The oil and gas industry faces numerous challenges in applying the fact-intensive rules of the so-called repair regulations to costs incurred to repair and maintain property during its service life. This item focuses on refining, chemicals, and marketing (the downstream sector) and provides an analytical framework designed to help prepare the industry for the challenges ahead.
The repair regulations were issued by Treasury and the IRS in December 2011 to bring greater clarity and certainty in determining the proper federal tax treatment of costs associated with a taxpayer’s tangible assets (T.D. 9564). These temporary regulations apply to costs incurred throughout the life cycle of tangible property, from acquisition through operation to disposition. Although the regulations provide discrete rules for each of these three “buckets” of costs, the second bucket—costs incurred to repair and maintain property during its service life—is at once the most complex and the most ambiguous.
Applying the repair regulations to the oil and gas industry presents numerous challenges, given the breadth and diversity of the assets involved. Roughly, the oil and gas industry can be divided into three principal sectors: exploration and extraction (upstream); transportation (midstream); and refining, chemicals, and marketing (downstream). While there is no universal definition marking when the product passes from upstream to midstream to downstream, a rough rule of thumb looks to the point at which the raw product has been extracted and gathered for transport to begin midstream activities and delivered to a refinery to initiate the downstream phase. This item focuses only on the application of the repair regulations to downstream operations.
Applying the repair regulations to downstream operations follows the same basic analytical path required for all industries. First, identify the appropriate unit of property. Second, determine whether a particular expenditure betters, restores, or adapts the property to a new or different use. Third, determine whether a special rule affects the application of the general standards.
Application to Refineries
Identifying the units of property in downstream operations is particularly critical with respect to refineries. Refineries represent a significant percentage of many downstream operations’ fixed assets and require frequent and costly maintenance and operational expenditures. Because the capitalization standards focus on whether various activities materially affect the unit of property, the taxpayer’s goal is to maximize the size of each unit of property within a refinery to the extent consistent with the regulations to reduce the likelihood that any particular activity will have a material effect on the identified unit.
As “plant property” (functionally interdependent machinery performing an “industrial process”), a refinery must be divided into assets or groupings of assets that are performing “discrete and major functions.” These become the relevant units of property (Temp. Regs. Sec. 1.263(a)-3T(e)(3)(ii)). The repair regulations provide no specific guidance as to how to apply this standard to refineries.
One approach to consider is treating each of the various production units within a refinery as serving discrete and major functions, such that each is a separate unit of property. These would include, for example, each crude unit, the alkylation unit, the coker unit, etc. The taxpayer must determine how to treat the refinery’s common elements, such as the electrical, water treatment, and fire suppression systems, as well as the “highway piping” that moves the product among the various production units. Large tank farms serving the refinery must be considered, including whether the appropriate unit of property is the entire tank farm, a functional grouping of the tanks, or each individual tank. The taxpayer must consider the treatment of any buildings (such as an administration building), as well as land improvements such as roads and parking areas.
The repair regulations require capitalizing costs incurred not only in improving an entire unit of property but also in replacing a “major component” of the identified unit. As a result, it is equally important to identify each major component of each unit of property within a refinery, keeping in mind that not every component is major. To minimize the subjectivity inherent in the capitalization standards, some companies are preparing schedules breaking the refineries down into each unit of property and its associated major components. Such a schedule helps local facility managers determine whether costs to replace a specific component must be capitalized, thus ensuring consistent treatment throughout the company.
After identifying the appropriate units of property, the company must determine whether particular repair and maintenance activities improve that unit. This may result from either bettering the unit of property (which can be a material improvement in capacity, efficiency, quality, size, or similar measures); adapting the property to a new or different use; or “restoring” the unit of property (Temp. Regs. Secs. 1.263(a)-3T(h)–(j)).
A restoration occurs if (among other things) the taxpayer has recognized either a gain or loss in connection with the event that gave rise to the maintenance (such as a casualty loss or a loss upon the retirement of a structural component that is being replaced), or if the taxpayer replaces a major component of the unit of property. The need to capitalize the costs of replacing a major component underscores the importance of carefully considering how to initially divide the refinery into units of property.
The capitalization standards are particularly relevant in the context of refinery turnarounds. A turnaround is a planned, periodic shutdown of all or a major portion of a refinery to perform maintenance tasks needed to keep the facility in safe and efficient operating condition. Because of the need to shut down and restart the refinery (and the hazards associated with doing so), turnarounds are planned many months or years in advance and are carefully orchestrated to minimize the time required to perform the needed tasks.
Under the repair regulations, refinery operators will need to consider whether the specific activities undertaken as part of a turnaround result in either a betterment to or restoration of an identified unit of property. For example, if as part of the turnaround the taxpayer installs equipment that materially increases the refinery’s capacity, the costs associated with that increase in capacity arguably must be capitalized as a betterment, even though other activities occurring during the turnaround are routine maintenance.
Costs incurred in replacing a major component of a unit of property during the turnaround would be capitalized as a restoration. Likewise, the taxpayer must consider whether any indirect costs incurred during the turnaround “directly benefit or are incurred by reason of” the identified capital improvement. If so, the repair regulations require those otherwise deductible costs to be capitalized as well (Temp. Regs. Sec. 1.263(a)-3T(f)(3)).
On the other hand, the regulations also make clear that the taxpayer is not required to capitalize the cost of replacing parts as a betterment simply because the new parts are more technologically advanced than the parts being replaced. Inevitable advances in technology and safety will result in nearly all new refinery components being better in some respect than the older parts being replaced. The issue is whether the replacement parts result in a material increase in capacity, strength, quality, etc. Again, the regulations provide little in the way of guidance, other than examples involving the replacement of wooden shingles with asphalt shingles (deductible) and the replacement of wooden shingles with high-tech composite shingles (capitalized) (Temp. Regs. Sec. 1.263(a)-3T(h)(4), Examples (13)–(15)).
Finally, after determining how the general capitalization standards apply to particular maintenance activities, the taxpayer must consider the potential application of any special rules. In particular, the company should consider whether the “routine maintenance safe harbor” applies. This safe harbor allows a deduction for the costs of activities the taxpayer expects to perform at least twice during the unit of property’s alternative depreciation system (ADS) class life. For refinery property, this period is 16 years.
Significantly, this safe harbor applies even if the activity results in the replacement of a major component, and the ability to deduct the costs of such replacements is potentially one of the safe harbor’s most beneficial applications (Temp. Regs. Sec. 1.263(a)-3T(g)(5), Example (6)). The safe harbor does not apply, however, to buildings or structural components of buildings, improvements, or activities resulting from events with respect to which the taxpayer recognized a gain or loss (e.g., a casualty event in which the taxpayer recognized a loss deduction) (Temp. Regs. Sec. 1.263(a)-3T(g)).
Even with these carve-outs , however, the routine maintenance safe harbor will be valuable to many refinery operators, particularly in the context of turnarounds. These taxpayers should carefully review their maintenance policies to identify activities they expect to perform at least twice during a 16-year period at the refinery, including the replacement of major components. Those costs generally will be deductible each time they are performed during the property’s entire service life (not just during the ADS class life). Again, however, the taxpayer must be careful to avoid applying the safe harbor to improvements.
Even though refineries tend to attract the greatest focus, downstream operations employ a broad array of assets. The range of assets varies by company but may consist of pipelines, storage facilities , ships, trucking fleets, terminals, power plants, and in some cases, retail facilities such as gas stations and convenience stores. Producers of natural gas and chemicals will have a similar collection of assets. In each case, however, the same basic analytical approach should be taken: Identify the unit of property and major components. Consider whether there has been a betterment, restoration, or adaptation of that unit of property to a new or different use. Consider the potential application of special rules, such as the routine maintenance safe harbor.
While it would be difficult to conclude that the repair regulations have dramatically simplified the capitalization standards of Sec. 263(a), adhering to this basic analytical framework helps prepare the taxpayer for the task of correctly applying these fact-intensive rules to the broad array of assets used in a downstream oil and gas operation.
A version of this item appeared in KPMG’s What’s News in Tax.
Mary Van Leuven is senior manager, Washington National Tax, at KPMG LLP in Washington, D.C.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or email@example.com.
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 represent 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.