New Regulations Govern Capitalization of Tangible Assets

The IRS has issued the third revision of the proposed regulations on capitalization, this time issuing at the same time identical temporary regulations, in TD 9564.  These regulations would, among other things, attempt to outline rules for determining whether an expenditure was a repair that could be currently expensed, or a capitalized improvement that must be depreciated for tax purposes.

Reg. §1.263(a)-1T outlines general rules for capital expenditures, Reg. §1.263(a)-2T provides provisions related to the acquisition of tangible property while Reg. §1.263(a)‑3T deals with the improvement of tangible property.  Temporary regulations were also added under IRC §§162 (related to materials and supplies, repairs and rentals), 165 (related to obsolescence of nondepreciable property), 167 (related to depreciation), 168 (related to cost recovery), 263A (related to uniform capitalization) and §1016 (related to the basis of assets).

While the temporary regulations roughly follow the 2008 proposed regulations, certain changes were made by the IRS.  As well, this is the first time that the regulations have been concurrently published as temporary regulations (the first two set were published only as proposed regulations).  Many provisions in these regulations will require a change of accounting method involving an automatic change request on a Form 3115 and a §481(a) adjustment.  In the preamble to the regulations the IRS justified a §481(a) adjustment as opposed to a cut-off adjustment to insure the same standards applied to all assets and transactions in a year under examination.

MATERIALS AND SUPPLIES AND ROTABLE SPARE PARTS [Reg. §1.162-3T]

The temporary regulations clarify the nature of materials and supplies.  Generally such items that are “nonincidental” must be deducted against income in the year in which they are used or consumed.  If the materials and supplies are “incidental” they can be expensed in the year in which they are acquired so long as a) no record of consumption is kept by the taxpayer and b) income continues to be clearly reflected even with such immediate expensing. [Reg. §1.162-3T(a)]

Reg. §1.162-3T(b) notes that this regulation does not change the treatment of items under any provision of the IRC, thus if another provision requires an expense to be capitalized the fact that the above rules would allow expensing would not justify such expensing.

Materials and supplies are defined as tangible personal property other than inventory that falls into one of the following categories:

• A component acquired to maintain, repair, or improve a unit of tangible property owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;
• Fuel, lubricants, water, and similar items reasonably expected to be consumed within 12 months;
• A unit of property as determined under § 1.263(a)-3t(e) that has an economic useful life of 12 months or less;
• A unit of property as determined under § 1.263(a)-3t(e) that has an acquisition cost or production cost (as determined under IRC §263A) of $100 or less (or such amount as the IRS may later publish to adjust this figure in the future)

Rotable spare parts are treated differently from other materials and supplies.  Such items are generally treated as expensed in the year in which the taxpayer disposes of such parts.  [Reg. §1.162-3T(a)(3)]  Rotable spares parts are defined as materials and supplies “that are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation.” [Reg. §1.162-3T(c)(2)]  Temporary spare parts are materials and supplies “that are used temporarily until a new or repaired part can be installed and then are removed and stored for later (emergency or temporary) installation.”

The regulations provide an alternative method that can be used for such parts.  The taxpayer can deduct the cost of the parts when the part is first installed.  However if such a part is later removed from a piece of property the taxpayer must include the fair value of the part in income at that point, deducting that amount only when the part is installed in another piece of equipment or is disposed of.  The taxpayer also may not currently deduct any amounts paid to maintain, repair or improve the part, but must add them to the basis of the part.  Both of the permissible methods are considered a method of accounting for income tax purposes, thus a taxpayer must ask for permission before being able to switch from one method to another.

A more generous option than the $100 cost option is available to taxpayers who meet certain criteria, and this option applies to items beyond merely materials and supplies (though the $100 rule is limited to materials and supplies).. A special de minimus rule can be applied by a taxpayer who meets all of the following criteria [Reg. §1.263(a)-2T(g)]:

• A financial statement that is either:
  • Filed with the Securities and Exchange Commission;
  • A statement audited by an independent CPA that is used for credit purposes, reporting to equity holders or for any substantial non-tax purpose or
  • A statement other than a tax return required to be provided to an agency of the federal or a state government (other than the IRS or the SEC)
• The taxpayer had written accounting procedures in place at the beginning of the taxable year treating amounts below a certain figure as an expense for nontax purposes
• The amounts are treated as an expense on the applicable financial statement and
• The total amount of such expensed items are less than or equal to the greater of:
  • 0.1% of federal income tax reported gross receipts for the year or
  • 2% of the taxpayer’s depreciation and amortization expense reported on the applicable financial statement

Note that many privately held entities will not have an “applicable financial statement” under these rules and thus will not qualify for the de minimus method.

The de minimus method cannot be used for amounts in inventory nor for land. [Reg. §1.263(a)-2T(g)(2)]  A taxpayer can elect not to apply the de minimus rule to any unit of property acquired during the year by simply capitalizing the amounts in question on its timely filed Federal income tax return for the year in question.  [Reg. §1.263(a)-2T(g)(4)]

The provisions apply to amounts paid or incurred in taxable years beginning on or after January 1, 2012, though the rotable parts optional method may be applied to taxable years beginning on or after January 1, 2012 (without regard to the years amounts were paid or incurred).

REPAIRS [Reg. §1.162-4T]

The repairs regulation is modified to specify that an item may only be taken as a repair to tangible property if the amounts are not otherwise required to be capitalized, effective for taxable years beginning on or after January 1, 2012.

CAPITAL EXPENDITURES – GENERAL RULE [Reg. §1.263(a)-1T]

The regulation provides the general rule for capitalization in Reg. §1.263(a)-1T(a), noting that except as otherwise provided for in Title 1 of the IRC no deduction will be allowed for:

• Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or
• Any amount paid in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.

Amounts paid to sell property, such as commissions and other transaction costs must be capitalized and treated as a reduction of the amount realized.  The amount is taken into account in which the sale occurs or when the sale is abandoned if a loss is allowed.  The capitalized amount does not add to the basis of the property, nor is it treated as an intangible under the intangible capitalization regulations of §1.263(a)-4. [Reg. §1.263‑1T(d)]

This provision is also effective for years beginning on or after January 1, 2012. [Reg. §1.263-1T(g)]  Changes to comply with these provisions will be treated as a change in accounting method to which §§446 and 481 apply. [Reg. §1.263-1T(f)]

AMOUNTS PAID TO PRODUCE TANGIBLE PROPERTY [Reg. §1.263-2T]

A taxpayer must capitalize amounts paid to “acquire or produce a unit of real or personal property” under this provision.  Such items specifically include:

• Leasehold improvements;
• Land and land improvements;
• Buildings;
• Machinery;
• Equipment;
• Furniture and fixtures

The amount to be capitalized includes the invoice price, amounts paid to facilitate the acquisition or production of the property and costs for work performed prior to the date the unit of property is placed in service (even if such work would have been treated as a repair had the property been in service, per the preamble the regulations).  The general capitalization rules extend to amounts paid to acquire tangible property for resale, or costs to produce such property. [Reg. §1.263(a)-2T(d)(1)]

An amount is treated as paid to facilitate the acquisition of the property if it is paid in the process of investigating or otherwise pursuing the acquisition. [Reg. §1.263(a)‑2T(f)(1)]  The following costs are deemed inherently facilitative under Reg. §1.263(a)‑2T(f)(ii):

• Transporting the property
• Appraisals (or other costs to determine the value or price of the property)
• Negotiation expenses
• Tax advice related to the acquisition
• Application fees, bidding costs or similar expenses
• Preparing documents for the acquisition process
• Examining and evaluating the title for the property
• Obtaining regulatory approval or securing permits
• Costs of conveying the property (such as sales taxes and title registration costs)
• Finders fees and brokers commissions
• Architectural, geological, engineering, environmental, or inspection services
• Services of a qualified intermediary or other facilitator of a §1031 exchange

However, for real property amounts paid to determine which real property to obtain or whether to acquire the property are not considered an inherently facilitating amount.  [Reg. §1.263(a)‑2T(f)(2)(iii)]  Similarly, amounts paid for employee compensation and overhead are also treated as amounts that do not facilitate acquisition of either real or personal property, although a taxpayer may elect to capitalize such amounts.  [Reg. §1.263(a)‑2T(f)(2)(iv)]

Amounts paid to defend or perfect title to real or personal property are considered a cost of acquisition and must also be capitalized.  [Reg. §1.263(a)-2T(e)(1)]

Changes in the treatment of items by a taxpayer are considered a change of accounting method subject to IRC §§446 and 481.  [Reg. §1.263(a)-2T(j)]  Most of this regulation will be applicable to taxable years beginning on or after January 1, 2012.  However, certain portions of the facilitating expense rules (such as inherently facilitating expenses) the regulation applies to amounts paid or incurred in taxable years beginning on or after January 1, 2012.

AMOUNTS TO IMPROVE TANGIBLE PROPERTY [REG. §1.263(a)-3T]

Generally a taxpayer must capitalize expenses paid to improve a unit of property owned by the taxpayer. [Reg. §1.263(a)‑3T(d)]  A unit of property is improved if the amounts paid:

• Result in a betterment of the property
• Restore the unit of property
• Adapt the unit of property to a new or different use

A unit of property is defined in Reg. §1.263(a)‑3T(e).  Generally, each building and its structural components are treated as a single unit of property.  For such buildings, an amount is to be treated as an improvement if the amount paid results to an improvement in any of the following:

• Building structure
• Building systems:
  • HVAC systems
  • Plumbing systems
  • Electrical systems
  • Escalators
  • Elevators
  • Fire protection and alarm systems
  • Security systems
  • Gas distribution systems
  • Other structural components identified by the IRS in published guidance [Reg. §1.263(a)‑3T(e)(2)]

In the case of the owner of a condominium or cooperative, the unit of property is that portion of the building the taxpayer owns (for a condominium) or has rights to possess (in a cooperative). [Reg. §1.263(a)‑3T(e)(2)(iii), (iv)]

For property other than a building, generally, subject to the specified exceptions in the regulation, all the components that are functionally interdependent constitute a single unit of property.  Functional interdependence is defined by looking at whether the placing of in service of one component is dependent on placing in service another component.  [Reg. §1.263(a)‑3T(e)(3)(i)]

The “specially defined” units are listed below:

Plant Property – Such property is compromised of functionally interdependent machinery or equipment, other than network assets (defined next), used to perform an industrial process.  In determining a unit of property in this case, the functionally interdependent group must be further subdivided, going beyond the general rule.  In this case, the unit is each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent group. [Reg. §1.263(a)-3T(e)(ii)]

Network Property – This property is narrowly defined to include “railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective industries.”  However, it excludes any item that would be considered a building structure or building systems under the regulation, as well separate property adjacent to, but not a part of, the network asset.  The determination of a unit of property in these cases is based on the taxpayer’s particular facts and circumstances (unless the IRS provides overriding published guidance).  The functional interdependence test does not serve to determine the unit of property for this type of asset.  [Reg. §1.263(a)‑3T(e)(iii)]

Leased Property Other Than Buildings – The general rule or, if applicable, one of the two special rules above, will apply to such property but with the caveat that the unit of property may not be larger than the unit of leased property.  That is, the leased property could end up being multiple “units” of property under the regulations, but the property itself may not be incorporated into other property to determine a unit of property.  [Reg. §1.263(a)‑3T(e)(iv)]

Regardless of the above rules, a components of a unit of property must be treated as separate units of property if the property belongs to a different MACRS class of property or the taxpayer had depreciated the component using a different method of depreciation than was used on the unit of property of which the component is a part. Similarly, if the taxpayer or IRS changes the determination of the MACRS class of property for the component in a later tax year, the component must be separated from the unit of property of which it was a part of and treated as a separate unit of property. [Reg. §1.263(a)‑3T(5)]

Special rules apply to improvements to leased property, as noted below:

Lessee Improvements – A lessee must capitalize the total amounts it pays to improve a unit of leased property unless IRC §110 (related to construction allowances) applies to the item or where the payment for the improvement constitutes a substitute for rent pursuant to Reg. §1.61-8(c).   The lessee must also capitalize the amount the lessor pays to improve a unit of leased property if the lessee is the owner of the improvement except to the extent that section 110 applies to a construction allowance received by the lessee for the purpose of such improvement.  The amount capitalized as a lessee improvement is a unit of property separate from the leased property.   However any later expenditure to improve the leasehold improvement itself is not a separate unit of property, but rather is considered part of the leasehold improvement under the unit of property rules.  [Reg. §1.263(a)‑3(f)(1)]

Lessor Improvements – A lessor must capitalize amounts it pays to improve a unit of leased property (either directly or via a construction allowance) where the lessor is the owner of the improvement or to the extent that IRC §110 applies to the construction allowance.  The lessor must also capitalize an improvement to the property paid for by the lessee that is a substitute for rent under Reg. §1.61‑8(c). [Reg. §1.263(a)-3T(f)(1)(iii)(A)]   An amount capitalized by the lessor is not treated as a unit of property separate from the leased property.  [Reg. §1.263(c)‑3T(f)(1)(iii)(B)]

Generally a taxpayer must capitalize all direct costs of an improvement and indirect costs that directly benefit or are incurred by reason of an improvement, using the uniform capitalization rules of §263A.  Other costs, such as indirect costs that do not directly benefit and are not incurred by a reason of an improvement are not to be capitalized.  An elective exception exists for property used as a residence.  For such property not used in the taxpayer’s trade or business and not held for the production of income, an individual may capitalize amounts paid for repairs and maintenance that are made at the same time as capital improvements to the residence if paid as part of a remodeling of the taxpayer’s residence.  [Reg. §1.263(a)‑3T(f)(3)]

A single improvement may be the aggregate of related amounts incurred over a period of more than one taxable year.  Such a determination of individual improvements is made based on the facts and circumstances of the situation.  [Reg. §1.263(a)‑3T(f)(4)]

A safe harbor is provided for routine maintenance on property other than buildings in Reg. §1.263(a)‑3T(g).  Such maintenance will be deemed not to improve that unit of property.  Routine maintenance includes the inspection, cleaning, and testing of the unit of property and replacement of parts of the unit of property with comparable and commercially available and reasonable replacement parts.  To be considered such routine maintenance, the taxpayer has to expect to perform these services more than once during the class life (determined for purposes of the alternative depreciation system) of the property in question. [Reg. §1.263(a)-3T(g)]

Regardless of the above, routine maintenance does not include any of the following:

• Amounts paid for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165-7).
• Amounts paid for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component.
• Amounts paid for the repair of damage to a unit of property for which the taxpayer has taken a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165.
• Amounts paid to return a unit of property to its ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use.
• Amounts paid for repairs, maintenance, or improvement of rotable and temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under § 1.162-3T(e). [Reg. §1.263(a)‑3T(g)(3)]

Generally a taxpayer must capitalize amounts that result in a betterment of the unit of property as defined in Reg. §1.263(a)-3T(h).  An amount paid results in a betterment only if the expenditure:

• Ameliorates a material condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;
• Results in a material addition (including a physical enlargement, expansion, or extension) to the unit of property; or
• Results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, strength, or quality of the unit of property or the output of the unit of property. [Reg. §1.263(a)‑3T(h)(1)]

For real property, a betterment occurs if there is an improvement in either the building structure or any of the enumerated building systems noted above, even if there is not a betterment in the building taken as a whole.  [Reg. §1.263(a)‑3T(h)(2)]

The determination of whether there has been a betterment is based on the overall facts and circumstances of the situation.  Factors to consider include:

• Purpose of the expenditure
• Physical nature of work performed
• Effect of the expenditure on the unit of property
• Taxpayer’s treatment of the expenditure on its applicable financial statement

As well, other factors that appear relevant in the particular case should also be considered.  [Reg. §1.263(a)‑3T(h)(3)(i)]

If a taxpayer is unable to obtain a comparable replacement part (due to technological advancements, product improvements, etc.), the mere fact that the part is replaced with an improved part will not, by itself, cause an expenditure to be treated as a betterment of the property.  [Reg. §1.263(a)‑3T(h)(3)(ii)]

If a particular event (such as the failure of a part) necessitates the expenditure, a comparison to determine if a betterment has taken place is made by comparing the condition of the property immediately after the expenditure with that immediately before the circumstance triggering the need for the expenditure.  If that event was normal wear and tear, the comparison is made to the property immediately after either the last time the maintenance for wear and tear was performed or, if such maintenance has not previously taken place, with the condition of the property when placed in service by the taxpayer.  [Reg. §1.263(a)‑3T(h)(3)(iii)]

Expenditures to restore a unit of property must be capitalized.  For purposes of these rules an amount is paid to restore a unit of property only if it:

• Is for the replacement of a component of a unit of property and the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165-7);
• Is for the replacement of a component of a unit of property and the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
• Is for the repair of damage to a unit of property for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165;
• Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
• Results in the rebuilding of the unit of property to a like-new condition after the end of its class life; or
• Is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property. [Reg. §1.263(a)‑3T(i)(1)]

As with betterments, with restorations of buildings the rules are applied to either the building structure or any of the enumerated building systems, with a restoration of either having to be capitalized.  [Reg. §1.263(a)‑3T(i)(2)]

Restoration to a “like-new” condition occurs if the unit of property is brought to “the status of new, rebuilt, remanufactured, or similar status under the terms of any federal regulatory guideline or the manufacturer’s original specifications.” [Reg. §1.263(a)‑3T(i)(3)]

The test or replacement of a major component or substantial part of a unit of property is a facts and circumstances test, including both the qualitative and quantitative significance of the replaced component(s) in relation to the unit of property taken as a whole. A major component or structural part “includes a part or combination of parts that comprise a large portion of the physical structure of the unit of property or that perform a discrete and critical function in the operation of the unit of property.” [Reg. §1.263(a)‑3T(i)(4)]

Adapting a property to a new or different use involves an adaption that “is not consistent with the taxpayer’s intended ordinary use of the unit of property at the time originally placed in service by the taxpayer.”  Again for buildings this test is applied to the building structure and any of the building systems separately.  [Reg. §1.263(a)‑3T(j)]

Taxpayers subject to the regulatory accounting rules of the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB) may elect to use the optional regulatory accounting method.  A taxpayer must use this method for determining capitalized expenditures as opposed to repair expenditures for all property subject to the regulatory accounting rules and bases the determination on the position taken for regulatory accounting purposes.  [Reg. §1.263(a)‑4(k)]

The IRS has also reserved to itself the ability to outline new repair allowance methods by publishing them in the Federal Register or in an Internal Revenue Bulletin.  [Reg. §1.263(a)‑4(l)]

The temporary regulation applies to taxable years beginning on or after January 1, 2012 [Reg. §1.263(a)-4(p)].  The items covered in this regulation are methods of accounting subject to IRC §§446 and 481.  Taxpayers changing their accounting methods to comply with this regulation will need to obtain the consent of the IRS to the change of method.

Conforming changes are made to the regulations under §§168 and 263A to take into account this guidance.

Each of the regulations have numerous examples illustrating the applications of the provisions.  Taxpayers should review those examples as they attempt to implement this new capitalization vs. expense regulation.  As well, taxpayers need to review what changes, if any, need to be made to capitalized assets and/or their own capitalization procedures to comply with the new regulation.

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