 14. Dispositions of MACRS PropertyPractice ConsiderationThe ability to dispose of a portion of a building is generally a taxpayer favorable provision intendedto alleviate certain inequities that existed in prior law (e.g., a taxpayer who replaced the roof on abuilding was required to capitalize the new roof and also required to continue depreciating the oldroof over the remainder of the 39-year recovery period). Componentization of buildings forpurposes of dispositions allows taxpayers to accelerate the cost recovery of the retired buildingcomponent. As discussed above, the disposition rules significantly impact the operation of therestoration improvement standard. The example highlights the relationship between therestoration improvement standard and the revised disposition rules for structural components.ExampleOn July 1, 2009, a calendar-year taxpayer, purchased and placed in service a multi-story officebuilding that costs $20,000,000. The cost of each structural component of the building was notseparately stated. Taxpayer accounts for the building in its records as a single asset with a cost of$20,000,000. Taxpayer depreciates the building as nonresidential real property and uses thestraight-line method, a 39-year recovery period, and the mid-month convention.On June 30, 2012, Taxpayer replaces one of the building’s elevators. Because Taxpayer cannotidentify the cost of the structural components of the office building from its records, Taxpayer usesa reasonable method that is consistently applied to all of the structural components of the officebuilding to determine the cost of the elevator. Using this reasonable method, Taxpayer allocates$150,000 of the $20,000,000 purchase price for the building to the retired elevator.For Taxpayer’s 2012 Federal income tax return, loss for the retired elevator is the adjusted basis ofthe retired elevator on the date of disposition. Using the straight-line method, a 39-year recoveryperiod, and the mid-month convention, the adjusted basis of the retired elevator on the date ofdisposition is $138,782 (unadjusted depreciable basis of $150,000 less accumulated depreciationallowed or allowable of $11,218 ( $150,000 x 35 months the asset is in service/ 468 total numberof months in the recovery period)). As a result, Taxpayer recognizes a loss of $138,782 for theretired elevator in 2012, which is subject to IRC § 1231.Because Taxpayer recognized a loss on the disposition of a structural component of a building, thecost to replace the elevator is automatically capitalized as a restoration underTemp. Reg. § 1.263(a)-3T(i)(1)(i).General Asset AccountsAs an alternative to the general rule of depreciation is the election to use the general asset accounts(―GAA‖). Under the Temporary Regulations, each GAA is effectively treated as the asset. However,each GAA must include only assets that have the same depreciation method, recovery period,convention and are placed-in-service in the same taxable year. Consistent with the expansion of thedefinition of disposition of MACRS property, the retirement of a structural component of a building isincluded in the definition of the disposition from a GAA and the same methods of identifying theplaced-in-service year of the asset disposed apply.No loss is realized upon the disposition of an asset in a GAA. The disposed asset is treated ashaving an adjusted depreciable basis of zero immediately before the disposition. Therefore, theunadjusted depreciable basis and depreciation reserve of the GAA is unaffected by the disposition.A taxpayer can elect to terminate GAA treatment for an asset in a GAA when the taxpayer disposesof the asset in a qualifying disposition. The Temporary Regulations expand a qualifying dispositionto include generally any disposition (such as a structural component of a building) not involving allassets or the last asset in the GAA. Deconstructing the Tangible Property Temporary Regulations 13
  • 15. Dispositions of MACRS PropertyPractice ConsiderationAlthough a taxpayer is required to recognize the gain or loss on the disposition of structuralcomponents of a building, the GAA election provides a taxpayer the flexibility to choose whether itwants to recover basis on the disposition of the component and recover the related repair cost overthe life of the asset or forgo basis recovery on the disposition and currently deduct the replacementcosts as a repair (assuming the expenditure otherwise qualifies).A taxpayer should also consider whether a GAA election is appropriate to reduce administrativeburden and protect its ability to deduct qualifying repair costs.ExampleAssume the same facts as the above example. If Taxpayer made a GAA election in the placed inservice year of the building, the subsequent removal of the elevator is not a disposition. BecauseTaxpayer does not recover basis through a disposition, the restoration improvement rule does notautomatically characterize the replacement of the elevator as an improvement. Rather, Taxpayermust evaluate the replacement of the elevator against the relevant building system (all of theelevators) to determine if the replacement must be capitalized as a betterment, restoration, oradaptation of the elevator building system.Casualty LossThe government received a number of comments regarding the treatment of expenditures followinga casualty event. A number of taxpayers have historically taken a casualty loss deduction underIRC § 165 and deducted the costs to repair the damaged property under Treas. Reg. § 1.162-4.Under the Temporary Regulations, the damaged part of a property is treated as retired, the basisattributable to the damaged part is recovered, and the damaged part is restored or replaced. Thecosts to restore or replace the portion of property for which the taxpayer has properly taken the basisadjustment as a result of the casualty loss under IRC § 165 is treated as a capital expenditure.The casualty loss rule does not limit a taxpayer’s ability to accelerate the recovery of the basisattributable to the damaged property through the IRC § 165 loss provisions. Instead, it requires ataxpayer to capitalize the costs of restoring the property, with recovery of such costs permittedthrough depreciation over the proper recovery period. The Temporary Regulations permit taxpayers(via the GAA election) to deduct qualifying expenditures as a repair under IRC § 162 rather thanrecover basis as a casualty loss under IRC § 165 (thereby triggering the restoration capitalizationrule). Deconstructing the Tangible Property Temporary Regulations 14
  • 16. Transition Guidance – Revenue Procedures 2012-19 and 2012-20Transition Guidance – RevenueProcedures 2012-19 and 2012-20GeneralOn March 7, 2012, the IRS issued Rev. Proc. 2012-19 and Rev. Proc. 2012-20 (the ―RevenueProcedures‖), which provide procedures for a taxpayer to obtain automatic consent of theCommissioner to comply with the Temporary Regulations. The Revenue Procedures apply fortaxable years beginning on or after January 1, 2012. Accordingly, taxpayers may not early adopt theprovisions in the Temporary Regulations.Complying with the Temporary Regulations generally requires a change in method of accountingunder IRC § 446. Method changes filed under the revenue procedures for a taxpayer’s first andsecond tax year beginning after December 31, 2011, are not subject to the normal scope limitationsthat apply to automatic method changes. Thus, for example, a taxpayer under examination is notprecluded from filing a method change to comply with the Temporary Regulations. Similarly, ataxpayer that made a change for repairs in the prior five taxable years is not precluded from makinga change for the same items under the Revenue Procedures.It is unlikely that a taxpayer’s present methods of accounting for tangible property are in fullcompliance with the Temporary Regulations. Rev. Proc. 2012-19 provides guidance on obtainingautomatic consent for method changes related to repair and maintenance, materials and supplies,capital expenditures, costs to acquire or produce tangible property or costs to improve tangibleproperty. Rev. Proc. 2012-20 provides guidance on obtaining automatic consent for methodchanges related to depreciation, including single, mass or general asset accounts, as well asdispositions of MACRS property.Upon filing a change in method of accounting pursuant to the Revenue Procedures, a taxpayerreceives IRS audit protection on the treatment of such item for taxable years prior to the year ofchange. Additionally, the back-year audit protection effectively stops the IRS from further examiningthe issue covered by the Revenue Procedures. These changes can impact unrecognized taxbenefits for financial statement purposes.IRC § 481(a) adjustmentIn general, accounting method changes made pursuant to the Revenue Procedures are effectuatedwith an IRC § 481(a) adjustment. However, for certain changes (e.g., materials and supplies, deminimis rule, facilitative costs), the IRC § 481(a) adjustment is computed taking into account onlyamounts paid or incurred in taxable years beginning on or after January 1, 2012. Additionally,certain changes are made using a cut-off method (i.e., the new method is applied prospectively) or amodified cut-off method (e.g., the unadjusted depreciable basis and the depreciation reserve for anasset as of the beginning of the year of change are accounted for using the new accountingmethod). The Revenue Procedures also expressly authorize the use of statistical sampling (usingthe sampling methodologies described in Rev. Proc. 2011-42) to compute IRC § 481(a) adjustmentswith respect to accounting method changes for certain items, and to support the item on a tax return Deconstructing the Tangible Property Temporary Regulations 15
  • 17. Transition Guidance – Revenue Procedures 2012-19 and 2012-20(such items include, repair expenditures, materials and supplies, improvements, and certaindispositions).Practice ConsiderationRev. Proc. 2011-42 provides guidance on sampling plan standards, sampling documentationstandards and technical formulas used when applying statistical sampling to substantiate items onthe income tax returns.Concurrent Method ChangesRev. Proc. 2011-14 provides that certain method changes involving an IRC § 263A cost that waspreviously excluded from capitalization must include a concurrent uniform capitalization (―UNICAP‖)method change. As such, Rev. Proc. 2012-19 and Rev. Proc. 2012-20 generally allow a taxpayer tomake a concurrent UNICAP change when it makes a change to comply with the TemporaryRegulations.Practice ConsiderationThe attached chart highlights certain aspects of the accounting method change procedures setforth in Rev. Proc. 2012-19 and Rev. Proc. 2012-20. Deconstructing the Tangible Property Temporary Regulations 16
  • 18. Large Business and International Division DirectiveLarge Business and InternationalDivision DirectiveGeneralOn March 15, 2012, the Large Business and International Division (―LB&I‖) at the IRS issued adirective to discontinue any exam activity relating to positions taken on original returns for tax yearsbeginning before January 1, 2012, relating to—(1) whether costs incurred to maintain, replace, orimprove tangible property must be capitalized under IRC § 263(a); and (2) any correlative issuesinvolving the disposition of structural components of a building or tangible depreciable assets (otherthan a building or its structural components).The directive does not apply to current examination activity relating to costs for which the IRSprovided specific guidance separate from the Temporary Regulations (e.g., Rev. Procs. 2011-27,2011-28, or 2011-43), or issues that do not address capitalization of costs under IRC § 263(a).In addition to directing examiners to cease current exam activity, the directive instructs examiners: Not to begin new exam activity with respect to the issues; If the taxpayer has filed a method change on or after December 23, 2011, for a tax year before the effective date of the Temporary Regulations, to assess and determine whether to review the Form 3115; For examination of tax years beginning on or after January 1, 2012 and before January 1, 2014, to determine if Form 3115 is filed in accordance with the applicable guidance, and if so, to perform the appropriate risk assessment; if no, and the scope limitation period has passed, perform a risk assessment on the issue; and For examination of tax years beginning on or after January 1, 2014, apply the guidance in effect, and perform normal exam procedures. Deconstructing the Tangible Property Temporary Regulations 17
  • 19. Tangible Property Temporary Regulations Automatic Method Change GuidanceTangible Property Temporary RegulationsAutomatic Method Change GuidanceOn March 7, 2012, the IRS issued Rev. Proc. 2012-19 and Rev. Proc. 2012-20, which provide the procedures for taxpayers to obtain automatic consent of theCommissioner to comply with the tangible property Temporary Regulations. Rev. Proc. 2012-19 covers accounting method changes in Rev. Proc. 2011-14, App. §§3.10-3.19 and §§ 10.08-10.10. Rev. Proc. 2012-20 covers accounting method changes in Rev. Proc. 2011-14, App. §§ 6.27-6.32. The following chart provides anoverview of the automatic method changes applicable to the Temporary Regulations.For accounting method changes made pursuant to Rev. Procs. 2012-19 and 2012-20, the following general rules apply: All changes have automatic consent under Rev. Proc. 2011-14; The scope limitations under Section 4.02 of Rev. Proc. 2011-14 are waived for method changes filed for the taxpayer’s first or second taxable year beginning after December 31, 2011; The taxpayer may obtain audit protection for prior years with respect to the item for which the change is requested, provided the taxpayer timely files a copy of the application with the national office, or if applicable the Ogden office, complies with the provisions of the applicable revenue procedures and complies with the provisions of Rev. Proc. 2011-14; For those items impacted by IRC § 263A, taxpayers who are not properly accounting for such items under IRC § 263A, the provisions of Rev. Procs. 2012-19 and 2012-20 are not available for such items, unless the taxpayer concurrently changes to a permissible UNICAP method under Appendix Section 11.01 or 11.02 of Rev. Proc. 2011-14; and A copy of the Form 3115 is to be filed with the Ogden, UT office in lieu of filing a copy with the national office.The chart should be read together with ―Deconstructing the Tangible Property Temporary Regulations‖. The following chart provides a high level overview of theautomatic method changes available under Rev. Proc. 2012-19 and Rev. Proc. 2012-20. Automatic Method Change Guidance Chart 18
  • 20. Tangible Property Temporary Regulations Automatic Method Change Guidance Method Changes for Materials and Supplies Rev. Proc.Rev. Proc. 2011-42 2011-14 Item Being Changed Inapplicability IRC § 481(a) Adjustment StatisticalAppendix § Sampling Change to deduct non-incidental Yes, but includes only amounts paid Does not apply to rotable or temporary spare parts 3.12 materials and supplies when used or incurred in tax years beginning Yes described in Treas. Reg. §1.162-3T(a)(3) or consumed on or after 1/1/2012 Change to deduct incidental Yes, but includes only amounts paid 3.13 materials and supplies when paid or incurred in tax years beginning Yes or incurred on or after 1/1/2012 Change to deduct non-incidental Yes, but includes only amounts paid 3.14 rotable and temporary spare parts or incurred in tax years beginning Yes when disposed of on or after 1/1/2012 Change to the optional method for 3.15 Yes Yes rotable and temporary spare parts Automatic Method Change Guidance Chart 19
  • 21. Tangible Property Temporary Regulations Automatic Method Change Guidance Method Changes for Costs of Acquiring or Producing Tangible Property Rev. Proc.Rev. Proc. 2011-42 2011-14 Item Being Changed Inapplicability IRC § 481(a) Adjustment StatisticalAppendix § Sampling Does not apply to— Change to deduct dealer expenses  Non-dealers in property; or 3.16 Yes No that facilitate the sale of property  Liabilities incurred to facilitate the disposition of assets that constitute a trade or business Does not apply to—  Amounts paid for property that is or is intended Yes, but includes only amounts Change to apply the de minimis rule to be included in inventory; 3.17 paid or incurred in tax years No under Treas. Reg. § 1.263(a)-2T(g)  Amounts paid for land; or beginning on or after 1/1/2012  Start-up expenditures as defined in IRC § 195(c)(1) Change to deduct certain costs for Yes, but includes only amounts Does not apply to start-up expenditures as defined in 3.18 investigating or pursuing the paid or incurred in tax years No IRC § 195(c)(1) acquisition of real property beginning on or after 1/1/2012 Does not apply to— Change to capitalize non-dealer 10.08 expenses that facilitate the sale of  Dealers in property; or Yes No property  Liabilities incurred to facilitate the disposition of assets that constitute a trade or business Change to capitalize acquisition or 10.09 Yes Yes production costs Automatic Method Change Guidance Chart 20
  • 22. Tangible Property Temporary Regulations Automatic Method Change Guidance Method Changes for Improvements to Tangible PropertyRev. Proc. Rev. Proc. 2011-14 2011-42 Item Being Changed Inapplicability IRC § 481(a) AdjustmentAppendix Statistical § Sampling Does not apply to— Change to deduct repair and  A change in method of accounting for Yes, but does not include any amount maintenance costs/Change unit of dispositions of depreciable property, including a attributable to property for which a 3.10 Yes property definition for applying change in the asset disposed of; or repair allowance election under Treas. improvement standards Reg. § 1.167(a)-11(d)(2) was made  Property for which a repair allowance election under Treas. Reg. § 1.167(a)-11(d)(2) was made Does not apply to—  A change in method of accounting for dispositions of depreciable property, including a Yes, but does not include any amount change in the asset disposed of; Change to the regulatory accounting attributable to property for which a 3.11 Yes method  Property for which a repair allowance election repair allowance election under Treas. under Treas. Reg. § 1.167(a)-11(d)(2) was Reg. § 1.167(a)-11(d)(2) was made made; or  Property not subject to regulatory accounting rules Change to the safe harbor for routine Does not apply to— maintenance on property other than 3.19  A building; or Yes Yes buildings or structural components thereof  A structural component of a building Does not apply for any—  Property for which a repair allowance election Yes, but does not include any amount Change to capitalize improvements to under Treas. Reg. § 1.167(a)-11(d)(2) was attributable to property for which a 10.10 made; or Yes tangible property repair allowance election under Treas.  Change in method of accounting for dispositions Reg. § 1.167(a)-11(d)(2) was made of depreciable property, including a change in the asset disposed of Automatic Method Change Guidance Chart 21
  • 23. Tangible Property Temporary Regulations Automatic Method Change Guidance Method Changes for Dispositions & Asset Accounts Rev. Rev. Proc. Proc. 2011-14 Item Being Changed Inapplicability IRC § 481(a) Adjustment 2011-42Appendix Statistical § Sampling Change for the depreciation 6.27 or amortization of leasehold Yes No improvements Only applies to property that is: Change in methods within  Depreciated under IRC § 168; Depending on the change, made with: single, multiple, or general  Depreciated under a method permitted under Treas. Reg.  An IRC § 481(a) adjustment; 6.28 asset accounts, including No §§ 1.168(i)-1T, 7T, or 8T; and  Cut-off method; or dispositions  Owned by the taxpayer as of the beginning of the year of  A modified cut-off method change Does not apply to— Change in method of  Property that is not depreciated under IRC § 168; accounting for dispositions  Property for which the taxpayer made a valid general 6.29 of buildings or structural Yes Yes asset account election under IRC § 168(i)(4); or components  Any multiple buildings, condominium units, or cooperative units that are treated or will be treated as a single building Does not apply to— Change in method of  Property that is not depreciated under IRC § 168; accounting for dispositions  Any building, condominium unit, cooperative unit, of tangible depreciable 6.30 structural component, or improvement or addition thereto; Yes Yes assets (other than a building or or its structural components)  Property for which the taxpayer made a valid general asset account election under IRC § 168(i)(4) Change in method of accounting for dispositions Does not apply to— of tangible depreciable  Property that is not depreciated under IRC § 168; or 6.31 Yes No assets in a general asset  Property for which a valid general asset account election account under IRC § 168(i)(4) was not made  Change made using a modified cut-off method if property is owned by Does not apply to late general asset account elections made taxpayer at the beginning of year of Change to make late general for any taxable year other than the taxpayer’s first or second change 6.32 asset account elections No taxable year beginning after 12/31/2011  Change made with an IRC § 481(a) adjustment if property disposed of by taxpayer as of the beginning of year of change Automatic Method Change Guidance Chart 22
  • 24. Contacts Jane Rohrs Chuck Kosal Director Principal Federal Tax Accouting Strategic Tax Advisory Team Washington National Tax National Federal Tax Services Tel: +1 202 370 2290 Tel: +1 313 396 3604 E-mail: jrohrs@deloitte.com E-mail: ckosal@deloitte.com Bob Kilinskis Partner Federal Tax Accounting Washington National Tax Tel: +1 312 486 9855 E-mail: rkilinskis@deloitte.comThis document contains general information only and Deloitte is not, by means of this document, rendering accounting, business,financial, investment, legal, tax, or other professional advice or services. This document is not a substitute for such professional adviceor services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision ortaking any action that may affect your business, you should consult a qualified professional advisor. Deloitte shall not be responsible forany loss sustained by any person who relies on this document.About DeloitteDeloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee, and its network ofmember firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/about for a detailed descriptionof the legal structure of Deloitte Touche Tohmatsu Limited and its member firms. Please see www.deloitte.com/us/about for a detaileddescription of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under therules and regulations of public accounting.Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries. With aglobally connected network of member firms in more than 150 countries, Deloitte brings world-class capabilities and high-quality serviceto clients, delivering the insights they need to address their most complex business challenges. Deloitte’s approximately 182,000professionals are committed to becoming the standard of excellence.Copyright © 2012 Deloitte Development LLC. All rights reserved.Member of Deloitte Touche Tohmatsu Limited Automatic Method Change Guidance Chart 23