In a technical advice memorandum (TAM 201638022), the IRS National Office of the Chief Counsel determined a taxpayer's substantial renovation, construction, and erection of certain property qualified as the construction of real property under Sec. 199 such that the gross receipts derived from those activities qualified as domestic production gross receipts (DPGR). In reaching its decision, the Chief Counsel determined that the property was "inherently permanent structures" (as defined in Regs. Sec. 1.263A-8(c)(3)) under Regs. Sec. 1.199-3(m)(3).
Facts
The taxpayer, a U.S. construction contractor, engaged in a trade or business that is considered construction for purposes of the North American Industry Classification System on a regular and ongoing basis and derived gross receipts from the renovation of major components and substantial structural parts of property used in facilities already in existence or being constructed.
The taxpayer claimed that the substantial renovation, construction, or erection of the property constituted the construction of real property under Sec. 199. The Large Business & International (LB&I) examination team, with the assistance of local counsel from LB&I Division Counsel, argued that the taxpayer's activities performed in constructing the property did not qualify as the construction of real property under Sec. 199, asserting the property was tangible personal property.
The taxpayer and LB&I requested technical advice from the Chief Counsel's Office on the qualification under Sec. 199 of gross receipts that the taxpayer derived from the projects related to the substantial renovation, construction, or erection of the items in the United States.
Law
Sec. 199(c)(4)(A)(ii) provides that, in the case of a taxpayer engaged in the active conduct of a construction trade or business, DPGR include gross receipts derived from construction of real property performed in the United States by the taxpayer in the ordinary course of that trade or business. Regs. Sec. 1.199-3(m)(1)(i) defines "construction" as activities and services relating to the construction or erection of real property in the United States. Regs. Sec. 1.199-3(m)(2)(i) describes activities constituting construction as those performed in connection with a project to erect or substantially renovate real property.
Regs. Sec. 1.199-3(m)(3) provides that "real property" includes "inherently permanent structures (as defined in [Regs. Sec.] 1.263A-8(c)(3)) other than machinery (as defined in [Regs. Sec.] 1.263A-8(c)(4)) (including items that are structural components of such inherently permanent structures)." Under Regs. Sec. 1.263A-8(c)(3), inherently permanent structures include property that is affixed to real property and that will ordinarily remain affixed for an indefinite period. Regs. Sec. 1.263A-8(c)(4), however, provides that a structure that is property in the nature of machinery or that is essentially an item of machinery or equipment is not an inherently permanent structure and is not real property.
Analysis
Because LB&I and the taxpayer agreed that, if the property was real property for purposes of Sec. 199, the activities performed by the taxpayer would constitute construction activities under Regs. Sec. 1.199-3(m)(2)(i), the Chief Counsel focused on the narrow question of whether the property is "real property" as defined under Regs. Sec. 1.199-3(m)(3). Because the Sec. 199 regulations cross-reference Regs. Sec. 1.263A-8(c)(3) (inherently permanent structures) and Regs. Sec. 1.263A-8(c)(4) (machinery), the Chief Counsel stated that "the determination under those sections controls for purposes of determining whether the [items] are real property for purposes of [Regs. Sec.] 1.199-3(m)(3)." Additionally, the Chief Counsel noted that it did not analyze whether the property was another type of real property described in Regs. Sec. 1.199-3(m)(3) (such as a building, infrastructure, or utility plant) because LB&I and the taxpayer agreed that the property did not constitute any other type of property.
The Chief Counsel stated in the TAM that an inherently permanent structure must meet two basic requirements under Regs. Sec. 1.263A-8(c)(3): The structure must (1) be affixed to real property and (2) ordinarily remain affixed for an indefinite period. The Chief Counsel concluded the property at issue in this case satisfied the first requirement on the basis of weight alone. Additionally, the Chief Counsel found that the property was affixed to real property through other means that satisfied the requirement for it to be affixed.
With respect to the second requirement, the Chief Counsel reasoned that the term "indefinite" is best interpreted to mean that the property is affixed to real property for the useful life of the property or the period during which the property remains in operating condition and serves a useful function at its installation site. The items of property at issue in the TAM would remain affixed to real property for the duration of their useful lives; therefore, the Chief Counsel concluded, they were affixed to real property for an indefinite period. As such, the property qualified as inherently permanent structures under Regs. Sec. 1.263A-8(c)(3).
Thus, because the property satisfied the definition of inherently permanent structures, it was real property for purposes of Sec. 199. Based on this conclusion, the gross receipts from the taxpayer's activities qualified as DPGR, and the taxpayer could be entitled to the deduction under Sec. 199 (assuming all other requirements of Sec. 199 were met).
Moreover, because the Chief Counsel concluded the property qualified as inherently permanent structures, it did not analyze whether the property would be considered machinery under Regs. Sec. 1.263A-8(c)(4). Specifically, the TAM states that machinery and inherently permanent structures are mutually exclusive categories of property; i.e., Regs. Sec. 1.263A-8(c)(4)(i) does not impose an additional test whereby property that otherwise qualifies as an inherently permanent structure under Regs. Sec. 1.263A-8(c)(3) must also not be machinery under Regs. Sec. 1.263A-8(c)(4).
The Chief Counsel further noted that its reading of the relationship between Regs. Sec. 1.263A-8(c)(3) and Regs. Sec. 1.263A-8(c)(4) as clarifying the mutually exclusive nature of machinery and inherently permanent structures is consistent with the preamble to the final Sec. 263A regulations. The Chief Counsel stated that its interpretation supports a broad reading of "real property" for purposes of Sec. 263A(f), consistent with the intent of Sec. 263A to ensure that taxpayers capitalize the appropriate amount of production costs, including the production of real property. Furthermore, several examples of inherently permanent structures provided in Regs. Sec. 1.263A-8(c)(3) have a mechanical function similar to functions of the items at issue in the TAM. The Chief Counsel noted it would not be reasonable to include the property as examples of inherently permanent structures only to remove it from that classification by recasting it as machinery under Regs. Sec. 1.263A-8(c)(4).
Implications
Notably, the analysis in TAM 201638022 regarding the relationship between Regs. Secs. 1.263A-8(c)(3) and 1.263A-8(c)(4) differs from prior guidance under Chief Counsel Advice (CCA) 201211011. The analysis in CCA 201211011 provides that "property that otherwise qualifies as an inherently permanent structure is not real property for purposes of [Sec.] 263A(f) if it is property in the nature of machinery or equipment." In TAM 201638022, however, the Chief Counsel states that it "disagree[s] with the portion of the analysis [from CCA 201211011] that concerns the relationship between [Regs. Secs.] 1.263A-8(c)(3) and 1.263A-8(c)(4)."
Additionally, application of the rationale in TAM 201638022 extends beyond the particular industry that was the subject of the TAM. Understanding the nature of the property is critical to applying the analysis in TAM 201638022.
EditorNotes
Michael Dell is a partner at Ernst & Young LLP in Washington.
For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.
