IRS Issues Regulations on Tangible Property Repairs
The Internal Revenue Service has released a long-awaited set of temporary and proposed tangible property repair regulations that could have a significant impact on a wide array of industries.
Utilities, telecommunications companies, manufacturers, retailers, real estate companies and other types of businesses could be affected. The proposed tangible property regulations under Section 263(a) of the Tax Code were issued in temporary form, so affected taxpayers are required to comply with them.
Many parts of the regulations impose a Section 481(a) adjustment. In addition to clarifying and expanding the current standards under 263(a) for repairs and improvements, the temporary regulations cover a broad range of other tangible property acquisition issues, including a definition of materials and supplies, and a de minimis capitalization threshold, according to an analysis by Ernst & Young. The temporary regulations also provide guidance under Section 168 and amend the general asset account regulations.
“The extensive proposed and temporary regulations announced today by the IRS will affect all taxpayers that acquire, produce or improve tangible property,” said Susan Grais, executive director of Ernst & Young LLP’s Federal Tax Services Group in Washington, D.C. “The new rules broadly impact companies across a diverse range of industries, including real estate, retail and manufacturing. A timely dedication of resources will be needed to comply for 2012. Because the regulations are issued in temporary form, affected taxpayers must comply. The regulations generally are applicable to tax years beginning on or after Jan. 1, 2012. The IRS last proposed the regulations under Section 263(a) in 2008. The prior draft regulations were not effective at the time (unlike the present rules).”
She noted that the regulations will likely be followed by one or more revenue procedures in January with transition rules covering areas such as whether and when to file an accounting method change, how to implement an accounting method change that may be required by the new regulations, and what the terms and conditions of those accounting method changes will be.
“These are probably the most broad-ranging guidance in terms of the breadth of the new rules and the taxpayers that they may affect across industries,” said Grais. “They are probably the most comprehensive set of rules issued related to fixed asset accounting for federal tax purposes, in my view, since the 1986 Tax Reform Act.”
An important part of the regulations addresses whether repairs to tangible property or capital are alternatively currently deductible, Grais noted. Other aspects of the regs address different issues such as how the retirement of components of tangible property are to be taken into account, such as buildings, manufacturing equipment and other equipment used in a business.
“Any entity that incurs repair and maintenance costs will be impacted by these regulations,” said Grais.
The regulations have been in the works for at least seven years. The IRS issued a notice in 2004 indicating that it planned to issue guidance on the matter after a number of cases had gone to court. In 2006, the IRS issued the first set of proposed regulations addressing the treatment of tangible property, and in 2008 the Service re-proposed the regulations.
“The IRS put a notice out in 2004 in response to a lot of litigation going on at that time,” said Eric Lucas, a principal in KPMG’s Washington National Tax Practice, who was formerly a Treasury official and helped draft the new regulations. “They said, ‘Help us taxpayers and practitioners interpret the improvement and capitalization standards, and tell us how we can define these rules so that there is less controversy in this area.’" Comments were submitted in response to that notice, and the IRS put out the first set of proposed regulations in 2006. Those were pretty widely criticized, so the IRS put out another set of proposed regulations in 2008, he noted.
“I was part of the team when I started at the Treasury in September 2008,” Lucas added. “There were 10 of us, including members from the IRS commissioner side, members from the IRS national office, and there were two of us from Treasury that participated on the working group that reviewed all of the comments, briefed the decision makers, and basically worked through the draft of what we have now in the current version of the proposed regs. These regs are temporary and will be effective for taxable years starting on or after Jan. 1, 2012. But they’re proposed, so there’s still an opportunity to comment.”
Grais noted that because the rules are so comprehensive and lengthy, it may take some time for companies to implement them in their fixed asset systems, and the IRS had been considering giving companies a choice of which year to implement the changes, as it did in a revenue procedure issued earlier this year for the utility industry.
“It may require some modifications to what taxpayers are currently doing in terms of accounting for these costs for tax purposes, and collecting information relative to the determination of whether these costs are capital or alternatively currently deductible in the year that they are incurred,” she said. “Typically, what would happen is if the repair cost is not deductible in the year incurred, it would be capitalized and depreciated. For example, if you had a machine and you perform a capitalizable repair on the machine, that additional repair cost would be capitalized and depreciated over the appropriate recovery period for tax [purposes]. If it’s a deductible repair cost, obviously you would get that deduction up front in the tax year incurred.”
There has been considerable controversy over the years between the IRS and taxpayers over whether repairs or capital were currently deductible, and the regulations were originally proposed as a way to address that.
“There is an abundance of case law involving controversies between the IRS and taxpayers over whether repairs are capital or not,” said Grais.
One of the most prominent cases involved Federal Express and the deductibility of aircraft maintenance expenditures. “That’s just one example of many cases going back many decades,” she said. “It’s an ambitious project for the Service to undertake to try to clarify this area, and I think the length of the regulations demonstrates that there is some complexity. I think companies across industries will be required to consider how these rules impact them, and they’re going to have to devote resources to doing that.”
Grais noted that there has been a significant level of interest in the rules from E&Y’s clients. “Because there have been two sets of proposed regulations, taxpayers have been on notice that these rules were forthcoming,” she said. “Over a number of years while all this guidance has been developing, there’s been an increase, generally speaking, in IRS examination activity of repair and maintenance expenditures. There also has been an increase by taxpayers in filing accounting method changes before these regulations were issued to change their treatment of repair and maintenance costs, so there’s been activity on both sides.”
KPMG’s Lucas noted that the IRS has offered industry-specific guidance in the meantime that has provided safe harbors for some industries such as utilities. “Taxpayers in those industries had the option of going to those safe harbors, I think, in 2010 or 2011,” he said. “If they did that, they received some benefit from doing it early, but basically those were just optional. These [new] regulations are effective for 2012, and there was no option to apply them earlier in 2011. But the regs do say they are implemented with a 481 adjustment. What that means is that you apply the new rules in 2012, but you have to adjust all of your opening accounts as if you had been on the new regulations. You would take into account the adjustment in the year of change—it may be positive or it may be negative—so that basically you true up all of your accounts at the beginning of the year.”
Companies, therefore, will need to implement the changes for the 2012 tax year. When the transitional guidance comes out, Lucas anticipates the IRS will treat these as automatic method changes, although he added that’s not clear yet. If that’s the case, taxpayers would be able to file the method change anytime before they file the tax return for the year.
Generally speaking, calendar-year taxpayers for 2012 would have until September 2013 to file the method change, he noted, but he added that the word is not out yet officially from the IRS. The Service will probably include that information in the two revenue procedures that are expected to come out soon spelling out the details on transitioning to the temporary regulations.
Lucas is telling clients that it’s a good idea to start earlier rather than later on the changes, although he noted there is some flexibility. “These regs do provide some more flexibility in certain areas that they will want to look at to help them decide how they want to account for certain assets,” he said. “It’s not urgent as of now, but they have to start looking through their accounts through 2012.”
He believes the new regulations will help reduce some of the litigation and controversy that occurred before the advent of the proposed regulations.
“Some of the standards in these new rules will still require factual analysis,” said Lucas. “We thought about bright-line objective rules, and it was difficult to put those into the regs because they may work well for one industry, but they don’t work well for another industry. There still is going to be some factual analysis. We tried to illustrate the application of the rules through more detailed examples.”
Lucas noted that the IRS commissioner’s side has been very willing to take on Industry Issue Resolution requests for specific industries, such as the telecom industry and electric transmission industry. “They put out those specific safe harbors where they gave them bright-line rules,” he said. “Now that these regulations are out, I’m pretty certain that they will continue to be more receptive to putting out industry-specific guidance. The retail industry is one that has wanted IIR guidance. The bright-line tests are really more suitable for industry-specific guidance.”
Lucas pointed out several significant changes in the latest version of the regulations, including the application of the improvement standards to building property. “Under the new rules, the improvement standards have to be applied to the major systems within a building or the major components, rather than the entire building, which is what the 2008 proposed rules did,” he said. “For example, when determining whether an expense has to be capitalized, you apply the improvement standards to either the heating and air conditioning system, the plumbing system, the electrical system, escalators, elevators, etc., rather than applying them to the entire building. That’s likely to result in more capitalization, at least relative to the 2008 proposed rules.”
Another significant change in the new regulations is that taxpayers can now take retirement losses on components of the building. “For example, if you replace the roof on a building and dispose of the old roof, you now have the option to allocate basis and take a retirement loss for the old roof," said Lucas. "You have to capitalize the replacement, but you can at least take a retirement loss. That’s a significant change relative to 2008 as well.”
The final significant change Lucas sees involves the de minimis expensing rule. “That’s an expensing rule that says if the taxpayer expenses the acquisition cost of property on his books for financial reporting purposes, and it has a written policy in place to do that, it can deduct the amount for tax purposes, but up to a threshold or ceiling,” he said. “The new regs allow all categories of materials and supplies to be eligible for the de minimis expensing rule, whereas under the 2008 [proposed regulations], they were not eligible, or only some categories were.”
The rule for when a taxpayer could get a deduction for materials and supplies has generally been when they are used or consumed in the trade or business, not when they’re purchased, he noted. Taxpayers would need to wait until the materials and supplies were actually used in the business before they could be deducted if they don't expense them under the de minimis rule.
“The [new] regulations define, I think, five categories of property that are treated as materials and supplies,” said Lucas. “All five categories of materials and supplies can now be expensed under this de minimis expensing rule, which generally would only apply to acquisitions of property of assets by itself, not materials and supplies. If you qualify to use the de minimis expensing rule for your materials and supplies, then you deduct them in the year they are purchased rather than the year they’re used in the business. It allows taxpayers a lot more flexibility to account for the different types of property.”