temporary repairs regulations (section 263(a))

TemporaryRepairs

Regulations Bob Montes, ASA

Principal, Tangible Asset Valuation Datawise Design, Inc.

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2013DatawiseDesign,Inc.–TemporaryRepairsRegulations(Section263(a))Notice:ThisdocumentwasnotintendedorwriFentobeused,anditcannotbeused,for

thepurposeofavoidingU.S.federal,stateorlocaltaxpenalties.

Overview Contents •  Notice 2012-73 delays effective date of

Temporary Regulations effective for taxable years beginning on of after Jan. 1, 2014

•  IRS will modify portions of Temp Regs related to De Mininis amounts, Dispositions, and Routine Maintenance Safe Harbor in 2013

•  Rev Proc 2012-19 (M&S, Capital Expenditures, Transaction Costs, and Improvements) and 2012-20 (Leased Property, GAA, MACRS Property, Dispositions of MACRS Property) provide guidance including Sec 481(a) method changes

•  Rev Proc 2012-20 permits late-GAA election for property placed in service prior to 2012 by filing Form 3115 within first two tax years beginning on or after Jan. 1, 2012 and Taxpayers should consider to timely elect GAA treatment for assets placed in service in 2012 on Form 4562 to take advantage of favorable disposition rules, especially for real property

•  Material, Supplies, and Rotable Spare Parts o  Define M&S as Tangible Personal

Property

•  De Minimis Rule o  Capitalization Threshold

•  Amounts Paid to Improve Tangible Property o  Routine Maintenance Safe

Harbor o  Define Unit of Property o  Improvement Standards

•  Dispositions and General Asset Account Election

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Materials,SuppliesandRotableSpareParts

•  Materials and Supplies (Temp. Reg. Sec. 1.162-3T) •  Temp Regs follow existing, pre-Jan 1, 2012 law for non-

incidental and incidental M&S •  Non-incidental M&S (deducted in year used or

consumed) •  Incidental M&S (expensed in the year acquired; TP does

not maintain a record of consumption or take physical inventories at year end)

•  Clarify and expand definition of M&S, eliminate the requirement that such property not be a Unit of Property (UoP, i.e., can be a larger, separate component), provide an optional, alternative method of accounting (election) for rotable and temporary spare parts, and provide an annual election to treat (each) certain M&S under the De Minimus Rule, i.e., deduct currently

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•  Define M&S as tangible personal property (other than inventory) used or consumed in a TP’s operations that meets the following criteria: o  A component acquired to maintain, repair, or improve a unit of tangible

property owned, leased, or serviced by the TP and that is not acquired as part of any single unit of tangible property (includes rotable and temporary spare parts);

o  Fuels, lubricants, water, and similar items reasonably expected to be consumed in 12 months or less beginning when used in a TP’s operations (new category);

o  A UoP that has an economic useful life of 12 months or less; o  A UoP with an acquisition or production cost of $100 or less; or o  Property identified in future published guidance.

•  A TP may elect annually to capitalize and depreciate each M&S. A TP makes such election on a timely filed original federal income tax return, including extensions, for the tax year the asset is placed in service

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•  Rotable and Temporary Spare Parts (Temp. Reg. Sec. 1.162-3T) •  RSP are defined as M&S that are acquired for installation on a

UoP, removable from that UoP, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation

•  TSP are M&S 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

•  Temp Regs provide 3 methods for treating costs for RSP and TSP: 1) deduct when used or consumed, (i.e., in the year when disposed of, default), 2) elect to capitalize and depreciate over the applicable recovery period, or 3) elect an optional, alternative method

•  The TP must use 1 of the 3 (same) methods for all RSP and TSP in the same trade or business

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•  Under the optional method, the TP deducts its basis in RSP and/or TSP in the year it is placed in service, recognizes income Fair Market Value (FMV) when the part is removed, capitalizes costs to fix the part, and then claims a deduction for such basis when the part is once again placed in service: o  Deduct the cost to produce or acquire the part when the part is first installed, o  Recognize in gross income the FMV of the part when removed from the UoP,

and include the FMV and cost to remove the part in the basis of the part, o  Add to the basis of the part any amount paid to repair, maintain, or improve

the part, o  Deduct the cost of reinstallation and basis not previously deducted in the tax

year in which the part is reinstalled, and o  Deduct any remaining amount of basis in the part in the tax year in which it is

disposed of.

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DeMinimisRule •  De Minimis Rule or “Capitalization Threshold” related to

amounts paid to acquire or produce tangible property (Temp. Reg. Sec. 1.263(a)-2T(g))

•  Temp Regs permit a TP to deduct certain expenditures that have a useful life greater than 12 months consistent with their treatment on their Applicable Financial Statement (AFS) subject to a ceiling

•  De Minimis Rule can be applied by a TP who meets all of the following criteria: o  AFS filed with Securities and Exchange Commission (SEC); or o  Audited financial statement by an independent CPA that is used for creditors

or other non-tax purpose; or o  Financial statement other than a tax return required to be provided to an

agency of the federal or state government other than the IRS or SEC; and o  Written financial accounting policy in place at the beginning of the tax year to

deduct a certain dollar threshold and expense amounts on its AFS (non-tax purpose) consistent with the written policy.

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DeMinimisRule •  The amounts are treated as an expense on the AFS; and •  The ceiling amount (i.e., the maximum deduction under the

De Minimis Rule) is equal to the greater of: o  0.1% of federal income tax reported gross receipts for the tax year, or o  2% of the TP’s total book depreciation and amortization expense for the tax

year reported on its AFS.

•  Temp Regs De Minimis Rule is available only to TP’s with an AFS; otherwise, will not qualify for the De Minimis Rule

•  The ceiling amount is not meant to be a “hard cap”; meaning that TP’s seeking a deduction for amounts in excess of the ceiling amount allowed by the De Minimis Rule may be mitigated by a written agreement between examiners and TP if certain amounts in excess are immaterial, provided such agreements clearly reflect income

•  TP may elect to capitalize amounts expensed under its AFS capitalization threshold to allow it to deduct the ceiling amount

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DeMinimisRule •  De Minimis Rule cannot be used for inventory or for land costs •  Amounts deducted as M&S are not included in the ceiling

computation unless the TP elects by simply deducting the amounts of any M&S in the tax year in which the amounts are paid

•  TP can elect not to apply the De Mininis Rule to any UoP acquired during the year simply by capitalizing the amounts on its timely filed federal income tax return

•  Determination of whether the TP has an AFS and a written policy to expense amounts below a certain threshold can be made at the consolidated group level

•  Determination and application of the ceiling amount is made separately for each consolidated group member

•  Lack of book and tax conformity will cause TPs to track the total cost of newly acquired assets that have been expensed during the tax year for financial statement purposes

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AmountsPaidtoImproveTangibleProperty

•  Temp Regs generally provide that amounts paid to improve a UoP (real or tangible personal) must to capitalized, if UoP results in: o  A betterment of the UoP; o  A restoration of the UoP; or o  An adaptation of the UoP to a new or different use.

•  Under the Routine Maintenance Safe Harbor, recurring maintenance activities on a UoP (other than a building or a structural component of a building) expected to occur more than once during the ADS (Alternative Depreciation System) class life of the UoP, as a result of normal wear and tear (use) to “keep” the UoP in its ordinary efficient operating condition as currently deductible, i.e., otherwise capitalized as a restoration or replacement of a major component of a UoP

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•  Routine maintenance includes inspecting, cleaning and testing a UoP and replacing parts with comparable and reasonable replacement parts

•  Factors to be considered in determining whether a TP is performing routine maintenance are the recurring nature of the activity, industry practice, manufacturer’s recommendations, the TP’s experience and treatment of the activity on its AFS

•  An activity is not considered routine and recurring if it results in a betterment or adaptation, is performed on property where a TP has taken into account the adjusted basis on the property, e.g. by claiming a loss, or if the property is in a state of nonfunctional disrepair prior to the expenditure

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•  Temp Regs define UoP as consisting of all components that are functionally interdependent, where placing one component in service is dependent on placing another component in service

•  Special UoP rules are provided for buildings and structural components, plant property, network assets, and leased property

•  Temp Regs provide that a component must be treated as a separate UoP, if that component is property treated as being within a different MACRS class (under IRC Sec 168(e)) than the class of the larger UoP, or has been properly depreciated using a different depreciation method (depreciation consistency rule)

•  MACRS consistency rule applies if a TP or IRS changes the MACRS class or depreciation method for any type of property during the placed in service year of the asset and in future years, e.g. if a TP completes a cost segregation study

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•  Temp Regs define a building and its structural components as a single UoP, but require that the improvement standards be applied separately to the building structure and specifically defined 8 building systems: o  Building Structure; o  HVAC System; o  Plumbing System; o  Electrical System; o  Conveyance Systems (Escalators, Elevators); o  Fire Protection and Alarm Systems, i.e., Fire, Life & Safety Systems; o  Security Systems; o  Gas Distribution Systems (practically lump-sum with Plumbing System); and o  Other structural components or systems identified in published guidance, e.g. Land

Improvements.

•  Under 2008 Regs, a building and and its structural components were a single UoP for an entire building; which will now likely result in additional capitalizable improvements on prior-year repair expenditures and may necessitate a Sec 481(a) method change

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•  Plant property is functionally interdependent machinery or equipment and is generally comprised of each component or group of components used to perform an industrial process, e.g. manufacturing, power generation, warehousing, distribution, automated materials handling, etc.

•  Temp Regs further divide functionally interdependent plant property into smaller UoPs based on components or groups of components that perform a discrete and major function or operation

•  The discrete and major function standard often results in a smaller UoP especially with assembly-line or continuous processes; which will now likely result in a Sec 481(a) method change where prior-year repair expenditures compared the entire production line as a single UoP

•  Temp Regs provide that the UoP for network assets is determined by the TP’s particular facts and circumstances or typically in published guidance, e.g. Rev Proc 2011-27 for wireline network assets, Rev Proc 2011-28 for wireless network assets, and Rev Proc 2011-43 for electric transmission and distribution property, TBD natural gas, cable TV, electric generation assets

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•  Leased (real or tangible personal) property other than leased buildings, follow the general rules for property other than buildings including the functional interdependence test and plant property rules for discrete and major function except that the UoP may not be larger than the unit of leased property (property subject to lease)

•  UoP for leasehold improvements for a lessor are included within the same UoP (added to) as the UoP (building and components) being improved

•  UoP for leasehold improvements for a lessee are separate from the leased portion of each building and its components; however, the cost of further improving the lessee improvements (2nd generation) are the same (added to) as the original leasehold improvements

•  After determining the correct UoP, the next step is to access whether the expenditure is an improvement to the UoP requiring capitalization, i.e., betterment, restoration or adaptation of the UoP to a new or different use

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•  An amount paid results in a betterment of a UoP if it: o  Corrects a material condition or defect that was pre-existing or arose during

the production of the UoP, whether the TP was aware of the condition or defect at the time of acquisition or production,

o  Results in a material addition (including a physical enlargement, expansion, or extension) to the UoP, or

o  Results in a material increase in capacity (volume or area), productivity, efficiency, strength, quality or output of the UoP.

•  The betterment standard is highly factual and requires TP’s to compare the cost of the repair against the UoP to determine whether an amount paid results in a betterment to that UoP

•  If an event necessitates the expenditure, compare the property immediately before and after the spend; if normal wear and tear, compare the property after current spend with property after the most recent prior spend

•  Temp Regs require the TP to take into account the purpose of the expenditure, the physical nature of the of the worked performed, the effect of the expenditure on the UOP, and the TP’s treatment of the expenditure on its AFS 16


•  Basis recovery on the disposition of property is a critical component of the restoration improvement standard; capitalizable restorations include an otherwise deductible repair when the TP recovers the adjusted basis on the disposition of a replaced component or part

•  Capitalization of amounts paid to restore a UoP include: o  Replacing a component of a UoP if the TP has property deducted a loss for

that component (other than a casualty loss under Reg Sec 1.165-7); o  Replacing a component of a UoP if the TP has properly taken unto account

the adjusted basis of the component in realizing gain or loss from the sale or exchange of the component;

o  Repairing damage to a UoP for which the TP has property taken a basis adjustment as a result of a casualty loss under Sec 165, or relating to a casualty event described in Sec 165;

o  Returning a property to its ordinarily efficient operating condition from a state of nonfunctional disrepair;

o  Rebuilding the property to a like-new condition after the end of its class life; or o  Replacing a major component or substantial structural part of a UoP, e.g. large

portion of the physical structure and/or performs a discrete and critical function in operation of UoP.

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•  Temp Regs eliminate the 50% bright-line measurement under 2008 Regs that allowed a TP to deduct an expenditure to restore property if less than 50% of the structure was replaced or less than 50% of the value of the unit of property was replaced in favor of a facts and circumstances approach

•  TP’s must capitalize amounts paid to adapt a UoP to a new or different use if the adaptation is not consistent with the TP’s intended , ordinary use of the UoP at the time originally placed in service by the TP

•  Temp Regs provide that in the case of a building, an amount paid to adapt the UoP to a new or different use include any of the properties listed in the Regs, i.e., buildings, condominiums, cooperatives, or leased buildings

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DispositionsandGeneralAssetAccountElection

•  Temp Regs provide that the retirement of a structural component of a building is a disposition of MACRS property; heretofore, there was only relief for tangible personal property or land improvements

•  The new disposition rules work with the new restoration rules, where a TP generally recovers the basis of the disposed component, but must capitalize repair costs

•  Temp Regs modified the General Asset Account (GAA) rules which allows TP’s to group property placed in service the same year with the same asset life, recovery method, and averaging convention

•  GAA election provides a TP the flexibility to forgo the basis recovery on the disposition and currently deduct the replacement costs as a repair

•  GAA election is made by checking the box on Form 4562 in the year the assets are placed in service (line 18 of the 2011 Form 4562); the TP is required to keep records that indicate which assets are in each GAA

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temporary repairs regulations (section 263(a))

Economy & Finance