IRS ‘Repairs’ The Examination Of Tangible Property Regulation Issues

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In March, the Internal Revenue Service published an IRS Large Business & International (LB&I) Directive1 (the Directive), which updates an earlier directive to field agents addressing the examination of capitalization and repair costs issues.2 In the previous directive, examining agents were instructed to stand down with respect to the review of issues associated with the costs of maintenance, repair, and improvement of tangible property. The updated Directive was issued in response to anticipated changes to temporary and proposed regulations under Section 263(a), referred to as the "Tangible Property Regulations."3 According to the Directive as well as public statements by Treasury and IRS executives, the Tangible Property Regulations are expected to be revised before the end of 2013 and when they are modified, significant changes are anticipated.

The Directive reflects a welcome approach. By minimizing the examination of these issues prior to the issuance of updated regulations, technical development will occur through the regulatory process rather than on a case-by-case basis in examination. More importantly, the Directive reinforces the importance of evaluating how to address capitalization and repair issues during the pendency of revisions to the Tangible Property Regulations.

Background

In late December 2011, the IRS published the Tangible Property Regulations addressing the tax treatment of amounts paid to acquire, produce or improve tangible property.4 The regulations were issued in both temporary and proposed form, which means that they had an immediate effective date. The rules were originally effective for tax years (or costs incurred in tax years) beginning on or after January 1, 2012, but were subsequently amended and are now effective for tax years (or costs incurred) beginning on or after January 1. 2014.5

The Tangible Property Regulations affect all taxpayers that acquire, produce, or improve tangible property (e.g., plants, buildings, equipment and machinery). Some of the most significant issues enumerated in the regulations involve the treatment of repair expenses associated with tangible property. As a result, the rules have very broad application and most corporate taxpayers are affected by these regulations.

According to the accompanying Preamble, the Tangible Property Regulations clarify and expand standards in the current regulations under Sections 162(a) and 263(a), providing certain bright-line tests (e.g., a de minimis rule for certain acquisitions, a safe harbor for certain maintenance, etc.), and aim to facilitate application of the rules. Further, the Tangible Property Regulations amend the general asset account regulations and provide guidance regarding the accounting for, and dispositions of, certain depreciable property subject to Section 168. It is significant that two sets of temporary regulations preceded the 2011 temporary and proposed regulations.6 Importantly, the Tangible Property Regulations include significant modifications to the 2008 proposed rules. Certain changes were welcome, such as the inclusion of a de minimis capitalization rule for acquisitions. However, other changes have not been embraced by taxpayers and practitioners. For example, the Tangible Property Regulations make unprecedented changes in the treatment of real property and the rules require taxpayers to develop complicated systems to capture the costs of maintaining building components. Additionally, safe harbors proposed by the 2008 proposed regulations were eliminated, further complicating application.

In March 2012, the IRS published procedures for making accounting method changes to comply with the Tangible Property Regulations. Two revenue procedures, Rev. Proc. 2012-19 and 2012-20, provide guidance regarding the myriad of accounting method changes that are required for taxpayers applying these rules.7

Because the Tangible Property Regulations affect so many taxpayers and because they represent a major departure from earlier proposed guidance, numerous comment letters have been submitted and a wealth of suggestions have been made regarding how the regulations should be finalized.8 Throughout 2012, the IRS and Treasury considered various revisions to the Tangible Property Regulations.

In the late fall, it became clear that certain positions would be revised significantly and for that reason, in Notice 2012-73, the IRS announced its plan to amend the Tangible Property Regulations to delay the effective date.9 The Notice announced that revised regulations would be issued in 2013 and would apply to tax years beginning on or after January 1, 2014. The IRS made clear that taxpayers will be given an option regarding which set of regulations to apply. The Notice indicates that taxpayers will be permitted to apply the revised regulations to tax years beginning on or after January 1, 2012.10 Further, the Notice specified that taxpayers are permitted to apply the Tangible Property Regulations in tax years beginning on or after January 1, 2012, until the effective date of any revised guidance.

Updated LB&I Directive

The Directive is limited to issues associated with two issues:

(i) whether costs incurred to maintain, replace, or improve tangible property must be capitalized under Section 263(a) or treated as repair and maintenance costs under Section 262, subject to accounting method changes under Rev. Proc. 2011-14, Appendix section 3.06, (designated change number 144); and

(ii) any correlative issues involving the disposition of structural components of a building or dispositions of tangible depreciable assets (other than a building or its structural components) (see, e.g., Rev. Proc. 2011-14, Appendix Sections 6.24 and 6.25 (designated change numbers 146 and 147, respectively)).

The Directive refers to these two items as the "Issues."11 As noted, taxpayers may choose to apply the Tangible Property Regulations for tax years beginning on or after January 1, 2012, and before the effective date provided in the forthcoming regulations. The Directive refers to this timeframe as the "Option Period."12 During the Option Period, the Directive reiterates that taxpayers applying the Tangible Property Regulations may rely on the procedural guidance for automatic IRS consent for a change in accounting methods.13

For examinations of tax years beginning before January 1, 2012, examining agents are instructed to discontinue (or not begin new) exam activity with regard to the Issues. However, additional instruction is provided if a Form 3115, (Application for Change of Accounting Method) with regard to the Issues has been filed following the effective date of the Tangible Property Regulations, (December 27, 2011), for a tax year not within the Option Period. In particular, if this occurs, then the examining agent is directed to "risk assess" the filing and determine whether examination is warranted.

For examinations of tax years beginning on or after January 1, 2012, but before January 1, 2014, the examining agent is instructed first to determine whether the taxpayer has changed its method of accounting with respect to the Issues. If its method of accounting has been changed, with or without filing a Form 3115, then the examining agent is directed to perform a risk assessment. If not, then the issue should not be examined.

For examinations of tax years beginning on or after January 1, 2014, examining agents are instructed to apply the regulations in effect and follow normal exam procedures.

Implications

As a general rule, the Directive instructs examining agents not to pursue the capitalization of costs incurred to maintain, repair or improve tangible property under Section 263(a) and correlative issues involving the dispositions of certain assets. The only exception to this general rule involves a situation in which a taxpayer filed a method change following the issuance of the Tangible Property Regulations. For tax years beginning on or after January 1, 2012, but before January 1, 2014, the exception applies regardless of whether an accounting method change request has been filed.

When an accounting method change is identified, the Directive provides that a risk assessment is appropriate, which means the examining agents will likely review the method change, including any Form(s) 3115 that was filed. They may also request documents supporting the change and/or the Section 481(a) adjustment(s). Examining agents are directed to consult with the Method of Accounting and Timing or the Deductible and Capital Expenditures Issue Practice Groups. For taxpayers that filed an accounting method change to apply the Tangible Property Regulations, or, subsequent to January 1, 2012, made a method change, additional scrutiny of repair costs and subsidiary issues should be anticipated in Exam. It is encouraging that examining agents are directed to avoid examination, which should make this review move quickly. Further, consultation with other specialists may reduce the likelihood than extraneous issues will be developed in examination. More importantly, this Directive makes clear that taxpayers should consider the range of alternative treatment for the Issues. Specifically, taxpayers should consider whether there is benefit in changing to a method under the Tangible Property Regulations prior to the issuance of revised regulations.

Endnotes

1 LB&I-04-0313-001 (March 22, 2013).

2 LB&I-4-0312-004 (March 16, 2012).

3 Treasury and the IRS issued guidance containing temporary and proposed regulations addressing Section 263(a) with respect to amounts paid to acquire, produce, or improve tangible property. T.D. 9564, 2012-14 I.R.B. 614, and REG-168745-03, 2012-14 I.R.B. 718 (December 23, 2011).

4 Id.

5 See amendments to T.D. 9564 published December 17, 2012, extending the effective date to January 1, 2014.

6 On August 21, 2006, the IRS and Treasury Department proposed amendments to the regulations under Section 263(a) relating to amounts paid to acquire, produce, or improve tangible property. See 71 FR 48590-01. The IRS and Treasury Department received numerous written comments and held a public hearing on December 19, 2006. On March 10, 2008, the IRS and Treasury Department withdrew the previously proposed regulations and proposed new regulations, 73 FR 47 12838-01. The IRS and Treasury Department again received several comment letters and held a public hearing on June 24, 2008.

7 Rev. Proc. 2012-19, 2012-14 I.R.B. 689; Rev. Proc. 2012-20, 2012-14 I.R.B. 700.

8 See, e.g., Comment Letter from Investor-Owned Hospital Company Coalition, Comments on Temporary Regulations under Section 263(a) – Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property (Oct. 24, 2012).

9 I.R.B. 2012-51, 713.

10 In December 2012, the IRS released technical amendments to the Tangible Property Regulations changing the effective date but also allowing taxpayers to apply the temporary regulations for tax years beginning on or after January 1, 2012.

11 LB&I-04-0313-001 (March 22, 2013).

12 Id.

13 See Revenue Procedures 2012-19 and 2012-20.