On December 23, the IRS issued long-awaited temporary and identical proposed regulations (T.D. 9564; REG-168745-03) regarding the treatment of expenditures incurred in selling, acquiring, producing, or improving tangible assets, including rules on determining whether costs related to tangible property are deductible repairs or capital improvements. The temporary regulations affect all taxpayers that acquire, produce, or improve tangible property.
The temporary regulations clarify and expand the standards in the current regulations under Secs. 162(a) and 263(a) and provide rules for applying these standards. They also provide guidance on accounting for, and dispositions of, property subject to Sec. 168 and amend the general asset account regulations.
Distinguishing between expenditures for capital improvements or for deductible ordinary repairs is a highly factual determination, and a number of court cases have set out tests for making the distinction. Because it has been difficult for taxpayers to apply the standards set out in case law, the regulations, and IRS guidance, the IRS issued proposed regulations in 2006 (later withdrawn) and 2008. The new temporary and proposed regulations respond to comments received in response to the prior proposed regulations.
The temporary regulations provide a general framework for capitalization and retain many of the provisions of the 2008 proposed regulations, which in many instances incorporated standards from existing authorities under Sec. 263(a).
Among the changes introduced by the temporary regulations, they revise the rules for determining whether an amount is paid for an improvement to a building, and they revise the rule for determining whether an amount is paid for the replacement of a major component or substantial structural part of a unit of property. The temporary regulations also provide several new rules that were not in the 2008 proposed regulations.
Materials and Supplies
The temporary regulations generally retain the framework in the 2008 proposed regulations for materials and supplies. In response to comments, however, the temporary regulations modify and expand the definition of materials and supplies, provide an alternative optional method of accounting for rotable and temporary spare parts, and provide an election to treat certain materials and supplies under a de minimis rule in Temp. Regs. Sec. 1.263(a)-2T. The temporary regulations also allow a taxpayer to elect to capitalize certain materials and supplies.
Under the 2008 proposed regulations, amounts paid for repairs and maintenance to tangible property are deductible if the amounts paid are not required to be capitalized under Regs. Sec. 1.263(a)-3. The temporary regulations retain this rule and clarify that a taxpayer is permitted to deduct amounts paid to repair and maintain tangible property provided such amounts are not required to be capitalized under Sec. 263(a) or any other provision of the Code or regulations.
Rentals and Leased Property
The temporary regulations make minor revisions to the rule in Regs. Sec. 1.162-11(b) that provides that the cost of erecting a building or making a permanent improvement to property leased by the taxpayer is a capital expenditure and is not deductible as a business expense.
The temporary regulations amend the rules in Regs. Secs. 1.162-11(b) and 1.167(a)-4 to provide that a lessee or lessor must depreciate or amortize its leasehold improvements under the cost recovery provisions of the Code applicable to the improvements, without regard to the term of the lease. They also remove the rules permitting amortization over the shorter of the estimated useful life or the term of the lease.
Amounts Paid to Acquire or Produce Tangible Property
The temporary regulations retain the rules from the 2008 proposed regulations on capitalization of amounts paid to acquire or produce units of tangible property. These include a general requirement to capitalize acquisition and production costs and a requirement to capitalize amounts paid to defend and perfect title to property. Responding to comments, the temporary regulations clarify how the rules apply to moving and reinstallation costs. They also retain the rule for costs incurred prior to placing property into service, add and clarify certain rules with respect to transaction costs, and modify and refine the de minimis rule.
The de minimis rule under the temporary regulations retains the requirement that a taxpayer may deduct certain amounts paid for tangible property if the taxpayer (1) has an applicable financial statement, (2) has written accounting procedures for expensing amounts paid for such property under certain dollar amounts, and (3) treats such amounts as expenses on its applicable financial statement in accordance with such written accounting procedures. However, the temporary regulations replace the “no distortion” requirement in the proposed regulations with an overall ceiling that generally limits the total expenses that a taxpayer may deduct under the de minimis rule.
Under the new criteria, the aggregate of amounts paid and not capitalized under the de minimis rule for the tax year must be less than or equal to the greater of (1) 0.1% of the taxpayer’s gross receipts for the tax year as determined for federal income tax purposes; or (2) 2% of the taxpayer’s total depreciation and amortization expense for the tax year as determined in its applicable financial statement.
Amounts to Improve Property
The temporary regulations retain the basic framework of the 2008 proposed regulations for determining the unit of property and for determining whether there is an improvement to the unit of property. They also retain many of the simplifying conventions set out in the 2008 proposed regulations, including the routine maintenance safe harbor and the optional regulatory accounting method.
The 2008 proposed regulations provided a safe harbor from capitalization for the costs of performing certain routine maintenance activities. Under the safe harbor, an amount paid was deemed not to improve the unit of property if it was for ongoing activities that a taxpayer (or a lessor) expected to perform as a result of the taxpayer’s (or the lessee’s) use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. The activities count as routine only if, at the time the unit of property was placed in service, the taxpayer reasonably expected to perform the activities more than once during the class life of the unit of property. Despite receiving numerous comments on this safe harbor, the IRS has retained it in the temporary regulations, but it is modified so that it will not apply to buildings.
Accounting and Disposition Rules for MACRS Property
The temporary regulations also revise the rules for accounting for modified accelerated cost recovery system (MACRS) property (i.e., assets to which Sec. 168 applies) and the rules for determining gain or loss upon the disposition of MACRS property.
The temporary regulations eliminate group accounts, classified accounts, and composite accounts under Regs. Sec. 1.167(a)-7. Instead, each multiple asset account must include, in most cases, assets that have the same depreciation method, recovery period, and convention and that are placed in service in the same tax year. The temporary regulations also provide rules for determining gain or loss upon the disposition of MACRS property that are consistent with the disposition rules under Prop. Regs. Sec. 1.168-6 of the proposed accelerated cost recovery system (ACRS) regulations.
The temporary regulations were generally effective for tax years beginning on or after January 1, 2012. A change to conform to the temporary regulations will be a change in method of accounting under Sec. 446(e), and, in general, a taxpayer seeking a change in method of accounting to comply with the temporary regulations must take into account an adjustment under Sec. 481(a). The IRS will provide procedures under which taxpayers may obtain automatic consent for a tax year beginning on or after January 1, 2012, to change to a method of accounting provided in the temporary regulations.