Elective capitalization as a TCJA planning tool

By James Atkinson, J.D., Washington, D.C.

Editor: Mary Van Leuven, J.D., LL.M.

One of the Internal Revenue Code's oldest provisions may prove useful in managing a taxpayer's position under some of its newest provisions. In considering how various provisions of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, have altered a company's tax planning posture, taxpayers whose overall tax position in a given year would benefit from accelerating gross income or from converting current deductions into capital expenditures should consider the elective capitalization provisions of Sec. 266. Doing so may prove useful, for example, in managing the taxable income limitation on the deduction allowed by Sec. 250 for foreign-derived intangible income (FDII) and global intangible low-taxed income (GILTI) amounts, the annual limitation on interest deductibility under Sec. 163(j), or the taxpayer's exposure to base-erosion and anti-abuse tax (BEAT) liability under Sec. 59A.

Sec. 266 prohibits a deduction for amounts paid or accrued in a given tax year for otherwise deductible "taxes and carrying charges" that the taxpayer elects to capitalize. Although phrased in the negative, Sec. 266 authorizes Treasury and the IRS to issue regulations permitting taxpayers to capitalize certain types of otherwise deductible interest, taxes, and carrying charges.

Enacted in 1932 and subsequently broadened and renumbered in 1942 and 1954, respectively, Sec. 266 was an early attempt by Congress to permit the same treatment of certain indirect costs that later became mandatory under the uniform capitalization rules of Sec. 263A (UNICAP rules). Although much of Sec. 266 was made redundant by Sec. 263A, the earlier provision remains in place and permits capitalizing certain indirect costs that escape the broad sweep of the UNICAP rules.

Scope of election

Regs. Sec. 1.266-1(b) allows the taxpayer to capitalize the following into the cost or adjusted basis of the relevant property.

In the case of unimproved and unproductive real property:

  • Annual taxes;
  • Mortgage interest; and
  • Other "carrying charges."

In the case of any real property, the taxpayer may elect to capitalize the following costs paid or incurred to develop real property or to construct an improvement or addition to the real property. To be eligible for the election, however, these costs must be incurred no later than the project's completion date:

  • Interest on a loan (but not theoretical interest of a taxpayer using his own funds);
  • Payroll taxes;
  • Taxes imposed on the purchase of materials, or on the storage, use, or other consumption of materials; and
  • Other necessary expenditures.

In the case of personal property, the taxpayer may capitalize any of the following amounts paid or incurred up to the date the property is installed or first used, whichever is later:

  • Taxes of an employer measured by compensation for services rendered in transporting or installing machinery or other fixed assets to the plant;
  • Interest on a loan to purchase, install, or transport the property;
  • Taxes imposed on the purchase, storage, use, or consumption of the property; and
  • Any other taxes or carrying charges that in the opinion of the IRS are, under sound accounting principles, chargeable to a capital account.

Elections for unimproved and unproductive real property must be made annually. All other elections, however, are made on a project-by-project basis. For any given project, the taxpayer may elect to capitalize one or more categories of eligible expenses and must continue capitalizing all costs within those categories for the duration of the project. The election may be made prospectively even if the taxpayer previously deducted the same costs in connection with that project. The election has no impact, however, on any costs incurred in connection with other projects.

In the case of real property, the regulations define a "project" as a particular development of, or construction of an improvement to, real property. In the case of personal property, a project means the transportation and installation of machinery or other fixed assets. For example, the IRS ruled in Letter Ruling 7109149970A that construction of a mill and a factory were separate projects, even though each was part of a much larger industrial development plan. As such, the taxpayer was permitted to make separate Sec. 266 elections for amounts incurred in connection with each.

The taxpayer elects to capitalize otherwise deductible interest, taxes, and other carrying costs by attaching to its original tax return for the election year a statement indicating the item or items included in the election. Once made, the election is irrevocable without IRS consent.

Otherwise deductible

Regs. Sec. 1.266-1(b)(2) provides that "an item not otherwise deductible may not be capitalized under [Sec.] 266." Expenses for which a deduction is disallowed, such as for fines and penalties, may not be capitalized and recovered through depreciation using Sec. 266.

The "otherwise deductible" requirement presents an interesting issue for amounts exceeding the interest deduction limitation of Sec. 163(j). Sec. 163 permanently prohibits any deduction for certain types of interest, such as Sec. 163(f) ("denial of deduction for interest on certain obligations not in registered form"); Sec. 163(h) ("disallowance of deduction for personal interest"); and Sec. 163(l) ("disallowance of deduction on certain debt instruments of corporations") (emphasis added). Clearly, these amounts are ineligible for elective capitalization under Sec. 266.

In contrast, Sec. 163(j) places a "limitation" on the amount of otherwise deductible interest that may be deducted in a given tax year but arguably neither "disallows" nor "denies" a deduction for those amounts. Instead, the otherwise deductible interest exceeding a given year's limitation may be carried forward indefinitely and deducted in future years having more "cap room." As such, while Sec. 163(j) defers an otherwise permissible deduction, it arguably does not permanently deny the taxpayer the benefit of the deduction.

Interestingly, the proposed Sec. 163(j) regulations provide detailed rules regarding the interaction of Sec. 163(j) with numerous other provisions that deny, defer, capitalize, or otherwise affect the treatment of interest. In particular, Prop. Regs. Sec. 1.163(j)-3(b)(5) would apply the interest capitalization rules of Sec. 263A before application of Sec. 163(j). This results in the full amount of interest within the scope of Sec. 263A(f) being capitalized in the tax year incurred (and in some cases immediately recovered as bonus depreciation) without regard to the Sec. 163(j) limitation. The proposed regulations do not, however, mention elective capitalization of interest under Sec. 266, notwithstanding that Sec. 266 and Sec. 263A(f) share the same tax policy rationale. As such, the interaction of the Sec. 163(j) limitation on the current-year deductibility of interest with the "otherwise deductible" requirement of Sec. 266 remains open to interpretation.

Interest, taxes, and other carrying charges

Sec. 266 does not provide the taxpayer with unlimited discretion in capitalizing carrying costs. First, Sec. 266 takes a back seat to Sec. 263A, specifically including the interest capitalization provisions of Sec. 263A(f), as well as to a variety of other provisions identified in Prop. Regs. Sec. 1.163(j)-3(b).

Second, the Sec. 266 regulations are somewhat unclear as to whether the debt generating the interest must have been incurred specifically to produce or acquire the property into whose basis the taxpayer seeks to capitalize it. Regarding unimproved real property ("interest on a mortgage") and personal property ("interest on a loan to purchase such property"), such a direct-tracing requirement seems likely. It is less clear in the case of projects to develop or improve real property. For those projects, Regs. Sec. 1.266-1(b)(1)(ii)(a) is phrased more broadly to apply to "interest on a loan" other than "theoretical interest" of a taxpayer using its own funds. Arguably, the breadth of that language would permit a broader sweep for elective interest capitalization for real estate development projects. Taxpayers should be cognizant, however, of courts' inclination to consider whether doing so accords with GAAP and "sound accounting principles" generally (see Purvis, 65 T.C. 1165 (1976); Megibow, 21 T.C. 197 (1953)).

Third, in the case of personal property, the election is limited to specific types of interest and taxes incurred for specific purposes (generally, the purchase, transportation, and installation of the property) up to the time when the taxpayer installs or first uses the property (whichever is later). For example, interest may be capitalized only if it is on a loan "to purchase such property or to pay for transporting or installing the same."

This provision applies broadly to "personal property," which the regulations do not define for this purpose. Although the regulations include as an example the purchase, delivery, and installation of manufacturing equipment, the rule itself is stated more broadly. As such, interest on debt incurred to purchase, transport, or install any form of "personal property" — including inventory or even intangible personal property — arguably should be eligible for elective capitalization.

In applying the Sec. 266 regulations this broadly, however, taxpayers should be cognizant of the regulations' references to the dates on which the personal property is "installed" or "first put into use" by the taxpayer, as well as the references to adding the costs to "capital account." The IRS might interpret (and a court might agree) that those references place an unstated limitation on the scope of the "personal property" within the intended scope of the provision.

Finally, although there is a catch-all provision for "other taxes and carrying charges" that the IRS concludes are properly capitalized under "sound accounting principles," the catch-all likewise has its limitations. For example, courts generally have looked to whether the items at issue are properly charged to capital for financial accounting purposes. The Tax Court did so in Purvis to conclude that even though the interest was a "carrying charge" paid on funds borrowed to purchase stock on margin, it could not be capitalized as a cost of the stock itself, because doing so did not accord with GAAP and the accounting literature reviewed by the court.

Planning considerations

The post-TCJA tax planning environment places a premium upon a holistic approach, analyzing the interaction of many seemingly unrelated provisions. In some situations, for example, taxpayers (both domestic and controlled foreign corporations) may benefit from accelerating income to manage the taxable income limitation under the Sec. 250 deduction for FDII and GILTI amounts. Similarly, converting an otherwise deductible item into a capital expenditure recovered through depreciation may prove beneficial in managing the taxpayer's BEAT liability under Sec. 59A or in some cases even its GILTI exposure under Sec. 951A.

As a planning tool, Sec. 266 may be particularly attractive for interest on loans to acquire personal property to which Sec. 263A(f) is inapplicable (as may be the case, for example, for equipment not meeting the minimum thresholds to be "designated property" under Regs. Sec. 1.263A-8(b)). In addition, even while application of the "otherwise deductible" requirement remains somewhat uncertain, the Sec. 266 election plainly is available for qualifying interest expense falling below the taxpayer's Sec. 163(j) limitation for a given year. Depending on the facts, electing to capitalize at least this portion of the taxpayer's qualifying interest expense may be beneficial.

The interactions of BEAT, GILTI, FDII, Sec. 163(j), the utilization of foreign tax credits, and various other TCJA provisions are complex and not always intuitive. Post-TCJA tax planning generally requires modeling these interactions to ensure the benefits and burdens of each are balanced optimally. These modeling exercises generally rely heavily upon the ability to shift the timing of income and expense items and to convert a deductible expense into a capital expenditure (or vice versa). The tax accounting toolbox is replete with options for doing so, and the elective capitalization of otherwise deductible interest under Sec. 266 should be included in that toolbox.

EditorNotes

Mary Van Leuven, J.D., LL.M., is a director, 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 mvanleuven@kpmg.com.

Unless otherwise noted, contributors are members of or associated with KPMG LLP.

These articles represent the views of the author(s) only, and do 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.

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