Editor: Mary Van Leuven, J.D., LL.M.
In March 2008, Treasury issued proposed regulations under Secs. 162 and 263(a) providing guidance on the capitalization and deduction of costs relating to tangible property (REG-168745-03). Included in these regulations are the “repair regulations,” a comprehensive set of rules for determining whether costs incurred for tangible property are deductible repairs or capital improvements. While these regulations offer extensive guidance on determining the unit of property for repair purposes, they do not define the unit of property for network assets.
Network assets are generally defined in the proposed regulations as railroad tracks, oil and gas pipelines, water and sewer pipelines, power transmission and distribution lines, and telephone and cable lines (Prop. Regs. Sec. 1.263(a)-3(d) (2)(iii)(C)). The IRS and Treasury have indicated that network asset guidance should be addressed industry by industry under the IRS’s Industry Issue Resolution program. While they wait for the IRS to issue such guidance, taxpayers owning network assets—who frequently incur significant recurring costs for such assets— face considerable uncertainty as to the proper treatment of such assets for repair and maintenance purposes.
Technical Advice Memorandum (TAM) 200902011, which provides guidance on how a taxpayer with power transmission and distribution lines should determine “single, identifiable properties” in a casualty loss context, may have alleviated some of this uncertainty. The TAM notes the importance of the “unit of property” determination in a Sec. 165 casualty loss context because the amount of basis available to allow the deduction hinges on that definition. The importance of the unit of property definition is certainly not limited to casualty losses; it is prevalent across the Code for interest capitalization under Sec. 263A, for depreciation under Sec. 168, and certainly for repairs under Secs. 162 and 263(a), among others.
In the second footnote of the TAM, the IRS notes that it is using the term “unit of property” in the generic sense and that this unit of property determination for casualty loss purposes is not binding upon such determinations for other Code provisions. Taxpayers are wise to heed this advice because there are different determining factors for the different Code provisions cited above. For example, in Chief Counsel Advice 200827034, the taxpayer suggested an equivalency between the unit of property determinations under Sec. 263A(f) for interest capitalization and those under Secs. 162 and 263(a) for repairs and maintenance, citing FedEx Corp., 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6th Cir. 2005). In this case, the court determined that the unit of property test involved several factors including but not limited to functional interdependence. Because the functional interdependence test under Regs. Sec. 1.263A-10 is an absolute test for determining the unit of property under Sec. 263A(f), the unit of property determined under Secs. 162 and 263(a) is “not necessarily the unit of property for purposes of § 263A(f).”
IRS disclaimers aside, the Sec. 165 casualty loss unit of property analysis in the TAM uses so many of the same factors required of a unit of property analysis for a repair deduction that this TAM may also provide a useful format for helping to determine the unit of property for repair and maintenance purposes for network property.
Several courts have considered the unit of property determination for repair purposes. Most significantly, the court in FedEx Corp. provided four factors that it identified from Ingram Industries, Inc.,
T.C. Memo. 2000-323, and Smith, 300 F.3d 1023 (9th Cir. 2002), to be applied in identifying the appropriate unit of property for purposes of applying the repair regulations:
- Functional interdependence;
- Industry treatment for regulatory, marketing, accounting, or other purposes;
- Coextensive useful lives; and
- Maintained while affixed.
Under the TAM, in determining “single, identifiable properties” for casualty loss purposes, the IRS considers a number of factors derived from relevant casualty loss case law. However, when viewed through the lens of the FedEx factors, one can see how the IRS might arrive at the same conclusion in a repair context for electrical transmission and distribution “network” assets.
In the TAM, the taxpayer made a functional interdependence argument that the entire transmission and distribution system derived its utility from functioning as a whole. The IRS, like the taxpayer, cited a need to determine “whether it is a unit whose utility derives from functioning as a whole.” However, the IRS disagreed with the taxpayer’s aggregation of the entire transmission and distribution network and instead divided the network into discrete components— in this case, lines, circuits, and substations. The IRS pointed to the fact that the utility planned extra capacity into the network to allow the discrete components to be de-energized for repair while not disrupting the rest of the network, as well as for other operational, functional, and management purposes. This policy of breaking functionally interdependent systems into discrete components is consistent with the proposed repair regulations’ definition of unit of property for plant property, as well as the discrete function test of the repair allowance regulations under Regs. Sec. 1.167(a)-11(d)(2)(vi).
The IRS states outright that some factors to consider in determining the proper unit of property for casualty loss purposes include “whether it is consistent with the taxpayer’s other tax accounting practices . . . whether it is accounted for and identifiable as a unit for non-tax accounting purposes . . . whether it is separately treated for operational and management purposes,” and specifically “whether it is consistent with industry practice.” The TAM goes on to address all these points in reaching its conclusion.
Coextensive Useful Lives
This is the only FedEx factor not directly addressed, but because no one factor is determinative, the weight of the other factors appears to support a broader unit of property than an item-byitem approach.
Maintained While Affixed
The TAM states that repairs to and maintenance of the transmission and distribution assets occur while both affixed to and removed from the system. The IRS observes that the taxpayer’s objective is to minimize disruption to its customers and that to do this it must isolate the damaged portion of the network during repair. It is further noted that the “assets being repaired . . . would remain in their physical location while being repaired.” Other minor components, such as transformers, would be removed, replaced with a serviceable unit, and repaired later. The TAM further notes that it would be rare for a casualty to damage an entire system but that certain segments of the system, such as lines, circuits, or substations, would likely be repaired or replaced.
Ultimately, the IRS reached a relatively favorable and reasonable unit of property determination for the taxpayer, concluding that each transmission line, transmission substation, distribution line, and distribution substation was the applicable unit of property, or “single, identifiable property” in the casualty loss context. While the IRS was careful to point out multiple times in the TAM that this determination is applicable only to casualty losses, with the absence of other guidance for network assets in the repair context, the IRS’s analysis provides a framework that taxpayers with network assets may consider when determining their applicable units of property.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
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For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.