The IRS concluded its long journey toward clarity in defining capitalization of improvements versus repair and maintenance costs when it issued final tangible property regulations in 2013 (T.D. 9636). However, not all industries received the same degree of finality of guidance in the regulations. The IRS continues to provide guidance for certain industries through its Industry Issue Resolution program, addressing capitalization issues and challenges unique to certain industries.
Recently, the IRS issued Rev. Proc. 2015-12 to provide guidance and several safe-harbor methods of accounting for cable system operators that provide video, high-speed internet, and voice-over-internet-protocol (VoIP) phone services through a "cable network." A cable network is an expansive system of interconnected assets covering one or more geographically contiguous regions or proximate customer populations that receive cable services from a cable operator. The cable network consists of property that receives signals at the "headend" from satellite antennae or fiber-optic cable and conveys the signals to customer premises using optic transmission and receiver devices, fiber-optic cable, hubs, fiber-optic transfer nodes, coaxial cable, amplifiers, taps, and customer drops.
The Industry Issue
Cable operators incur significant costs to maintain, replace, and improve real and personal cable network property. Whether these costs are deducted as repairs under Sec. 162 or capitalized as improvements under Sec. 263(a) depends on whether the costs are for a betterment or restoration to a unit of property, or adapt a unit of property to a new or different use. Cable operators and the IRS often have difficulties identifying the units of property that constitute these networks and disagree over whether the cost to replace a particular item is an improvement that operators must capitalize.
Disagreements between cable operators and the IRS also extend to the proper depreciation classification of cable network assets. Rev. Proc. 2015-12 clarifies and extends to cable operators prior guidance in Rev. Proc. 2003-63 for determining whether network assets are used for providing one-way or two-way communication services. One-way communication assets are depreciated pursuant to Rev. Proc. 87-56 under asset class 48.42 (CATV-Subscriber Connection and Distribution Systems) over a seven-year recovery period, while two-way communication assets are depreciated over a 15-year period pursuant to Sec. 168(e)(3)(E)(ii).
New Safe Harbors and Guidance to Resolve Disputes
The tangible property regulations specifically excluded unit-of-property rules for network assets, thereby excluding cable operators (Regs. Sec. 1.263(a)-3(e)(3)(iii)). Rev. Proc. 2015-12 provides extensive new guidance along with illustrations to minimize these industry disputes with the IRS. The key concepts of this new guidance are:
- Two alternative safe-harbor approaches to determine whether expenditures to maintain, replace, or improve cable network assets must be capitalized under Sec. 263(a):
- A "network asset maintenance allowance" method that provides a simplified approach to determine the portion of costs capitalized for financial statement purposes that, for federal tax purposes, may be deducted as additional repairs under Sec. 162 or must be capitalized as improvements under Sec. 263(a).
- Alternatively, new unit-of-property definitions that, if properly applied under the principles of Sec. 263(a), the IRS will not challenge. A taxpayer is not required to use all of the unit-of-property determinations provided and, therefore, may use one or more of the units of property. Once used, however, a unit-of-property determination applies to all assets in that grouping.
- Two alternative approaches for determining whether costs for installations and customer drops (property that connects the final cable distribution network point with the customer) may be deducted as repairs under Sec. 162 or must be capitalized as improvements under Sec. 263(a):
- The "specific identification" method provides that the costs of internal drops (cable and any associated connectors within the interior of customer premises), drop replacements, and installing customer premises equipment may be deducted, while the costs of installing initial external drops (cable and any associated connectors from the final connection point (tap) to the exterior of customer premises) must be capitalized.
- Alternatively, the safe-harbor method provides a simplified allocation methodology for determining which customer drop costs are for external drops and which are for internal drops or drop replacements. The safe-harbor method allows an allocation of 12% of total customer drop costs for the tax year to initial external drops to be capitalized under Sec. 263(a). The remaining 88% of total customer drop costs for the tax year are allocated to internal drop costs and drop replacement costs and are treated as deductible expenditures. Notwithstanding this general rule, under the safe harbor, the costs of replacing an external drop that result in a betterment or an adaption to a new or different use must be capitalized, unless the costs are otherwise deductible under another provision of the Code or regulations.
- The revenue procedure provides a safe-harbor approach for determining for depreciation classification purposes whether cable distribution network assets are primarily used for providing one-way or two-way communication services. The safe harbor determines one-way versus two-way primary use via any reasonable manner consistently applied, such as an allocation of gross receipts or customer count for each service within the cable system. The revenue procedure includes examples of allocation methodologies to determine primary use.
Actions to Take
In summary, Rev. Proc. 2015-12 provides for the cable industry units of property for cable network assets, safe harbors for determining deductible repair and maintenance versus capital improvements, a safe harbor for classification of cable network property for depreciation purposes, and accounting method change guidance to adopt the new guidance. The revenue procedure provides guidance for cable operators to obtain automatic consent to change to a method of accounting provided by Rev. Proc. 2015-12.
Cable operators should evaluate their current units of property and methodologies for determining capital improvements versus deductible repairs for cable network assets and determine whether the methods provided in Rev. Proc. 2015-12 are more advantageous than current methods. Taxpayers may also find that the safe harbors ease administrative burden over current methodologies. Lastly, cable operators should evaluate whether the safe harbor for identifying one-way and two-way communication assets will allow a change to a shorter depreciation recovery period where appropriate. Where it is optimal or advantageous to use a different method of accounting, cable operators may file an automatic request for a change in method of accounting.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.