IRS issues new directive on exams of costs related to generation property
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On July 6, 2015, the IRS issued a directive (LB&I-04-0315-002) providing administrative guidance to industry directors and field specialists regarding examinations involving whether costs incurred to maintain, repair or improve steam or electric generation property must be capitalized under section 263(a). The directive applies to taxpayers that have properly changed to the method of accounting provided in Rev. Proc. 2013-24 for determining units of property and major components of steam or electric generation property.
On Sept. 13, 2013, and Aug. 14, 2014, respectively, the IRS released final regulations regarding the treatment of costs to acquire, maintain and improve tangible property and final regulations on the dispositions of tangible property (collectively, the regulations). The regulations generally apply to a taxpayer's first taxable year beginning in 2014 and provide that an expenditure related to tangible property must be capitalized if the expenditure results in a betterment, adaptation or restoration of the property. Among other things, a restoration occurs when the taxpayer replaces a major component or substantial structural part of a unit of property.
On April 30, 2013, the IRS released Rev. Proc. 2013-24 providing a safe harbor for defining units of property and major components of steam or electric generation property. Rev. Proc. 2013-24 also provides for an automatic method change to adopt some or all of the unit of property/major component definitions and waives the scope limitations of the automatic change procedures of Rev. Proc. 2011-14 for a taxpayer's first, second or third taxable year ending after Dec. 20, 2012 (see Procedural guidance on treatment of power generation property costs).1
Shortly after the issuance of Rev. Proc. 2013-24, the IRS issued a directive (LB&I-04-0713-005) providing for a temporary stand-down of examinations of the treatment of costs incurred to maintain, replace or improve steam or electric generation property and of any correlative issues involving the disposition of structural components of a building or dispositions of tangible depreciable assets (see IRS directive on steam or electric generation property costs). The stand-down reflects the three-year period taxpayers have to adopt one or more of the unit of property/major component definitions provided for in Rev. Proc. 2013-24. However, if a taxpayer has filed a Form 3115 to adopt all, or some, of the unit of property/major component definitions provided in Rev. Proc. 2013-24, examiners must determine whether the change was consistent with Rev. Proc. 2013-24, including determining whether the section 481(a) adjustment was accurately computed and recognized.
The LB&I-04-0315-002 directive provides guidance to field examiners on determining whether a major component of steam or electric generation property has been replaced. Specifically, the directive provides that when examining tax years ending on or after Dec. 31, 2012, if a taxpayer has adopted the method of accounting provided for in Rev. Proc. 2013-24, examiners should not challenge a taxpayer's treatment of its expenditures as an improvement when substantially all of a major component has been replaced and capitalized. The directive provides that the term "substantially all" means 80 percent or more of the major component. Correspondingly, if less than 80 percent of the major component has been replaced, examiners should not challenge the treatment of such expenditure as a deductible repair. However, if the agent believes the expenditure otherwise results in a betterment, adaptation or other restoration of the unit of property, the treatment may be challenged but only after consultation with the director of field operations.
The directive also provides that an agent should not challenge the use of either of the following measurement methodologies to determine whether substantially all of the major component has been replaced:
- Comparing the actual replacement costs recorded on the taxpayer's financial statements to the undepreciated financial statement costs of the major component; or
- Comparing the actual replacement cost recorded on the taxpayer's financial statements to the estimated replacement cost of the entire major component.
Additionally, since the measurement methodologies are not methods of accounting, agents should not challenge a change in measurement methodology as an unauthorized change in method of accounting.
The regulations generally fail to provide bright-line tests in determining whether an amount is paid or incurred for the improvement of a unit of property. As a result, the directive's 80 percent threshold should provide comfort to taxpayers that incur costs to maintain, repair or improve steam or electric generation property and have adopted one or more of the unit of property/major component definitions provided by Rev. Proc. 2013-24. However, the applicable restoration rule under Reg. section 1.263(a)-3(k) would seemingly only require the capitalization of the replacement of a major component of non-building property when the entire component is replaced (as opposed to a substantially all). Since most of the property described in Rev. Proc. 2013-24 is non-building property, it is unclear how this directive will impact the application of the restoration rules to applicable taxpayers that have deducted the cost of replacing more than 80 percent but less than 100 percent of a major component as defined in Rev. Proc. 2013-24.
All taxpayers should work with their tax advisors to ensure appropriate treatment of costs incurred to repair and improve tangible property. Taxpayers with steam or electric generation property are encouraged to evaluate existing methods to determine whether filing a Form 3115 to adopt some, or all, of the unit of property and major component definitions in Rev. Proc. 2013-24 is advisable.
1 Pursuant to the new automatic method change procedures of Rev. Procs. 2015-13 and 2015-14, the eligibility rules regarding the final year of a taxpayer's trade or business and the prior five-year item change rule are waived for a taxpayer making a change to comply with Rev. Proc. 2013-24 for the first, second or third years ending after Dec. 20, 2012 (see section 3.20 of Rev. Proc. 2015-14).