[Federal Register: March 10, 2008 (Volume 73, Number 47)]
[Proposed Rules]
[Page 12837-12867]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr10mr08-21]
[[Page 12837]]
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Part III
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Guidance Regarding Deduction and Capitalization of Expenditures Related
to Tangible Property; Proposed Rule
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-168745-03]
RIN 1545-BE18
Guidance Regarding Deduction and Capitalization of Expenditures
Related to Tangible Property
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking, a notice of public hearing, and
withdrawal of previously proposed regulations.
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SUMMARY: This document contains proposed regulations that explain how
section 263(a) of the Internal Revenue Code (Code) applies to amounts
paid to acquire, produce, or improve tangible property. The proposed
regulations clarify and expand the standards in the current regulations
under section 263(a), as well as provide some bright-line tests (for
example, a de minimis rule for acquisitions). The proposed regulations
will affect all taxpayers that acquire, produce, or improve tangible
property. This document also provides a notice of public hearing on the
proposed regulations and withdraws the proposed regulations published
in the Federal Register on August 21, 2006 (71 FR 161).
DATES: Written or electronic comments must be received by June 9, 2008.
Outlines of topics to be discussed at the public hearing scheduled for
June 24, 2008, at 10 a.m., must be received by June 3, 2008.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-168745-03), room
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
168745-03), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC 20224, or sent electronically, via the
Federal eRulemaking Portal at www.regulations.gov (IRS REG-168745-03).
The public hearing will be held in the auditorium of the Internal
Revenue Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Merrill D. Feldstein or Mon L. Lam, (202) 622-4950; concerning
submission of comments, the hearing, and/or to be placed on the
building access list to attend the hearing,
Richard.A.Hurst@irscounsel.treas.gov.
SUPPLEMENTARY INFORMATION:
Background
On August 21, 2006, the IRS and Treasury Department published in
the Federal Register (71 FR 161) proposed amendments to the regulations
under section 263(a) (2006 proposed regulations) relating to amounts
paid to acquire, produce, or improve tangible property. The IRS and
Treasury Department received numerous written comments. A public
hearing was held on December 19, 2006. After considering the comment
letters and the statements at the public hearing, the IRS and Treasury
Department are withdrawing the 2006 proposed regulations and are
proposing new regulations.
Summary of Comments and Explanation of Provisions
I. Overview
These new proposed regulations include many of the provisions
contained in the 2006 proposed regulations, including the proposed
format changes in which Sec. 1.263(a)-1 provides general rules for
capital expenditures, Sec. 1.263(a)-2 provides rules for amounts paid
for the acquisition or production of tangible property, and Sec.
1.263(a)-3 provides rules for amounts paid for the improvement of
tangible property. However, these new proposed regulations provide many
additional rules that were not included in the 2006 proposed
regulations. For example, these new proposed regulations provide a
definition of materials and supplies under Sec. 1.162-3 (including a
special 12-month rule and a $100 de minimis rule), a book conformity de
minimis rule for acquisitions of units of property under Sec.
1.263(a)-2, a safe harbor for routine maintenance under Sec. 1.263(a)-
3, and an optional simplified method for regulated taxpayers under
Sec. 1.263(a)-3. Additionally, these new proposed regulations provide
significant changes to the rules relating to unit of property,
restorations, and allow for industry-specific repair allowance methods
in future Internal Revenue Bulletin guidance. These new proposed
regulations generally will apply to taxable years beginning on or after
the date that final regulations are published in the Federal Register.
II. Withdrawal and Re-Proposal of Regulations
In addition to providing specific comments, many commentators
suggested that, given the broad scope and effect of the regulations and
the numerous comments received on the 2006 proposed regulations,
consideration should be given to re-proposing the regulations in their
entirety. This suggestion has been adopted and the 2006 proposed
regulations are withdrawn and replaced with these new proposed
regulations.
III. Materials and Supplies Under Sec. 1.162-3
Various commentators thought that the 2006 proposed regulations
failed to fully address the relationship between the rules for
capitalization of tangible property under section 263(a) and the
materials and supplies rules provided in Sec. 1.162-3 of the current
regulations because the 2006 proposed regulations did not provide
special rules for the interaction between the two provisions.
Specifically, commentators noted that under the 2006 proposed
regulations, tangible property with a useful life of 12 months or less
was not treated as a material and supply, which treatment was
inconsistent with existing authorities, particularly with regard to the
timing of when to deduct amounts paid to acquire the property with a
useful life of 12 months or less. Commentators pointed out that the
2006 proposed regulations were inconsistent with Sec. 1.162-3 and
would create uncertainty with regard to which provision should be
applied to which property. In response, the IRS and Treasury Department
decided to revise Sec. Sec. 1.162-3 and 1.263(a)-2 to provide clear
and consistent treatment for those items that traditionally have been
considered to be materials and supplies and to provide distinct, but
coordinated, treatment for those items that should be addressed under
section 263(a).
The new proposed regulations provide additional guidance under
Sec. 1.162-3 with respect to the definition of materials and supplies.
Specifically, the proposed rules define a material and supply as
tangible property that (a) is not a unit of property, (b) is a unit of
property with an economic useful life of 12 months or less, (c) is a
unit of property that costs $100 or less, or (d) is identified as a
material and supply in future guidance.
Under the existing regulations, the costs of non-incidental
materials and supplies are deducted as the materials and supplies are
used or consumed, and the costs of incidental materials and
[[Page 12839]]
supplies are deducted as the costs are incurred. These new proposed
regulations retain this treatment of materials and supplies, except
with respect to rotable and temporary spare parts. These new proposed
regulations provide that rotable or temporary spare parts treated as
materials and supplies will be considered used or consumed in the
taxable year in which the taxpayer disposes of the parts. This rule
prevents taxpayers from prematurely deducting the cost of a unit of
property by systematically replacing components with rotable spare
parts. The IRS and Treasury Department anticipate that taxpayers with
rotable or temporary spare parts that are not discarded after their
original use generally will prefer to capitalize their costs and treat
those parts as depreciable assets. These new proposed regulations
provide for an election to capitalize these costs.
Taxpayers should recognize that the used or consumed standard for
non-incidental materials and supplies generally is met later than the
placed in service standard used for depreciation. In addition,
taxpayers are reminded that after a material or supply is used or
consumed, capitalization of the material or supply cost to another
property may be required. For example, amounts paid for materials and
supplies used in the production of inventory or a self-constructed
asset generally are required to be capitalized under section 263A.
Similarly, amounts paid to produce materials and supplies generally are
required to be capitalized as part of the production costs of the
materials and supplies. Nothing in these new proposed regulations is
intended to change this treatment.
First, these new proposed regulations provide that property that is
not a unit of property as defined in Sec. 1.263(a)-3 will be
considered a material and supply. In general, this definition is
intended to describe spare and replacement parts and is consistent with
the current characterization of these items.
Second, these new proposed regulations provide that property that
has an economic useful life of 12 months or less will be considered a
material and supply. Commentators requested clarification concerning
the application of the 12-month rule provided in the 2006 proposed
regulations. For purposes of applying the 12-month rule, these new
proposed regulations generally adopt the economic useful life
definition in Sec. 1.167(a)-1(b) and provide that, for purposes of
these new proposed material and supplies regulations, the measurement
period for economic useful life begins when the item is first used or
consumed in the taxpayer's trade or business. Therefore, the time prior
to when an item is used or consumed is not taken into consideration in
determining the economic useful life of the asset for these new
proposed regulations, notwithstanding the fact that the item may have
been placed in service (ready and available for its intended use) for
depreciation.
In addition, these new proposed regulations provide a special
economic useful life test under the 12-month rule for taxpayers with
applicable financial statements (AFS). Under this rule, taxpayers with
AFS are required to determine the economic useful life in a manner
consistent with the economic useful life used for purposes of
determining depreciation in the books and records supporting their AFS.
An exception is provided if a taxpayer does not assign a useful life to
certain property in its AFS (for example, the item is currently
expensed in the taxpayer's AFS because it is considered de minimis).
The 2006 proposed regulations did not provide a de minimis rule for
the acquisition or production of property but requested comments on
whether a de minimis rule should be adopted. Commentators generally
agreed that the regulations should include a de minimis rule but varied
on how that rule should be structured.
Third, these new proposed regulations provide a $100 de minimis
rule within the definition of materials and supplies. Materials and
supplies include a unit of property that has a production or
acquisition cost of $100 or less, without regard to the treatment of
the item in the taxpayer's financial statements. Allowing small items
to be treated as materials and supplies resolves uncertainty with
respect to whether those items represent a depreciable asset or a
material and supply, and $100 is a low enough threshold to alleviate
concerns about the potential distortion of income. However, treating a
small unit of property as a material and supply may affect the timing
of the deduction for the material and supply cost because expensing an
amount paid for a non-incidental material and supply will only occur in
the period in which the item is used or consumed.
Various commentators pointed out that taxpayer burden may be
reduced by allowing taxpayers to capitalize amounts paid for items that
otherwise would qualify as materials and supplies and treat the items
as depreciable assets. For example, many taxpayers currently treat
rotable spare parts as capital expenditures depreciable over the life
of the unit of property in which the rotables are used. See Rev. Rul.
69-200 (1969-1 CB 60). See Sec. 601.601(d)(2)(ii)(b).
Under these new proposed regulations, taxpayers may elect to treat
an amount paid for a material and supply as a capital expenditure. In
general, the election is made separately for each material and supply
and is revocable only with the consent of the Commissioner. The
election is made by capitalizing the cost of the material and supply in
the year the cost is incurred and beginning depreciation of the item in
the year it is placed in service.
IV. Repairs under Sec. 1.162-4
The 2006 proposed regulations revised Sec. 1.162-4 (the repair
rules), to provide rules consistent with the improvement rules under
Sec. 1.263(a)-3 of the 2006 proposed regulations. Commentators
expressed concern that the proposed changes would result in challenges
to the deductibility of costs that the IRS has long agreed with
taxpayers are deductible. The IRS and Treasury Department do not think
that the proposed change to Sec. 1.162-4 creates a burden of proof
higher than that which exists under current law or requires
capitalization of costs that are not required to be capitalized under
current law. Therefore, these new proposed regulations do not propose
any specific changes to the rules proposed in the 2006 proposed
regulations. However, a routine maintenance safe harbor is provided in
these new proposed regulations in Sec. 1.263(a)-3.
V. Professional Expenses Under Sec. 1.162-6
The existing regulations under Sec. 1.162-6 provide rules for
professional expenses. These new proposed regulations propose to remove
Sec. 1.162-6. In general, the treatment of the items listed in Sec.
1.162-6 is adequately addressed in these new proposed regulations and
other existing regulations. The proposed removal of Sec. 1.162-6 is
not intended to result in any substantive changes in the treatment of
professional expenses.
VI. Capital Expenditures
A. Amounts Paid To Sell Property
The 2006 proposed regulations provided rules for the capitalization
of selling expenses, except in the case of dealers, under Sec.
1.263(a)-1. The 2006 proposed regulations included an example that
required the capitalization
[[Page 12840]]
of advertising costs as a selling expense that must be offset against
the sale proceeds. Various commentators questioned this treatment of
advertising costs. In general, advertising costs are not capital
expenditures. Therefore, these new proposed regulations retain the
general rule but remove the references to advertising costs provided in
the 2006 proposed regulations and update the examples accordingly.
B. Interests in Land
The 2006 proposed regulations did not provide a specific
capitalization rule for amounts paid to acquire or create intangible
interests in land. The 2006 proposed regulations specifically requested
comments on this issue, but no comments were received. These new
proposed regulations provide that amounts paid to acquire or create
interests in land, such as easements, life estates, mineral interests,
timber rights, zoning variances, or other interests in land, are
examples of capital expenditures. Comments are specifically requested
on this proposed rule.
VII. Amounts Paid To Acquire or Produce Tangible Property
The 2006 proposed regulations provided rules for the capitalization
of amounts paid to acquire or produce tangible property under Sec.
1.263(a)-2. These new proposed regulations generally retain the same
format, but make some modifications to the 2006 proposed regulations.
For example, modifications have been made to clarify the interaction of
Sec. 1.263(a)-2 of these new proposed regulations with the materials
and supplies rules under Sec. 1.162-3. Significant modifications and
clarifications are discussed further in this preamble.
A. Definition of Produce
Commentators asked whether the term ``produce'' as used in the 2006
proposed regulations had the same meaning as the term ``produce'' under
section 263A. These new proposed regulations clarify that the
definition of the term produce for purposes of Sec. 1.162-3 and Sec.
1.263(a)-2 generally is the same as the definition of the term produce
for section 263A purposes. The sole difference is that the term
``improve'' is not included in Sec. 1.162-3 and Sec. 1.263(a)-2
because ``improve'' under section 263A is specifically defined in Sec.
1.263(a)-3 of these new proposed regulations, relating to the
improvement of tangible property.
B. Transaction Costs
The 2006 proposed regulations generally required a taxpayer to
capitalize amounts paid to facilitate the acquisition of real or
personal property, and included a list of typical transaction costs.
Commentators suggested that with respect to the rules requiring the
capitalization of facilitative transaction costs, an exception should
be provided for transaction costs for pre-decisional investigatory
costs, similar to the exception provided with respect to certain
intangibles in Sec. 1.263(a)-4(e)(1)(iii) (creation of certain
contract rights) and Sec. 1.263(a)-5(e) (acquisition of a trade or
business). These new proposed regulations provide a general rule
similar to the rules in the intangibles regulations requiring that
taxpayers capitalize all costs that facilitate an acquisition of
tangible property, including the costs of investigating the
acquisition, but adopt the commentators' suggestion in part by
providing an exception for certain costs incurred in the investigation
of real property acquisitions. The IRS and Treasury Department think it
is appropriate to provide an exception for real property acquisitions
because these types of transactions most often raise the issue of
whether the investigatory costs are deductible business expansion costs
rather than capital expenditures to acquire a specific asset. The
exception provides that costs relating to activities performed in the
process of determining whether to acquire real property and which real
property to acquire generally are deductible pre-decisional costs.
Under this exception, capitalization will not be required for certain
pre-decisional investigative activities, such as marketing studies,
that are not specifically identified in these regulations as being
inherently facilitative. These new proposed regulations provide that
inherently facilitative costs must be capitalized and list the costs,
such as transportation and shipping costs, that are inherently
facilitative.
A commentator pointed out that section 263A does not apply to
acquisitions of property that are not intended for resale, and thus,
taxpayers should not be required to capitalize overhead costs to this
type of property. These new proposed regulations address this comment
by providing a simplifying convention for employee compensation and
overhead costs similar to the rules provided for intangible property.
However, the new proposed regulations reiterate that section 263A does
apply to the production of real or personal property. Section 263A
contains rules for certain costs incurred prior to production.
Under current law, if a taxpayer engages in multiple separate and
distinct transactions, the taxpayer may allocate transaction costs to
the separate transactions and recover the allocable transaction costs
as each distinct transaction is abandoned. Sibley, Lindsay & Curr Co.
v. Commissioner, 15 T.C. 106, 110 (1950), acq., 1951-1 CB 3. See Sec.
601.601(d)(2)(ii)(b). However, if the transactions are viewed as
alternatives, only one of which the taxpayer can complete, the courts
have held that the taxpayer must capitalize all the transaction costs
to the one transaction ultimately completed. United Dairy Farmers, Inc.
v. United States, 267 F.3d 510 (6th Cir. 2001); Nicolazzi v.
Commissioner, 79 T.C. 109 (1982), aff'd, 722 F.2d 324 (6th Cir. 1983).
To avoid the difficulty inherent in administering this rule, including
ascertaining the intent of the taxpayer, the new proposed regulations
provide a more objective rule. This rule allows taxpayers to allocate
inherently facilitative costs among the separate and distinct
properties considered, regardless of the taxpayer's ultimate intent or
plan. The taxpayer capitalizes the allocable transaction costs to each
property, including properties not acquired, and recovers the costs as
appropriate under the applicable provision of the Code (for example,
section 165, 167, or 168). Examples are provided to demonstrate the
application of these rules.
In addition, a commentator noted that the rule contained in the
2006 proposed regulations with respect to costs incurred prior to
placing property in service is really a rule for acquisition costs, not
improvement costs. The IRS and Treasury Department agree that
activities occurring prior to placing the property in service are
conceptually more related to the acquisition of the property than to
the improvement of property. Therefore, these new proposed regulations
move to the acquisition cost section of these regulations the
requirement to capitalize amounts paid for work performed prior to
placing property in service.
C. De minimis rule
The 2006 proposed regulations did not provide a specific de minimis
rule for the acquisition or production of property, but the preamble
provided a detailed proposal of what might be an appropriate de minimis
rule and requested comments from taxpayers on this issue. Numerous
comments supported the adoption of a de minimis rule to the extent such
a proposal would not alter the current understandings between taxpayers
and examining agents with respect to what type of transactions are
considered de minimis
[[Page 12841]]
on examination for purposes of evaluating risk. Therefore, to reduce
burden and provide simplification, these new proposed regulations
provide a de minimis rule. With respect to the concerns raised by
commentators as to the adoption of a de minimis rule, the IRS and
Treasury Department want to make clear that the adoption of such a rule
is not intended to alter the general risk analysis currently employed
by examining agents. Therefore, the de minimis rule proposed in these
regulations should not affect any current understandings between
examining agents and taxpayers with respect to the size and character
of transactions that will be the focus of examinations.
The proposed de minimis rule is based primarily on a qualifying
taxpayer's financial statement standards. A qualifying taxpayer is a
taxpayer that: (a) Has an AFS, (b) has written accounting procedures
for the expensing of de minimis items, and (c) recognizes de minimis
costs as expenses on its AFS. Under the rule provided in these new
proposed regulations, a qualifying taxpayer can use the de minimis
standard adopted in its AFS to the extent the AFS de minimis standard
does not result in a distortion of income. Although commentators varied
regarding whether it is appropriate to require conformity with AFS to
qualify for a de minimis rule, the IRS and Treasury Department think
that it provides simplification and reduces burden only to allow
deductions for de minimis amounts paid for property (other than the
$100 rule for materials and supplies) that are already being deducted
for AFS purposes.
The primary concern with the adoption of a de minimis rule is that
expensing items under a de minimis rule may not clearly reflect income
under section 446, particularly for aggregate or bulk purchases of de
minimis items. In general, the IRS and Treasury Department recognize
that accounting for an item using generally accepted accounting
principles will not result in a distortion of income. Nonetheless, a
distortion of income standard has been adopted in an effort to avoid
intentional manipulations of the de minimis rule. These new proposed
regulations provide a safe harbor in which the use of an AFS de minimis
standard will be deemed not to distort income. Specifically, the safe
harbor provides that an amount deducted under the AFS de minimis rule
for the taxable year will be deemed not to distort income if that
amount, added to the amounts deducted in the taxable year as materials
and supplies for units of property costing $100 or less, is less than
or equal to the lesser of (i) 0.1 percent of the taxpayer's gross
receipts for the taxable year, or (ii) 2 percent of the taxpayer's
total depreciation and amortization for the taxable year as determined
in its AFS. The safe harbor provided in these new proposed regulations
is based upon percentages and comparisons provided in case law. See
Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo. 2001-
149; Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United States, 424
F.2d 563 (Ct. Cl. 1970). This safe harbor is not intended to be used in
other contexts as a bright-line rule of an amount that distorts income.
Whether amounts above the safe harbor result in a distortion of income
depends upon the taxpayer's facts and circumstances.
These new proposed regulations also provide that gain on the sale
or disposition of property accounted for under the de minimis rule is
not treated as gain resulting from the sale or disposition of a capital
asset under section 1221 or as property used in the trade or business
under section 1231. These new proposed regulations also clarify that
property accounted for under the de minimis rule is not a material or
supply under Sec. 1.162-3.
Moreover, these new proposed regulations provide that taxpayers may
elect to capitalize items that might otherwise be within the scope of
the de minimis rule. In general, this election to capitalize is made
separately for each asset by treating the amount paid as a capital
expenditure on the tax return.
These new proposed regulations also make a conforming change to the
regulations under section 263A to ensure that amounts paid for property
produced by the taxpayer also qualify under the de minimis rule,
because there is no basis for distinguishing between acquired and
produced property for this purpose. This change is provided in Sec.
1.263A-1(b)(14) of the these new proposed regulations. The rule
provides that the cost of property to which a taxpayer properly applies
the de minimis rule contained in Sec. 1.263(a)-2(d)(4) of these new
proposed regulations (including the requirement that it not distort
income) is not required to be capitalized under section 263A as a
separate unit of property, but may be required to be capitalized as a
cost incurred by reason of the production of other property. This
change is necessary because without a conforming change to section
263A, property produced by the taxpayer that qualified under the de
minimis rule would be capitalized under section 263A despite the de
minimis rule under section 263(a).
These new proposed regulations do not impose any specific record
keeping requirements for the use of the de minimis rule. However, under
section 6001, taxpayers are required to keep books and records
sufficient to establish their eligibility to use the de minimis rule.
Specifically, taxpayers must maintain books and records reasonably
sufficient to determine (1) the total amounts paid and deducted as
materials and supplies pursuant to Sec. 1.162-3(d)(1)(iii) of these
new proposed regulations; (2) the total amounts paid and not
capitalized pursuant to Sec. 1.263(a)-2(d)(4)(i) of these new proposed
regulations; (3) the computation of the safe harbor amount provided by
Sec. 1.263(a)-2(d)(4)(iii) of these new proposed regulations; (4) that
income has not been distorted by the aggregate of the deductions under
Sec. Sec. 1.162-3(d)(1)(iii) and 1.263(a)-2(d)(4)(i) of these new
proposed regulations if the aggregate amount exceeds the safe harbor
amount determined pursuant to Sec. 1.263(a)-2(d)(4)(iii) of these new
proposed regulations; and (5) that the requirements of Sec. 1.263(a)-
2(d)(4)(i)(A)-(C) of these new proposed regulations have been met.
VIII. Improvements
In general, these proposed regulations are intended to reduce
controversy and provide clarity on how to determine whether an amount
paid must be capitalized under section 263(a) as an improvement cost.
Consistent with that intent, the 2006 proposed regulations contained
rules with respect to improvements, including rules to determine
whether an amount paid results in a material increase in value or
prolonged useful life. As described below, these regulations modify the
rules set forth in the 2006 proposed regulations to reflect comments
received. While these proposed regulations attempt to provide more
certainty in an area of law that currently requires a subjective
analysis, the IRS and Treasury Department request comments on whether
the improvement rules in these regulations are consistent with the
overriding goal of providing clarity and certainty in this area.
The IRS and Treasury Department received numerous comments
regarding the improvement rules provided in the 2006 proposed
regulations. Many of the comments received included a general request
that consideration be given to providing more bright-line rules and
clarifying definitions as well as providing greater consistency with
other
[[Page 12842]]
provisions of the Code. The rules contained in these new proposed
regulations attempt to address these concerns.
Section 1.263(a)-3 of the 2006 proposed regulations provided that
taxpayers are required to capitalize amounts paid to improve a unit of
property. Under the general rule in the 2006 proposed regulations, a
unit of property is improved if the amounts paid (i) materially
increase the value of the unit of property; or (ii) restore the unit of
property. Under the 2006 proposed regulations, amounts paid to adapt a
unit of property to a new or different use were considered to
materially increase the value of a unit of property. The 2006 proposed
regulations also contained rules for determining the appropriate unit
of property.
These new proposed regulations remove the new or different use
standard from the material increase in value rules and provide a
separate category for new or different use. Additionally, the material
increase in value standard has been renamed the ``betterment'' standard
because the betterment standard more closely reflects the manner in
which section 263(a) has been interpreted and applied under current
law. Therefore, these new proposed regulations identify three
categories of costs that result in an improvement to property.
Taxpayers under the new proposed regulations must capitalize amounts
paid that:
(i) Result in a betterment to a unit of property;
(ii) Restore a unit of property; or
(ii) Adapt a unit of property to a new or different use.
These new proposed regulations continue to include rules for
defining the unit of property to be used in making these
determinations.
The 2006 proposed regulations did not prescribe a plan of
rehabilitation doctrine as traditionally described in the case law.
That judicially-created doctrine provides that a taxpayer must
capitalize otherwise deductible repair costs if they are incurred as
part of a general plan of rehabilitation to the property. See Norwest
Corp. v. Commissioner, 108 T.C. 265 (1997); Moss v. Commissioner, 831
F.2d 833 (9th Cir. 1987); United States v. Wehrli, 400 F.2d 686 (10th
Cir. 1968). Commentators requested that the regulations specifically
state that the plan of rehabilitation doctrine either is eradicated or
is limited to clearly defined circumstances.
Section 263A requires that all direct costs of an improvement and
all indirect costs that directly benefit or are incurred by reason of
the improvement must be capitalized. See section 263A(b), which states
that section 263A applies to real or tangible property produced by the
taxpayer, and section 263A(g)(1), which states that the definition of
``produce'' includes improve. See also Sec. 1.263A-1(e), which
requires the capitalization of direct costs and of all indirect costs
that directly benefit or are incurred by reason of the performance of
production activities. Section 263A, therefore, requires a taxpayer to
capitalize otherwise deductible repair costs as part of an improvement
if the taxpayer improves a unit of property and the otherwise
deductible repair costs directly benefit or are incurred by reason of
the improvement to the property. Thus, section 263A has eliminated the
need for a plan of rehabilitation doctrine to determine the allocable
costs that must be capitalized as part of an improvement. Although some
commentators requested that the circumstances in which otherwise
deductible repair costs must be capitalized as part of an improvement
be limited, for example, to property that is totally dysfunctional and
unsuitable for its intended purpose, there is no authority for doing so
because section 263A specifically applies to improvements. The
legislative history to the Tax Reform Act of 1986, Public Law 99-514
(100 Stat. 2085) also indicates that Congress intended section 263A to
apply to improvements to property. See, for example, S. Rep. No. 99-
313, 99th Cong., 2d Sess. 133-152 (1986), which states that the uniform
capitalization rules will apply to assets or improvements to assets
constructed by a taxpayer for its own use in a trade or business or in
an activity engaged in for profit, and that the rules are not intended
to apply to expenditures properly treated as repair costs under present
law that do not relate to the manufacture, remanufacture, or production
of property.
Section 263A does not require otherwise deductible repair costs to
be capitalized if the repairs do not directly benefit or are not
incurred by reason of a production activity (for example, an
improvement). The judicially-created plan of rehabilitation doctrine,
however, has been cited to require capitalization of otherwise
deductible repair costs solely because the taxpayer has a plan (written
or otherwise) to perform periodic repairs or maintenance, or solely
because the taxpayer performs several repairs to the same property at
one time even though the property is not improved. As stated in the
preamble to the 2006 proposed regulations, the IRS and Treasury
Department do not think this characterization is appropriate. These new
proposed regulations specifically provide that repairs that are made at
the same time as an improvement, but that do not directly benefit or
are not incurred by reason of the improvement, are not required to be
capitalized under section 263(a). These new proposed regulations do not
prescribe a plan of rehabilitation doctrine. Therefore, when these new
proposed regulations are finalized, the judicially-created plan of
rehabilitation doctrine will be obsolete, particularly with regard to
the assertion that the doctrine transforms otherwise deductible repair
costs into capital improvement costs solely because the repairs are
performed at the same time as an improvement, or are pursuant to a
maintenance plan, even though the repairs do not improve the property
under Sec. 1.263(a)-3. However, section 263A continues to require a
taxpayer to capitalize otherwise deductible repair costs if the
taxpayer improves a unit of property and the otherwise deductible
repair costs directly benefit or are incurred by reason of the
improvement to the property.
A. Unit of Property
The 2006 proposed regulations began with an initial unit of
property determination of all components that are functionally
interdependent to define the largest unit of property as a starting
point for the analysis. Special rules applied to buildings and their
structural components and to property used in certain regulated
industries; network assets were excluded from the definition of unit of
property. The unit of property determination for other personal
property employed a facts and circumstances test based on the
application of four exclusive factors--(1) marketplace treatment; (2)
industry practice and financial accounting; (3) treatment as a rotable
spare part; and (4) functional use. An overriding rule required
taxpayers to treat property as a unit of property for purposes of
section 263 if the taxpayer did so for any other Federal income tax
purpose.
The IRS and Treasury Department received multiple comments on the
definition of a unit of property provided in the 2006 proposed
regulations. The commentators generally expressed dissatisfaction with
the unit of property rules provided in the 2006 proposed regulations,
particularly with respect to the regulated industry rules and the rule
for rotable spare parts. Commentators generally agreed with the unit of
property rules for a building, but raised
[[Page 12843]]
objections that the remaining rules provided in the 2006 proposed
regulations were overly complex and ambiguous. Many commentators
recommended that the determination of a unit of property be based
primarily on the functional interdependence test, similar to that used
for depreciation and section 263A purposes, with no further factors,
while other commentators recommended that the determination be based on
the factors used in FedEx Corp. v. United States, 291 F. Supp. 2d 699
(W.D. Tenn. 2003), aff'd, 412 F.3d 617 (6th Cir. 2005).
The IRS and Treasury Department think that most of the factors
listed in the 2006 proposed regulations were the same as the factors
used in FedEx. However, commentators generally criticized the manner in
which the 2006 proposed regulations applied these factors. Nonetheless,
the IRS and Treasury Department agree that some factors, such as the
rotable spare parts factor, may be overly burdensome, particularly for
taxpayers that use small components in their businesses. Additionally,
although some taxpayers in regulated industries favored the ability to
conform to regulatory reporting, many that are not subject to
regulatory accounting for all assets objected to the conformity rule as
inappropriate and a potential source for uncertainty and controversy.
Therefore, these new proposed regulations substantially modify the unit
of property definition contained in the 2006 proposed regulations.
These new proposed regulations provide unit of property rules that
generally are based on the functional interdependence standard, and
include special rules for buildings, plant property, and network
assets. Additional rules are provided that may require a smaller unit
of property characterization in certain circumstances. Generally,
improvements to a unit of property are not considered separate units of
property even though the improvements are treated as separate assets
for depreciation purposes.
These new proposed regulations generally provide the same rule for
buildings as the 2006 proposed regulations. A building and its
structural components are treated as a single unit of property.
However, a special rule for condominiums and cooperatives is provided.
Additionally, a leasehold improvement that is section 1250 property and
is made by a lessee is a separate unit of property.
For property other than a building, these new proposed regulations
provide that, in general, a single unit of property includes all
components that are functionally interdependent. However, a number of
special rules are provided that may require a smaller unit of property
to be considered. The IRS and Treasury Department do not think that
applying solely a functional interdependence test results in the
appropriate unit for all types of property. For some types of property,
such as machinery and equipment in a manufacturing plant, the
functional interdependence test often results in a very expansive unit
of property. The IRS and Treasury Department think it is inappropriate
to use such a large unit of property for making a determination
regarding improvements.
These new proposed regulations provide a special rule for plant
property, which is defined as ``functionally interdependent machinery
or equipment * * * used to perform an industrial process * * *.'' This
definition is not intended to include all types of property used in a
taxpayer's trade or business, but is intended only to capture the
functionally interdependent machinery and equipment used in industrial
processes like manufacturing, electric generation, distribution,
warehousing, as well as equipment used in providing industrial services
such as automated materials handling equipment. This special rule
requires that the functionally interdependent machinery and equipment
be separated into a component or a group of components that performs a
discrete and major function or operation. These new proposed
regulations provide various examples to illustrate activities that will
constitute a discrete and major function.
These new proposed regulations provide the same definition of
network assets as the 2006 proposed regulations and continue to reserve
on providing a special rule for network assets. The IRS and Treasury
Department think that in many situations, the unit of property for
network assets should be smaller than the unit of property determined
under the functional interdependence test. The IRS and Treasury
Department generally think that the unit of property rules for network
assets should be addressed on an industry by industry basis in Internal
Revenue Bulletin guidance. Industries are invited to submit requests
for guidance under the Industry Issue Resolution (IIR) program after
these regulations are finalized.
These new proposed regulations also provide two additional rules
that may require a smaller unit of property determination than that
provided under the general rule. The first rule is triggered if the
taxpayer has assigned different economic useful lives for financial
statement or regulatory purposes to components of a single unit of
property at the time the unit of property is placed in service by the
taxpayer. Simply accounting for components separately (for example,
recording the property separately in depreciation or other asset-
tracking books and records) does not trigger this rule. However,
assigning a different economic useful life to components will require
that the unit of property determination be limited to those components
that have been assigned the same useful life for financial statement
purposes. The second rule applies when components of a single unit of
property are depreciated by the taxpayer under different MACRS classes
(including a different MACRS class that results from a change in method
of accounting). This second rule also applies if components of a single
unit of property are depreciated by the taxpayer using different
recovery methods (for example, double-declining balance versus unit-of-
production). Again, simply recording various components separately in
the taxpayer's depreciation books and records will not trigger the
rule.
These rules are intended to prevent overly broad unit of property
determinations that are inconsistent with the taxpayer's
characterization of the unit of property for depreciation purposes. In
general, the IRS and Treasury Department anticipate that these limiting
rules will apply only in unique circumstances. The IRS and Treasury
Department encourage taxpayers to provide comments on the application
of these limiting rules and to identify situations (if any) in which
the limiting rules may not operate as intended.
B. Routine Maintenance Safe Harbor
The 2006 proposed regulations did not contain a routine maintenance
safe harbor. Various commentators requested that the regulations
provide guidance to clarify when the cost of a routine maintenance
activity will be considered a deductible expense. In addition,
commentators expressed concern that under the rules provided in the
2006 proposed regulations, routine maintenance activities are required
to be capitalized if performed near the end of the economic useful life
of the property, regardless that identical activities were considered
deductible if performed earlier in the useful life.
To address this concern, these new proposed regulations provide a
routine maintenance safe harbor under which qualifying activities will
be deemed to not improve the unit of property. Under
[[Page 12844]]
this safe harbor, routine maintenance activities include recurring
activities that a taxpayer expects to perform more than once over the
class life of the unit of property as a result of the taxpayer's use of
the unit of property to keep the unit of property in its ordinarily
efficient operating condition. Amounts paid for betterments do not keep
the unit of property in an ordinarily efficient operating condition;
however, the replacement of minor parts with improved but comparable
parts generally does not result in a betterment. Thus, for example, the
safe harbor includes amounts paid for replacement parts that the
taxpayer expects to replace more than once during the class life of the
unit of property, even if the replacement part is an improved but
comparable part. As part of the safe harbor provisions, these new
proposed regulations provide a list of relevant considerations to be
taken into account in determining whether an amount is paid for routine
maintenance. These considerations include the recurring nature of the
activity, industry practice, manufacturer recommendations, taxpayer
experience and the treatment of the activity on the taxpayer's AFS. The
safe harbor maintenance rule specifically applies to maintenance
activities performed on rotable or temporary spare parts, but reminds
taxpayers that under the rules proposed in Sec. 1.162-3(b) of these
new proposed regulations, the capitalized costs associated with rotable
and temporary spare parts (that is, acquisition costs) may be deducted
only in the taxable year in which the rotable or temporary spare part
is discarded.
One concern with establishing a maintenance safe harbor that
includes the costs of replacement parts is creating an incentive for
taxpayers to componentize assets in an effort to recover basis upon the
removal of a component while deducting the replacement cost as a repair
or maintenance expense. Therefore, the safe harbor does not apply to
the cost of replacement components in situations in which the taxpayer
has taken into account the basis of the component being replaced in
determining gain or loss resulting from a sale or exchange of the
replacement component, has taken a loss related to the retirement of
the component, or has taken a basis adjustment related to a casualty
event under section 165.
The safe harbor is intended to operate only as a safe harbor in
which qualifying costs will be deemed not to constitute an improvement.
The IRS and Treasury Department recognize that many activities that do
not qualify for the safe harbor nonetheless may be activities that do
not give rise to capitalization of costs under section 263(a).
Additionally, costs deductible under the maintenance safe harbor may be
required to be capitalized under section 263A to other property
produced or acquired for resale.
C. Betterments
1. Overview
The 2006 proposed regulations used the term ``material increase in
value'' to generally describe the concept of a betterment. In general,
commentators agreed with the standards outlined in the 2006 proposed
regulations to determine whether an amount paid materially increases
the value of property. However, commentators differed on whether
taxpayers should be allowed to override the material increase in value
test by proving that the activity did not actually increase fair market
value. Consistent with the preamble to the 2006 proposed regulations,
the IRS and Treasury Department continue to think that whether an
amount paid should be capitalized as a betterment to a unit of property
depends upon the purpose, the physical nature, and the effect of the
work for which the amounts were paid, and not upon an analysis of the
fair market value of the property before and after the work. Therefore,
to clarify this distinction, these new proposed regulations change the
name of the material increase in value test to the betterment test. The
general rule focuses on betterments to the condition of the property,
the costs of which should be capitalized as an improvement if the
betterment is material, regardless of whether the betterment increases
the fair market value.
Commentators noted that the general concept of a betterment is
difficult to apply and suggested that the language in the regulations
better define what types of events would give rise to a betterment.
Additionally, commentators pointed out that some of the betterment
tests were redundant. The IRS and Treasury Department agree that the
general concept of a betterment or improvement can be difficult to
apply. In developing these new proposed regulations, consideration was
given to retaining the rules provided in the current regulations
without providing clarification of material increase in value, prolong
useful life, and new or different use. The principal concern in
providing detailed rules on the concept of an improvement is the
potential to create controversy in areas where none currently exists,
which would undermine one of the primary purposes of the project.
Nonetheless, because commentators generally did not oppose the
tests provided for material increase in value under the 2006 proposed
regulations, these new proposed regulations continue to provide an
exclusive list of tests that determine whether an amount paid results
in a betterment in an attempt to further solicit comments in this area.
The IRS and Treasury Department specifically request comments as to
whether the exclusive list of tests with respect to improvements
provides additional certainty in this area and if not, why. Given the
continuing evaluation of this area, taxpayers should be particularly
aware that no reliance should be placed on the rules provided in these
new proposed regulations until such rules are finalized.
The tests included in the original proposed regulations have been
reorganized in these new proposed regulations in an attempt to provide
additional clarification. Under these new proposed regulations, an
amount paid results in a betterment if it:
(i) Ameliorates a material condition or material defect that
existed prior to the acquisition or arose during the production of the
property,
(ii) Results in a material addition to the unit of property
(including a physical enlargement, expansion, or extension), or
(iii) Results in a material increase in the capacity, productivity,
efficiency, strength, or quality of the unit of property or its output.
2. Ameliorates a Material Condition or Defect
This rule generally follows the rule contained in the 2006 proposed
regulations but clarifies, in response to comments received, that
capitalization is only required to the extent the condition or defect
is considered material. Commentators noted that a taxpayer may not know
of a condition or defect that exists at the time property is acquired
and that requiring capitalization of costs in this situation would
create a hardship for those taxpayers. Although taxpayers may not be
aware of defects that exist at the time of acquisition, the remedial
activity being performed necessarily results in a betterment,
regardless of whether the activity actually increases the fair market
value of the property. The rule provided in these proposed regulations
is consistent with established case law. See United Dairy Farmers, Inc.
v. United States, 267 F.3d 510 (6th Cir. 2001);
[[Page 12845]]
Dominion Resources, Inc. v. United States, 219 F.3d 359 (4th Cir.
2000).
Moreover, adopting a rule based on a taxpayer's knowledge at the
time of acquisition or production would be difficult to administer. The
IRS and Treasury Department recognize that application of this rule to
used property acquired by a taxpayer will result in some costs that
would otherwise be deductible as repair costs being capitalized the
first time the repairs are performed (if the condition or defect is
material) if the nature of the activities is to correct the effects of
wear and tear that was not caused by the taxpayer's use of the
property. This result is consistent with the routine maintenance safe
harbor, which requires the activities under that safe harbor to be
performed as a result of the taxpayer's own use of the property.
The IRS and Treasury Department understand that certain cases exist
in which a taxpayer contaminates property during its operations, the
taxpayer disposes of the property, and the taxpayer reacquires the
property to clean up the contamination. Under the proposed rule, a
taxpayer would be required to capitalize the costs incurred to clean up
the property even though it was the taxpayer's own activities that
contaminated the property. The IRS and Treasury Department request
comments regarding the appropriate treatment of environmental
remediation costs in these circumstances, considering that the
remediation is performed as a result of the taxpayer's own use of the
property. The IRS and Treasury Department also request comments
regarding how to determine whether the contamination was due solely to
the taxpayer's prior operations or, if an interim owner may have added
to the contamination, how to determine the appropriate treatment of
remediation costs in that circumstance.
3. Results in a Material Increase in the Capacity, etc.
This rule applies both to material increases in the capacity,
efficiency, strength, or quality of the unit of property itself as well
as to material increases in the capacity, efficiency, strength, or
quality of the output of the unit of property.
4. Application of Betterments Rule
Commentators requested that, to the extent possible, additional
guidance be provided with respect to how the betterments rules,
including materiality, should be applied. The IRS and Treasury
Department considered various possible bright-line rules with respect
to materiality, but determined that each rule was inappropriate under
certain circumstances. For example, the IRS and Treasury Department
considered a rule that presumed materiality if the amounts paid are
capitalized in the taxpayer's financial statements as a permanent
improvement, that is, the betterment is capitalized in the taxpayer's
financial statements over the remaining economic useful life of the
unit of property or longer. The IRS and Treasury Department think that
financial statement treatment is an important factor in determining
materiality, because if the activity is material enough to treat as an
improvement for financial statements, then generally it should be a
material improvement for tax purposes. However, this bright-line rule
was not adopted because the IRS and Treasury Department recognize that
the standards used for financial statement purposes for capitalization
of improvements do not coincide with the rules for capitalization of
improvements in these proposed regulations. For example, some taxpayers
may defer major maintenance expenses and amortize the expenses over the
period until the next maintenance cycle rather than immediately
expensing the costs for financial statement purposes. The taxpayer's
reason for not immediately expensing the cost for financial statement
purposes (that is, treating the cost as a deferred expense or as a
material capital expenditure) may not be readily apparent to the IRS,
creating administrative burden and a potential source of controversy.
Therefore, under these new proposed regulations, materiality will be
based upon the facts and circumstances in each case. Examples are
provided to illustrate to the application of materiality.
5. Appropriate Comparison for Betterments
The 2006 proposed regulations specifically provided that the
appropriate comparison for determining whether an amount paid results
in a betterment is made by comparing the condition of the unit of
property immediately after the expenditure with the condition of the
property prior to the circumstances necessitating the expenditure.
These new proposed regulations retain the same comparison test.
D. Restorations
1. Overview
The 2006 proposed regulations provided that, consistent with
section 263(a)(2), a taxpayer must capitalize amounts paid that restore
a unit of property. The 2006 proposed regulations provided that amounts
paid restore a unit of property only if they substantially prolong the
economic useful life of the unit of property, and provided four rules
for making that determination. The restoration of property rules
contained in the 2006 proposed regulations were criticized by
commentators as being overbroad and difficult to apply. In particular,
the AFS definition of economic useful life and the bright-line one-year
rule were denounced as providing inappropriate results. In response,
these new proposed regulations make numerous modifications to the 2006
proposed regulations.
These new proposed regulations continue to require a taxpayer to
capitalize amounts paid to restore a unit of property. However, the
one-year rule and the AFS conformity requirement for economic useful
life have been removed. These new proposed regulations provide a series
of bright-line rules to determine when an amount paid is deemed to
restore property. Although some commentators criticized rules that deem
the cost of certain activities to be capitalized as restorations, the
IRS and Treasury Department think that bright lines under this test
will reduce controversy and help ease administration. These rules also
expand on the rules provided in the 2006 proposed regulations with
regard to the restoration of property after a casualty loss.
Section 263(a)(2) states that no deduction is allowed for any
amount paid in restoring property or in making good the exhaustion
thereof for which an allowance is or has been made. The IRS and
Treasury Department think that this language requires capitalization of
a replacement component if the taxpayer removes the basis of the
replaced component from its books and records and takes the basis of
the replaced component into account in its tax return. If a taxpayer
takes into account the basis of a replaced component in its tax return,
then the replacement of that component ``makes good the exhaustion
thereof for which an allowance has been made.'' Therefore, these new
proposed regulations provide that if the taxpayer has properly taken a
portion of the existing adjusted basis of the restored asset into
account in the computation of gain or loss on a sale or exchange, or as
a retirement loss or other loss under the Code, the replacement of that
component will be deemed to restore the unit of property.
[[Page 12846]]
2. Restoration of Property Destroyed In a Casualty
The 2006 proposed regulations required a taxpayer to capitalize
amounts paid to repair property if the taxpayer properly deducted a
casualty loss under section 165 with respect to a unit of property and
the amounts paid restore the unit of property to a condition that is
the same or better than before the casualty. The casualty loss rule
provided in the 2006 proposed regulations was criticized. In general,
commentators thought there should be no link between the recognition of
a casualty loss under section 165 and the determination of whether the
cost to replace the property destroyed (in part or in whole) after a
casualty event constitutes a capital expenditure. However, significant
authority implies that a casualty-type event generally may only be
characterized either as an extraordinary event (thus giving rise to a
``loss'' under section 165), or as an ordinary and necessary event in
the operation of a trade or business (thus giving rise to an ordinary
and necessary deduction under section 162). See, e.g., R. R. Hensler,
Inc. v. Commissioner, 73 T.C. 168, 179 (1979), acq., (1980-2 CB 1);
Hubinger v. Commissioner, 36 F.2d 724, 726 (2d Cir. 1929), cert.
denied, 281 U.S. 741 (1930). Thus, a casualty is not an ordinary event,
and the cost to repair property damaged by a casualty is not an
ordinary expense. Stated differently, a loss under section 165
represents a destruction of property necessitating a replacement, which
is capital, while an ordinary event generally represents damage to
property necessitating a repair, which may or may not be capital.
Because the restoration cost resulting from a loss is not ordinary, it
is not allowed as an ordinary and necessary expense under section 162,
but is treated as a capital expenditure under section 263(a). Although
it is clear that a casualty event generally results in two economic
costs to the taxpayer (the destruction of the previously invested
capital and the costs to replace the destruction), the event giving
rise to both of these costs is the same.
These new proposed regulations generally require consistent
characterization of all costs arising from a single event. Therefore,
under the rules provided in these new proposed regulations, a taxpayer
that experiences an extraordinary loss event sufficiently destructive
to invoke the provisions of section 165 will be required to treat the
resulting restoration costs as a capitalized replacement of the
destroyed property. This rule is required to ensure consistency in tax
treatment among similarly situated taxpayers. For example, a taxpayer
whose property is completely destroyed by a casualty event is required
to capitalize the restoration of the loss because the restoration
results in the replacement of the destroyed property with an entirely
new unit of property. However, without a consistency rule, a taxpayer
who experiences the same casualty event but only has part of a unit of
property destroyed might argue that the cost to replace the destroyed
portion of the unit of property is deductible because it simply returns
the unit of property as a whole to its pre-casualty state. Allowing
this type of disparity in tax treatment would provide an incentive to
characterize destructions of property as partial destructions in order
to leave open the position that a deduction may be taken for both the
destruction of property resulting from the casualty event, as well as
the ordinary and necessary expense of replacing the destroyed property.
This rule also eliminates the dual characterization of minor costs
incurred for items such as broken windows or blown-off shingles as both
a casualty loss under section 165 and an ordinary and necessary expense
under section 162.
Commentators noted that a rule requiring the capitalization of
restoration costs following the recognition of a casualty loss would
unfairly burden taxpayers that routinely experience extraordinary loss
events in their trade or business. However, it should be noted that
under these new proposed regulations, capitalization is required only
if a loss or basis adjustment to the property is recognized by the
taxpayer with respect to the event.
Various judicial authorities have held that events that generally
are viewed as extraordinary loss events may nonetheless be considered
ordinary occurrences in a particular industry. See Atlantic Greyhound
Corp. v. United States, 111 F. Supp. 953 (Ct. Cl. 1953). In this
situation, the costs to replace property destroyed in what would
normally be characterized as a casualty event may result in an ordinary
and necessary expenditure under section 162 rather than a loss under
section 165. In this regard, the IRS and Treasury Department will
consider providing guidance on what types of events may be considered
ordinary in a particular industry. Taxpayers are encouraged to provide
comments on this issue.
Commentators also noted that the rule provided in the 2006 proposed
regulations created a disparity between taxpayers that recognized a
loss under section 165 and taxpayers that received untaxed insurance
proceeds as a result of a casualty event and adjusted the basis of the
damaged asset accordingly. These new proposed regulations eliminate
this disparity.
3. Other Restorations
Similar to the 2006 proposed regulations, these new proposed
regulations provide additional circumstances in which a restoration is
deemed to occur. Capitalization is required for amounts paid to return
a unit of property to its ordinarily efficient operating condition if
the property has deteriorated to a state of disrepair and can no longer
function for its intended purpose. The IRS and Treasury Department
anticipate that these types of restorations will occur either as a
result of lack of maintenance by the taxpayer or after the end of the
property's useful life. A unit of property that is damaged by a
casualty is not considered to be deteriorated to a state of disrepair.
These new proposed regulations also require capitalization of
amounts paid to rebuild a unit of property to a like-new condition
after the end of its economic useful life. The IRS and Treasury
Department anticipate that this standard will apply to the traditional
rebuilding of a unit of property to return it to a like-new condition.
In general, a restoration under this rule will not result from routine
maintenance activities, even if performed near the end of the useful
life of the property, but instead represents a fundamental renewal of
the economic useful life of the asset.
Similar to the 2006 proposed regulations, the new proposed
regulations require capitalization of amounts paid to replace a major
component or substantial structural part of a unit of property. In
response to comments regarding the uncertainty in applying this
standard, these new proposed regulations define the term ``major
component or substantial structural part.'' Specifically, these new
proposed regulations provide that the replacement of a major component
or substantial structural part will be deemed to occur only if (a) the
replacement costs constitute 50 percent or more of the replacement cost
of the unit of property or (b) the replacement part or parts constitute
50 percent or more of the physical structure of the unit of property.
These 50 percent thresholds apply solely for purposes of the
restoration rules and are not intended to be applied to the betterment
or new or different use rules.
[[Page 12847]]
E. New or Different Use
In general, these new proposed regulations contain the rules set
forth in the 2006 proposed regulations with respect to the
capitalization of amounts paid to adapt property to a new or different
use. However, these new proposed regulations remove the parenthetical
contained in the 2006 proposed regulations relating to ``structural
alterations to the unit of property.'' Commentators noted that,
although permanent structural alterations may result in adapting
property to a new or different use, those alterations also could result
in betterments to the unit of property and, in certain circumstances,
could constitute routine maintenance. Commentators also noted that
adapting property to a new or different use does not necessarily make
the property better or increase its value, but nevertheless is a
capital expenditure. Therefore, the new or different use rules are
provided separately from the betterment rules in these new proposed
regulations.
These new proposed regulations also clarify that amounts paid will
be deemed to adapt property to a new or different use only if the new
use is not consistent with the taxpayer's intended use of the property
at the time the property is placed in service by the taxpayer.
Additional examples have been added to clarify the application of this
rule.
F. Repair Allowance
The 2006 proposed regulations provided a repair allowance similar
to the CLADR repair allowance, but did not specify different repair
allowance percentages for different industries. Commentators generally
favored the idea of a repair allowance; however, they widely criticized
the lack of percentages tailored to specific industries. Some
commentators in regulated industries requested that they be allowed to
determine their deductible repair costs and their capital improvement
costs for tax purposes based on conformity with regulatory accounting
reporting.
These new proposed regulations adopt the request by certain
regulated industries to conform the tax treatment of amounts paid to
maintain, repair, or improve tangible property to their regulatory
accounting treatment. An optional regulatory accounting method is
proposed for amounts paid to maintain, repair, or improve tangible
property subject to regulatory accounting. For purposes of this method,
regulated accounting industries include industries regulated by the
Federal Energy Regulatory Commission (FERC), the Federal Communications
Commission (FCC), and the Surface Transportation Board (STB). The IRS
and Treasury Department recognize that conformity with the regulatory
accounting rules in these industries frequently may result in the
overcapitalization of costs, and sometimes the undercapitalization of
costs, as compared to the general rules for improvements under these
new proposed regulations. The regulatory accounting method is not
intended to be used as a definitive test of what should be capitalized
for taxpayers that do not elect to use the method.
These new proposed regulations do not propose a detailed repair
allowance like the one that was provided in the 2006 proposed
regulations. Some commentators stated that very large taxpayers will
want to have a repair allowance, because applying the general rules
asset-by-asset is too burdensome because of their numerous assets. The
commentators made clear, however, that taxpayers would not widely use a
one-size-fits-all approach and that any repair allowance must be
tailored to individual industries. Therefore, these new proposed
regulations provide authority for issuing industry-specific repair
allowance guidance in the future.
IX. Accounting Method Changes
These new proposed regulations do not provide any specific rules
for changes in method of accounting. Because these proposed regulations
are not effective until they are published as final regulations,
taxpayers may not change their accounting method to conform to a method
of accounting provided in these proposed regulations. Generally, a
taxpayer's treatment of an amount paid to conform with these proposed
regulations will be a change in method of accounting under section
446(e). For example, a change to the routine maintenance safe harbor in
Sec. 1.263(a)-3(e) of these proposed regulations or to the optional
regulatory accounting method in Sec. 1.263(a)-3(i) of these proposed
regulations is a change in method of accounting. The IRS and Treasury
Department request comments on whether a change to or from the use of
the de minimis rule in Sec. 1.263(a)-2(d)(4) of these proposed
regulations is a change in method of accounting under section 446(e).
Proposed Effective Date
These regulations are proposed to apply to taxable years beginning
on or after the date the final regulations are published in the Federal
Register. The final regulations will provide rules applicable to
taxpayers that seek to change a method of accounting to comply with the
rules contained in the final regulations. Taxpayers may not change a
method of accounting in reliance upon the rules contained in these new
proposed regulations until the rules are published as final regulations
in the Federal Register.
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also has
been determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and, because
the regulation does not impose a collection of information on small
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not
apply. Pursuant to section 7805(f), this notice of proposed rulemaking
will be submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on its impact on small business.
Comments and Public Hearing
Before the proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) or electronic comments that are submitted timely
to the IRS. Comments are requested on all aspects of the proposed
regulations. In addition, the IRS and Treasury Department specifically
request comments on the clarity of the proposed rules and how they may
be made easier to understand. All comments will be available for public
inspection and copying.
A public hearing has been scheduled for June 24, 2008, at 10 a.m.
in the Auditorium, Internal Revenue Building, 1111 Constitution Avenue,
NW., Washington, DC. Due to building security procedures, visitors must
enter at the Constitution Avenue entrance. In addition, all visitors
must present photo identification to enter the building. Because of
access restrictions, visitors will not be admitted beyond the immediate
entrance area more than 30 minutes before the hearing starts. For
information about having your name placed on the building access list
to attend the hearing, see the FOR FURTHER INFORMATION CONTACT section
of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit electronic or
written comments by June 9, 2008 and an outline of the topics to be
discussed and
[[Page 12848]]
the time to be devoted to each topic (signed original and eight (8)
copies) by June 3, 2008. A period of 10 minutes will be allotted to
each person for making comments. An agenda showing the scheduling of
the speakers will be prepared after the deadline for receiving outlines
has passed. Copies of the agenda will be available free of charge at
the hearing.
Drafting Information
The principal author of these regulations is Merrill D. Feldstein,
Office of the Associate Chief Counsel (Income Tax and Accounting).
However, other personnel from the IRS and Treasury Department
participated in their development.
Withdrawal of Proposed Amendments to the Regulations
Accordingly, under the authority of 26 U.S.C. 7805, the notice of
proposed rulemaking (REG-168745-03) published in the Federal Register
on August 21, 2006, (71 FR 161) is withdrawn.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.162-3 is revised to read as follows:
Sec. 1.162-3 Materials and supplies.
(a) In general--(1) Non-incidental materials and supplies. Amounts
paid to acquire or produce materials and supplies are deductible in the
taxable year in which the materials and supplies are used or consumed
in the taxpayer's operations.
(2) Incidental materials and supplies. Amounts paid to acquire or
produce incidental materials and supplies that are carried on hand and
for which no record of consumption is kept or physical inventories at
the beginning and end of the year are not taken, are deductible in the
taxable year in which these amounts are paid, provided taxable income
is clearly reflected.
(b) Rotable and temporary spare parts. For purposes of this
section, rotable spare parts are parts that are removable from the unit
of property, generally repaired or improved, and either reinstalled on
other property, or stored for later installation. Temporary spare parts
are parts that are used temporarily until a new or repaired part can be
installed, and then removed and stored for later (emergency or
temporary) installation. For purposes of paragraph (a)(1) of this
section, rotable and temporary spare parts are used or consumed in the
taxpayer's business in the taxable year in which the taxpayer disposes
of the parts.
(c) Coordination with other provisions of the Internal Revenue
Code. Nothing in this section changes the treatment of any amount that
is specifically provided for under any provision of the Internal
Revenue Code (Code) or regulations other than section 162(a) or section
212 and the regulations under those sections. For example, see section
Sec. 1.263(a)-3, which requires taxpayers to capitalize amounts paid
to improve units of property and section 263A and the regulations under
section 263A, which require taxpayers to capitalize the direct and
allocable indirect costs, including the cost of materials and supplies,
to property produced or to property acquired for resale.
(d) Definitions--(1) Materials and supplies. For purposes of this
section, materials and supplies means tangible property that is used or
consumed in the taxpayer's operations and that--
(i) Is not a unit of property (as determined under Sec. 1.263(a)-
3(d)(2)) and is not acquired as part of a single unit of property; or
(ii) Is a unit of property (as determined under Sec. 1.263(a)-
3(d)(2)) that has an economic useful life of 12 months or less,
beginning when the property is used or consumed in the taxpayer's
operations; or
(iii) Is a unit of property (as determined under Sec. 1.263(a)-
3(d)(2)) that has an acquisition cost or production cost (as determined
under section 263A) of $100 or less; or
(iv) Is identified in published guidance in the Federal Register or
in the Internal Revenue Bulletin (see Sec. 601.601(d)(2)(ii)(b) of
this chapter) as materials and supplies for which treatment is
permitted under this section.
(2) Economic useful life--(i) General rule. The economic useful
life of a unit of property is not necessarily the useful life inherent
in the property but is the period over which the property may
reasonably be expected to be useful to the taxpayer or, if the taxpayer
is engaged in a trade or business or an activity for the production of
income, the period over which the property may reasonably be expected
to be useful to the taxpayer in its trade or business or for the
production of income, as applicable. See Sec. 1.167(a)-1(b) for the
factors to be considered in determining this period.
(ii) Taxpayers with an applicable financial statement. For
taxpayers with an applicable financial statement (as defined in
paragraph (d)(2)(iii) of this section), the economic useful life of a
unit of property, solely for the purposes of applying the provisions of
paragraph (d)(1)(ii) of this section, is the useful life initially used
by the taxpayer for purposes of determining depreciation in its
applicable financial statement, regardless of any salvage value of the
property. If a taxpayer does not have an applicable financial statement
for the taxable year in which the property was originally acquired or
produced, the economic useful life of the unit of property must be
determined under paragraph (d)(2)(i) of this section. Further, if a
taxpayer treats amounts paid for a unit of property as an expense in
its applicable financial statement on a basis other than the useful
life of the property or if a taxpayer does not depreciate the unit of
property on its applicable financial statement, the economic useful
life of the unit of property must be determined under paragraph
(d)(2)(i) of this section. For example, if a taxpayer has a policy of
treating as an expense on its applicable financial statement amounts
paid for property costing less than a certain dollar amount,
notwithstanding that the property has a useful life of more than one
year, the economic useful life of the property must be determined under
paragraph (d)(2)(i) of this section.
(iii) Definition of applicable financial statement. The taxpayer's
applicable financial statement is the taxpayer's financial statement
listed in paragraphs (d)(2)(iii)(A) through (C) of this section that
has the highest priority (including within paragraph (d)(2)(iii)(B) of
this section). The financial statements are, in descending priority--
(A) A financial statement required to be filed with the Securities
and Exchange Commission (SEC) (the 10-K or the Annual Statement to
Shareholders);
(B) A certified audited financial statement that is accompanied by
the report of an independent CPA (or in the case of a foreign entity,
by the report of a similarly qualified independent professional), that
is used for--
(1) Credit purposes;
(2) Reporting to shareholders, partners, or similar persons; or
(3) Any other substantial non-tax purpose; or
(C) A financial statement (other than a tax return) required to be
provided to
[[Page 12849]]
the Federal or a state government or any Federal or state agencies
(other than the SEC or the Internal Revenue Service).
(3) Amount paid. For purposes of this section, in the case of a
taxpayer using an accrual method of accounting, the terms amount paid
and payment mean a liability incurred (within the meaning of Sec.
1.446-1(c)(1)(ii)). A liability may not be taken into account under
this section prior to the taxable year during which the liability is
incurred.
(4) Produce. For purposes of this section, produce means construct,
build, install, manufacture, develop, create, raise or grow. See also
Sec. 1.263(a)-2(b)(4). This definition is intended to have the same
meaning as the definition used for purposes of section 263A(g)(1) and
Sec. 1.263A-2(a)(1)(i), except that improvements are excluded from the
definition in this paragraph (d)(4) and are separately defined and
addressed in Sec. 1.263(a)-3. Amounts paid to produce materials and
supplies must be capitalized under section 263A.
(e) Election to capitalize. A taxpayer may elect to treat as a
capital expenditure the cost of any material or supply as defined in
paragraph (d)(1) of this section, unless the material or supply is a
component of a unit of property as described in paragraph (d)(1)(i) of
this section, and the unit of property is a material or supply under
paragraph (d)(1)(ii)-(iv) of this section, rather than a capital
expenditure. An election made under this paragraph (e) applies to
amounts paid during the taxable year to acquire or produce any material
or supply to which paragraph (a) of this section would apply (but for
the election under this paragraph (e)). A taxpayer makes the election
by capitalizing the amounts paid to acquire or produce a material or
supply in the taxable year the amounts are paid and by recovering the
costs when the material or supply is placed in service by the taxpayer
for the purposes of determining depreciation under the applicable Code
and regulation provisions. A taxpayer must make this election in its
timely filed original Federal income tax return (including extensions)
for the taxable year the material or supply is placed in service by the
taxpayer for purposes of determining depreciation. See Sec. 1.263(a)-2
for the treatment of amounts paid to acquire or produce real or
personal tangible property. In the case of a pass-through entity, the
election is made by the pass-through entity, and not by the
shareholders, partners, etc. An election must be made for each material
and/or supply. A taxpayer may revoke an election made under this
paragraph (e) with respect to a material or supply only by filing a
request for a private letter ruling and obtaining the Commissioner's
consent to revoke the election. An election may not be made or revoked
through the filing of an application for change in accounting method or
by an amended Federal income tax return. A taxpayer that revokes an
election may not re-elect to capitalize the material or supply for a
period of at least 60 months, beginning with the taxable year of
revocation.
(f) Examples. The rules of this section are illustrated by the
following examples, in which it is assumed (unless otherwise stated)
that the property is not an incidental material or supply, that the
taxpayer is a calendar year, accrual method taxpayer, and that the
taxpayer has not elected to capitalize under paragraph (e) of this
section.
Example 1. Not a unit of property; component of personal
property. X operates a fleet of aircraft. In 2008, X purchases a
stock of spare parts, which it uses to maintain and repair its
aircraft. The spare parts are not units of property as determined
under Sec. 1.263(a)-3(d)(2) and are not rotable or temporary spare
parts. In 2009, X uses the spare parts in a repair and maintenance
activity that does not improve the property under Sec. 1.263(a)-3.
Under paragraph (a)(1) of this section, the amounts paid for the
spare parts are deductible as materials and supplies in 2009, the
taxable year in which the spare parts are used to repair and
maintain the aircraft.
Example 2. Not a unit of property; rotable spare parts. X
operates a fleet of specialized vehicles that it uses in its service
business. At the time that it acquires a new type of vehicle, X also
acquires a substantial number of rotable spare parts that will be
kept on hand to quickly replace similar parts in X's vehicles as
those parts break down or wear out. These rotable replacement parts
are not units of property as determined under Sec. 1.263(a)-
3(d)(2), are removable from the vehicles, and are repaired or
reconditioned, so that they can be reinstalled on the same or
similar vehicles. In 2008, X acquires several vehicles and
associated rotable spare parts. In 2009, X makes repairs to several
vehicles by using these rotable spare parts to replace worn or
damaged parts. In 2010, X removes these rotable spare parts from its
vehicles, repairs them and reinstalls them on other similar
vehicles. In 2012, X can no longer use the rotable parts it acquired
in 2008 and disposes of them as scrap. Under paragraph (d)(1) of
this section, the rotable spare parts acquired in 2008 are materials
and supplies. However, under paragraph (b) of this section, these
parts are not used or consumed until the taxable year in which X
disposes of the parts. Therefore, under paragraph (a)(1) of this
section, X may deduct the amounts paid for the rotable spare parts
in 2012, the taxable year in which X disposes of the parts.
Example 3. Not a unit of property; part of a single unit of real
property. X owns an apartment building and discovers that a window
in one of the apartments is broken. In 2008, X pays for the
acquisition, delivery, and installation of a new window to replace
the broken window. In the same year, the new window is installed.
The window is not a unit of property as determined under Sec.
1.263(a)-3(d)(2), and the replacement of the window does not improve
the property under Sec. 1.263(a)-3. Under paragraph (a)(1) of this
section, the amounts paid for the acquisition, delivery, and
installation of the window are deductible as materials and supplies
in 2008, the taxable year in which the window is installed in the
apartment building.
Example 4. Economic useful life of 12 months or less. X operates
a fleet of aircraft that carries freight for its customers. X owns a
storage tank on its premises, which can hold a one-month supply of
jet fuel for its aircraft. On December 31, 2008, X purchases a one-
month supply of jet fuel. In 2009, X uses the jet fuel purchased on
December 31, 2008, to fuel the aircraft used in its business. Under
paragraph (a)(1) of this section, the amounts paid for the jet fuel
are deductible as materials and supplies in 2009, the taxable year
in which the jet fuel is used or consumed in the operation of X's
aircraft.
Example 5. Unit of property that costs $100 or less. X operates
a rental business that rents out a variety of small individual items
to customers (rental items). X maintains a supply of rental items on
hand to replace worn or damaged items. In 2008, X purchases a large
quantity of rental items to use in its rental business. Each of
these rental items is a unit of property that costs $100 or less. In
2009, X begins using all of the rental items purchased in 2008 by
providing them to customers of its rental business. X does not sell
or exchange these items on established retail markets at any time
after the items are used in the rental business. Under paragraph
(a)(1) of this section, the amounts paid for the rental items are
deductible as materials and supplies in 2009, the taxable year in
which the rental items are used in X's business.
Example 6. Unit of property that costs $100 or less. X provides
billing services to its customers. In 2008, X incurs costs to
purchase 50 facsimile machines to be used by its employees. Each
facsimile machine is a unit of property that costs less than $100.
In 2008, X's employees begin using 35 of the facsimile machines, and
X stores the remaining 15 machines for use in a later taxable year.
Under paragraph (a)(1) of this section, the amounts paid for 35 of
the facsimile machines are deductible as materials and supplies in
2008, the taxable year in which X uses those machines. The amounts
paid for each of the remaining 15 machines are deductible in the
taxable year in which each machine is used.
Example 7. Materials and supplies used in improvements;
coordination with Sec. 1.263(a)-3. X owns various machines that are
used in its business. In 2008, X purchases a supply of spare parts
for its machines. The spare parts are not units of property as
determined under Sec. 1.263(a)-3(d)(2) and are not rotable or
temporary spare parts. The spare parts may be used by X in the
repair or maintenance of a machine under Sec. 1.162-4 or in the
improvement of a machine under
[[Page 12850]]
Sec. 1.263(a)-3. In 2009, X uses all of these spare parts in an
activity that improves the unit of property under Sec. 1.263(a)-3.
Under paragraph (d)(1)(i) of this section, the spare parts purchased
by X in 2008 are materials and supplies. Under paragraph (a)(1) of
this section, the amounts paid for the spare parts are otherwise
deductible as materials and supplies in 2009, the taxable year in
which X uses those parts. However, because these materials and
supplies are used to improve X's property, X is required to
capitalize the amounts paid for those spare parts under Sec.
1.263(a)-3. See also section 263A requiring taxpayers to capitalize
the direct and allocable indirect costs of property produced or
acquired for resale.
Example 8. Cost of producing materials and supplies;
coordination with section 263A. X is a manufacturer that produces
liquid waste as part of its operations. X determines that its
current liquid waste disposal process is inadequate. To remedy the
problem, in 2008, X constructs a leaching pit to provide a draining
area for the liquid waste. The leaching pit has an economic useful
life of less than 12 months, starting on the date that X begins to
use the leaching pit as a draining area. At the end of this period,
X's factory will be connected to the local sewer system. In 2009, X
starts using the leaching pit in its operations. The amounts paid to
construct the leaching pit (including the direct and allocable
indirect costs of property produced under section 263A) are amounts
paid for a material or supply under paragraph (d)(1)(ii) of this
section. Under paragraph (a)(1) of this section, the amounts paid
for the leaching pit are otherwise deductible as materials and
supplies in 2009, the taxable year in which X uses the leaching pit.
However, because the amounts paid to construct the leaching pit are
incurred by reason of X's manufacturing operations, X is required to
capitalize the amounts paid to construct the leaching pit to X's
property produced. See Sec. 1.263A-1(e)(3)(ii)(E).
Example 9. Costs of acquiring materials and supplies for
production of property; coordination with section 263A. In 2008, X
purchases jigs, dies, molds, and patterns for use in the manufacture
of X's products. The economic useful life of each jig, die, mold,
and pattern is 12 months or less, beginning when each item is used
in the manufacturing process. X begins using the purchased items in
2009 to manufacture its products. These items are materials and
supplies under paragraph (d)(1)(ii) of this section. Under paragraph
(a)(1) of this section, the amounts paid for the items are otherwise
deductible as materials and supplies in 2009, the taxable year in
which X uses those items. However, because the amounts paid for
these materials and supplies directly benefit or are incurred by
reason of the taxpayer's production activities, X is required to
capitalize the amounts paid for these items to X's property
produced. See Sec. 1.263A-1(e)(3)(ii)(E).
Example 10. Election to capitalize. X operates a rental business
that rents out a variety of items (rental items) to its customers,
each of which is a separate unit of property as determined under
Sec. 1.263(a)-3(d)(2). X does not sell or exchange these items on
established retail markets at any time after the items are used in
the rental business. In 2008, X incurs costs to purchase various
rental items, all of which cost less than $100 or have an economic
useful life of less than 12 months, beginning when used or consumed.
X begins using the rental items in its business in 2008. Under
paragraph (a)(1) of this section, the amounts paid for each rental
item purchased in 2008 are deductible as a material or supply in the
taxable year in which the item is used. However, for administrative
reasons, X would prefer to treat all of its rental items as capital
expenditures subject to depreciation. Under paragraph (e) of this
section, X may elect not to apply the rule contained in paragraph
(a)(1) of this section to the rental items. X makes this election by
capitalizing the amounts paid for each rental item in the taxable
year the costs are incurred and by beginning to recover the costs of
each item on its timely filed Federal income tax return for the
taxable year that the item is placed in service by X for purposes of
determining depreciation under the applicable Code and regulation
provisions. See Sec. 1.263(a)-2(e) for the treatment of capital
expenditures.
Example 11. Election to capitalize. X is an electric utility. In
2008, X acquires certain temporary spare parts, which it keeps on
hand to avoid operational time loss in the event it must make
emergency repairs to a unit of property that is subject to
depreciation. These parts are not units of property as determined
under Sec. 1.263(a)-3(d)(2) and are not used to improve property
under Sec. 1.263(a)-3(d)(1). These temporary spare parts are used
until a new or repaired part can be installed, and then removed and
stored for later emergency installation. Under paragraphs (a)(1) and
(b) of this section, the amounts paid for the temporary spare parts
are deductible as materials and supplies in the taxable year in
which they are disposed of by the taxpayer. However, because it is
unlikely that the temporary spare parts will be disposed of in the
near future, X would prefer to treat the spare parts as capital
expenditures subject to depreciation. Accordingly, X may elect under
paragraph (e) of this section not to apply the rule contained in
paragraph (a)(1) of this section to each of its temporary spare
parts. X makes this election by capitalizing the amounts paid for
each spare part in the taxable year the costs are incurred and by
beginning to recover the costs of each part on its timely filed
Federal income tax return for the taxable year that the part is
placed in service by X for purposes of determining depreciation
under the applicable Code and regulation provisions. See Sec.
1.263(a)-2(e) for the treatment of capital expenditures and section
263A requiring taxpayers to capitalize the direct and allocable
indirect costs of property produced or acquired for resale.
Par. 3. Section 1.162-4 is revised to read as follows:
Sec. 1.162-4 Repairs.
Amounts paid for repairs and maintenance to tangible property are
deductible if the amounts paid are not required to be capitalized under
Sec. 1.263(a)-3.
Sec. 1.162-6 [Removed]
Par. 4. Section 1.162-6 is removed.
Par. 5. Section 1.263(a)-0 is amended by revising the entries for
Sec. Sec. 1.263(a)-1, 1.263(a)-2 and 1.263(a)-3 to read as follows:
Sec. 1.263(a)-0 Table of contents.
* * * * *
Sec. 1.263(a)-1 Capital expenditures; in general.
(a) General rule for capital expenditures.
(b) Coordination with section 263A.
(c) Examples of capital expenditures.
(d) Amounts paid to sell property.
(1) In general.
(2) Treatment of capitalized amount.
(3) Examples.
(e) Amount paid.
(f) [Reserved]
(g) Effective/applicability date.
Sec. 1.263(a)-2 Amounts paid to acquire or produce tangible property.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(4) Produce.
(c) Coordination with other provisions of the Internal Revenue
Code.
(1) In general.
(2) Materials and supplies.
(d) Acquired or produced tangible property.
(1) In general.
(i) Requirement of capitalization.
(ii) Examples.
(2) Defense or perfection of title to property.
(i) In general.
(ii) Examples.
(3) Transaction costs.
(i) In general.
(ii) Scope of facilitate.
(A) In general.
(B) Inherently facilitative amounts.
(C) Special rule for acquisitions of real property.
(D) Employee compensation and overhead costs.
(1) In general.
(2) Election to capitalize.
(iii) Treatment of transaction costs.
(iv) Examples.
(4) De minimis rule.
(i) In general.
(ii) Exceptions to de minimis rule.
(iii) Safe harbor.
(iv) Additional rules.
(v) Election to capitalize.
(vi) Definition of applicable financial statement.
(vii) Examples.
(e) Treatment of capital expenditures.
(f) Recovery of capitalized amounts.
(1) In general.
(2) Examples.
(g) [Reserved]
(h) Effective/applicability date.
Sec. 1.263(a)-3 Amounts paid to improve tangible property.
(a) Overview.
[[Page 12851]]
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(4) Applicable financial statement.
(c) Coordination with other provisions of the Internal Revenue
Code.
(1) In general.
(2) Example.
(d) Improved property.
(1) Capitalization rule.
(2) Determining the unit of property.
(i) In general.
(ii) Building and structural components.
(iii) Property other than buildings.
(A) In general.
(B) Plant property.
(1) Definition.
(2) Unit of property for plant property.
(C) Network assets.
(1) Definition.
(2) [Reserved]
(D) Additional rules.
(iv) Examples.
(3) Compliance with regulatory requirements.
(4) Repairs and maintenance performed during an improvement.
(i) In general.
(ii) Exception for individuals.
(5) Aggregate of related amounts.
(e) Safe harbor for routine maintenance.
(1) In general.
(2) Exceptions.
(3) Rotable or temporary spare parts.
(4) Class life.
(5) Examples.
(f) Capitalization of betterments.
(1) In general.
(2) Application of general rule.
(i) Facts and circumstances.
(ii) Unavailability of replacement parts.
(iii) Appropriate comparison.
(A) In general.
(B) Normal wear and tear.
(C) Particular event.
(3) Examples.
(g) Capitalization of restorations.
(1) In general.
(2) Rebuild to like-new condition.
(i) In general.
(1) Like-new condition.
(2) Economic useful life.
(ii) Exception.
(3) Replacement of a major component or substantial structural
part.
(i) In general.
(ii) Exception.
(4) Examples.
(h) Capitalization of amounts to adapt property to a new or
different use.
(1) In general.
(2) Examples.
(i) Optional regulatory accounting method.
(1) In general.
(2) Eligibility for regulatory accounting method.
(3) Description of regulatory accounting method.
(4) [Reserved]
(5) Examples.
(j) Repair allowance.
(k) Treatment of capital expenditures.
(l) Recovery of capitalized amounts.
(m) [Reserved]
(n) Effective/applicability date.
Par. 6. Section 1.263(a)-1 is revised to read as follows:
Sec. 1.263(a)-1 Capital expenditures; in general.
(a) General rule for capital expenditures. Except as provided in
chapter 1 of the Internal Revenue Code (Code), no deduction is allowed
for--
(1) Any amount paid for new buildings or for permanent improvements
or betterments made to increase the value of any property or estate, or
(2) Any amount paid in restoring property or in making good the
exhaustion thereof for which an allowance is or has been made.
(b) Coordination with section 263A. Section 263(a) generally
requires taxpayers to capitalize an amount paid to acquire, produce, or
improve real or personal tangible property. Section 263A generally
prescribes the direct and indirect costs that must be capitalized to
property produced or improved by the taxpayer and property acquired for
resale.
(c) Examples of capital expenditures. The following amounts paid
are examples of capital expenditures:
(1) An amount paid to acquire or produce real or personal tangible
property. See Sec. 1.263(a)-2.
(2) An amount paid to improve real or personal tangible property.
See Sec. 1.263(a)-3.
(3) An amount paid to acquire or create intangibles. See Sec.
1.263(a)-4.
(4) An amount paid or incurred to facilitate an acquisition of a
trade or business, a change in capital structure of a business entity,
and certain other transactions. See Sec. 1.263(a)-5.
(5) An amount paid to acquire or create interests in land, such as
easements, life estates, mineral interests, timber rights, zoning
variances, or other interests in land.
(6) An amount assessed and paid under an agreement between
bondholders or shareholders of a corporation to be used in a
reorganization of the corporation or voluntary contributions by
shareholders to the capital of the corporation for any corporate
purpose. See section 118 and Sec. 1.118-1.
(7) An amount paid by a holding company to carry out a guaranty of
dividends at a specified rate on the stock of a subsidiary corporation
for the purpose of securing new capital for the subsidiary and
increasing the value of its stockholdings in the subsidiary. This
amount must be added to the cost of the stock in the subsidiary.
(d) Amounts paid to sell property--(1) In general. Except in the
case of dealers in property, commissions and other transaction costs
paid to facilitate the sale of property generally must be capitalized.
However, in the case of dealers in property, amounts paid to facilitate
the sale of property are treated as ordinary and necessary business
expenses. See Sec. 1.263(a)-5(g) for the treatment of amounts paid to
facilitate the disposition of assets that constitute a trade or
business.
(2) Treatment of capitalized amount. Amounts capitalized under
paragraph (d)(1) of this section are treated as a reduction in the
amount realized and generally are taken into account either in the
taxable year in which the sale occurs or in the taxable year in which
the sale is abandoned if a loss deduction is permissible. The
capitalized amount is not added to the basis of the property and is not
treated as an intangible under Sec. 1.263(a)-4.
(3) Examples. The following examples, which assume the sale is not
an installment sale under section 453, illustrate the rules of this
paragraph (d):
Example 1. Sales costs of real property. X owns a parcel of real
estate. X sells the real estate and pays legal fees, recording fees,
and sales commissions to facilitate the sale. X must capitalize the
fees and commissions and, in the taxable year of the sale, offset
the fees and commissions against the amount realized from the sale
of the real estate.
Example 2. Sales costs of dealers. Assume the same facts as in
Example 1, except that X is a dealer in real estate. The commissions
and fees paid to facilitate the sale of the real estate are treated
as ordinary and necessary business expenses under section 162.
Example 3. Sales costs of personal property used in a trade or
business. X owns a truck for use in X's trade or business. X decides
to sell the truck and on November 15, 2008, X pays for an appraisal
to determine a reasonable asking price. On February 15, 2009, X
sells the truck to Y. X is required to capitalize in 2008 the amount
paid to appraise the truck and, in 2009, is required to offset the
amount paid against the amount realized from the sale of the truck.
Example 4. Costs of abandoned sale of personal property used in
a trade or business. Assume the same facts as in Example 3, except
that, instead of selling the truck on February 15, 2009, X decides
on that date not to sell the truck and takes the truck off the
market. X is required to capitalize in 2008 the amount paid to
appraise the truck. However, X may treat the amount paid to appraise
the truck as a loss under section 165 in 2009 when the sale is
abandoned.
Example 5. Sales costs of personal property not used in a trade
or business. Assume the same facts as in Example 3, except that X
does not use the truck in X's trade or business, but instead uses it
for personal purposes. X decides to sell the truck and on November
15, 2008, X pays for an appraisal to determine a reasonable asking
price. On February 15, 2009, X sells the truck to Y. X is required
to capitalize in 2008 the amount
[[Page 12852]]
paid to appraise the truck and, in 2009, is required to offset the
amount paid against the amount realized from the sale of the truck.
Example 6. Costs of abandoned sale of personal property not used
in a trade or business. Assume the same facts as in Example 5,
except that, instead of selling the truck on February 15, 2009, X
decides on that date not to sell the truck and takes the truck off
the market. X is required to capitalize in 2008 the amount paid to
appraise the truck. Although the sale is abandoned in 2009, X may
not treat the amount paid to appraise the truck as a loss under
section 165 because the truck was not used in X's trade or business
or in a transaction entered into for profit.
(e) Amount paid. In the case of a taxpayer using an accrual method
of accounting, the terms amount paid and payment mean a liability
incurred (within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable
year during which the liability is incurred.
(f) [Reserved]
(g) Effective/applicability date. The rules in this section apply
to taxable years beginning on or after the date of publication of the
Treasury decision adopting these rules as final regulations in the
Federal Register.
Par. 7. Section 1.263(a)-2 is revised to read as follows:
Sec. 1.263(a)-2 Amounts paid to acquire or produce tangible property.
(a) Overview. This section provides rules for applying section
263(a) to amounts paid to acquire or produce a unit of real or personal
property. Paragraph (b) of this section contains definitions. Paragraph
(c) of this section contains the rules for coordinating this section
with other provisions of the Internal Revenue Code (Code). Paragraph
(d) of this section provides the rules for determining the treatment of
amounts paid to acquire or produce a unit of real or personal property,
including amounts paid to defend or perfect title to real or personal
property and amounts paid to facilitate the acquisition of property.
Paragraph (d) also provides a de minimis rule.
(b) Definitions. For purposes of this section, the following
definitions apply:
(1) Amount paid. In the case of a taxpayer using an accrual method
of accounting, the terms amount paid and payment mean a liability
incurred (within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable
year during which the liability is incurred.
(2) Personal property means tangible personal property as defined
in Sec. 1.48-1(c).
(3) Real property means land and improvements thereto, such as
buildings or other inherently permanent structures (including items
that are structural components of the buildings or structures) that are
not personal property as defined in paragraph (b)(2) of this section.
Any property that constitutes other tangible property under Sec. 1.48-
1(d) is treated as real property for purposes of this section. Local
law is not controlling in determining whether property is real property
for purposes of this section.
(4) Produce means construct, build, install, manufacture, develop,
create, raise, or grow. This definition is intended to have the same
meaning as the definition used for purposes of section 263A(g)(1) and
Sec. 1.263A-2(a)(1)(i), except that improvements are excluded from the
definition in this paragraph (b)(4) and are separately defined and
addressed in Sec. 1.263(a)-3.
(c) Coordination with other provisions of the Internal Revenue
Code--(1) In general. Nothing in this section changes the treatment of
any amount that is specifically provided for under any provision of the
Code or regulations other than section 162(a) or section 212 and the
regulations under those sections. For example, see section 263A
requiring taxpayers to capitalize the direct and certain indirect costs
of producing property or acquiring property for resale.
(2) Materials and supplies. Nothing in this section changes the
treatment of amounts paid to acquire or produce property that is
properly treated as materials and supplies under Sec. 1.162-3.
(d) Acquired or produced tangible property--(1) In general--(i)
Requirement of capitalization. Except as provided in paragraph (d)(4)
of this section (relating to the de minimis rule) and in Sec. 1.162-
3(d)(1)(ii), (iii), and (iv) (relating to certain materials and
supplies), a taxpayer must capitalize amounts paid to acquire or
produce a unit of real or personal property (as determined under Sec.
1.263(a)-3(d)(2)), including leasehold improvement property, land and
land improvements, buildings, machinery and equipment, and furniture
and fixtures. Amounts paid to acquire or produce a unit of real or
personal property include the invoice price, transaction costs as
determined under paragraph (d)(3) of this section, and costs for work
performed prior to the date that the unit of property is placed in
service by the taxpayer (without regard to any applicable convention
under section 168(d)). A taxpayer also must capitalize amounts paid to
acquire real or personal property for resale and to produce real or
personal property. See section 263A for the costs required to be
capitalized to property produced by the taxpayer or to property
acquired for resale.
(ii) Examples. The rules of this section are illustrated by the
following examples, in which it is assumed that the taxpayer does not
apply the de minimis rule under paragraph (d)(4) of this section:
Example 1. Acquisition of personal property. In 2008, X
purchases new cash registers for use in its retail store located in
leased space in a shopping mall. Assume each cash register is a unit
of property as determined under Sec. 1.263(a)-3(d)(2), and is not a
material or supply under Sec. 1.162-3. X must capitalize under this
paragraph (d)(1) the amount paid to purchase each cash register.
Example 2. Relocation of personal property. Assume the same
facts as in Example 1, except that X's lease expires in 2009 and X
decides to relocate its retail store to a different building. In
addition to various other costs, X pays $5,000 to move the cash
registers. X is not required to capitalize under this paragraph
(d)(1) the $5,000 amount paid for moving the cash registers.
Example 3. Acquisition of personal property that is not a unit
of property; coordination with Sec. 1.162-3. X operates a fleet of
aircraft. In 2008, X purchases a stock of spare parts, which it uses
to maintain and repair its aircraft. Assume that the spare parts are
not units of property as determined under Sec. 1.263(a)-3(d)(2). X
does not make elections under Sec. 1.162-3(e) to treat the
materials and supplies as capital expenditures. In 2009, X uses the
spare parts in a repair and maintenance activity that does not
improve the property under Sec. 1.263(a)-3. Because the parts are
not units of property, X is not required to capitalize the amounts
paid for the parts under this paragraph (d)(1). Rather, X must apply
the rules in Sec. 1.162-3, governing the treatment of materials and
supplies, to determine the treatment of these amounts.
Example 4. Acquisition of unit of personal property;
coordination with Sec. 1.162-3. X operates a rental business that
rents out a variety of small individual items to customers (rental
items). X maintains a supply of rental items on hand to replace worn
or damaged items. In 2008, X purchases a large quantity of rental
items to be used in its business. Assume that each of these items is
a unit of property under Sec. 1.263(a)-3(d)(2) and that several of
these rental items are materials and supplies under the definition
provided in Sec. 1.162-3(d). Therefore, X must apply the rules in
Sec. 1.162-3 to determine the treatment of the amounts paid to
acquire rental items that are materials and supplies. Under this
paragraph (d)(1), X must capitalize the amounts paid for the rental
items that are units of property and do not otherwise qualify as
materials and supplies under Sec. 1.162-3(d).
Example 5. Acquisition or production cost. X purchases or
produces jigs, dies, molds, and patterns for use in the manufacture
of X's products. Assume that each of these items is a unit of
property as determined under Sec. 1.263(a)-3(d)(2), and is not a
material and supply under Sec. 1.162-3(d). X is required to
[[Page 12853]]
capitalize under this paragraph (d)(1) the amounts paid to produce
or purchase the jigs, dies, molds, and patterns. See section 263A
for the costs to be capitalized to property produced by X.
Example 6. Acquisition of land. X purchases a parcel of
undeveloped real estate. X must capitalize under this paragraph
(d)(1) the amount paid to acquire the real estate. See Sec.
1.263(a)-2(d)(3) for the treatment of amounts paid to facilitate the
acquisition of real property.
Example 7. Acquisition of building. X purchases a building. X
must capitalize under this paragraph (d)(1) the amount paid to
acquire the building. See Sec. 1.263(a)-2(d)(3) for the treatment
of amounts paid to facilitate the acquisition of real property.
Example 8. Acquisition of property for resale. X purchases goods
for resale. X must capitalize under this paragraph (d)(1) the
amounts paid to acquire the goods. See section 263A for the costs to
be capitalized to property acquired for resale.
Example 9. Production of property for sale. X produces goods for
sale. X must capitalize under this paragraph (d)(1) the amount paid
to produce the goods. See section 263A for the costs to be
capitalized to property produced by X.
Example 10. Production of building. X constructs a building. X
must capitalize under this paragraph (d)(1) the amount paid to
construct the building. See section 263A for the costs to be
capitalized to real property produced by X.
Example 11. Acquisition of assets constituting a trade or
business. Y owns tangible and intangible assets that constitute a
trade or business. X purchases all the assets of Y in a taxable
transaction. X must capitalize under this paragraph (d)(1) the
amount paid for the tangible assets of Y. See Sec. 1.263(a)-4 for
the treatment of amounts paid to acquire intangibles and Sec.
1.263(a)-5 for the treatment of amounts paid to facilitate the
acquisition of assets that constitute a trade or business. See
section 1060 for special allocation rules for certain asset
acquisitions.
Example 12. Work performed prior to placing the property in
service. In 2008, X purchases a building for use as a business
office. The building is in a state of disrepair. Prior to placing
the building in service, X incurs costs to repair cement steps,
shore up parts of the first and second floors, replace electrical
wiring, remove and replace old plumbing, and paint the outside and
inside of the building. All the work was performed on the building
or its structural components. In 2010, X places the building in
service and begins using the building as its business office. Assume
the building and its structural components is the unit of property.
The amounts paid must be capitalized as costs of acquiring the
building because they were for work performed prior to X's placing
the building in service.
Example 13. Work performed prior to placing the property in
service. In January 2008, X purchases a new machine for use in an
existing production line of its manufacturing business. Assume that
the machine is a unit of property under Sec. 1.263(a)-3(d)(2).
After the machine is installed, X performs critical testing on the
machine to ensure that it is operational. On November 1, 2008, the
critical testing is complete and X places the machine in service on
the production line. X continues to perform testing for quality
control. The amounts paid for the installation and critical testing
must be capitalized as costs of acquiring the machine because they
were for work performed prior to X's placing the machine in service.
However, amounts paid for quality control testing after the machine
is placed in service by X are not required to be capitalized as a
cost of acquiring the machine.
(2) Defense or perfection of title to property--(i) In general.
Amounts paid to defend or perfect title to real or personal property
are amounts paid to acquire or produce property within the meaning of
this section and must be capitalized. See section 263A for the costs
required to be capitalized to property produced by the taxpayer or to
property acquired for resale.
(ii) Examples. The following examples illustrate the rule of this
paragraph (d)(2):
Example 1. Amounts paid to contest condemnation. X owns real
property located in County. County files an eminent domain complaint
condemning a portion of X's property to use as a roadway. X hires an
attorney to contest the condemnation. Amounts paid by X to the
attorney must be capitalized because they were to defend X's title
to the property.
Example 2. Amounts paid to invalidate ordinance. X is in the
business of quarrying and supplying for sale sand and stone in a
certain municipality. Several years after X establishes its
business, the municipality in which it is located passes an
ordinance that prohibits the operation of X's business. X incurs
attorney's fees in a successful prosecution of a suit to invalidate
the municipal ordinance. X prosecutes the suit to preserve its
business activities and not to defend X's title in the property.
Therefore, attorney's fees paid by X are not required to be
capitalized under this paragraph (d)(2). However, under section
263A, all indirect costs, including otherwise deductible costs, that
directly benefit or are incurred by reason of the taxpayer's
production activities must be capitalized to the property produced
for sale. See Sec. 1.263A-1(e)(3)(i). Therefore, because the
amounts paid to invalidate the ordinance are incurred by reason of
X's production activities, the amounts paid must be capitalized
under section 263A to the property produced for sale by X.
Example 3. Amounts paid to challenge building line. The board of
public works of a municipality establishes a building line across
X's business property, adversely affecting the value of the
property. X incurs legal fees in unsuccessfully litigating the
establishment of the building line. Amounts paid by X to the
attorney must be capitalized because they were to defend X's title
to the property.
(3) Transaction costs--(i) In general. A taxpayer must capitalize
amounts paid to facilitate the acquisition or production of real or
personal property. See section 263A for the costs required to be
capitalized to property produced by the taxpayer or to property
acquired for resale. See Sec. 1.263(a)-5 for the treatment of amounts
paid to facilitate the acquisition of assets that constitute a trade or
business.
(ii) Scope of facilitate--(A) In general. Except as otherwise
provided in this section, an amount is paid to facilitate the
acquisition of real or personal property if the amount is paid in the
process of investigating or otherwise pursuing the acquisition. Whether
an amount is paid in the process of investigating or otherwise pursuing
the acquisition is determined based on all of the facts and
circumstances. In determining whether an amount is paid to facilitate
an acquisition, the fact that the amount would (or would not) have been
paid but for the acquisition is relevant, but is not determinative.
These amounts include, but are not limited to, inherently facilitative
amounts specified in paragraph (d)(3)(ii)(B) of this section.
(B) Inherently facilitative amounts. An amount paid in the process
of investigating or otherwise pursuing the acquisition of real or
personal property facilitates the acquisition if the amount is
inherently facilitative. An amount is inherently facilitative if the
amount is paid for--
(1) Transporting the property (for example, shipping fees and
moving costs);
(2) Securing an appraisal or determining the value or price of
property;
(3) Negotiating the terms or structure of the acquisition and
obtaining tax advice on the acquisition;
(4) Application fees, bidding costs, or similar expenses;
(5) Preparing and reviewing the documents that effectuate the
acquisition of the property (for example, preparing the bid, offer,
sales contract, or purchase agreement);
(6) Examining and evaluating the title of property;
(7) Obtaining regulatory approval of the acquisition or securing
permits related to the acquisition, including application fees;
(8) Conveying property between the parties, including sales and
transfer taxes, and title registration costs;
(9) Finders' fees or brokers' commissions, including amounts paid
that are contingent on the successful closing of the acquisition;
(10) Architectural, geological, engineering, environmental or
inspection services pertaining to particular properties; and
[[Page 12854]]
(11) Services provided by a qualified intermediary or other
facilitator of an exchange under section 1031.
(C) Special rule for acquisitions of real property. Except as
provided in paragraph (d)(3)(ii)(B) of this section (relating to
inherently facilitative amounts), an amount paid by the taxpayer in the
process of investigating or otherwise pursuing the acquisition of real
property does not facilitate the acquisition if it relates to
activities performed in the process of determining whether to acquire
real property and which real property to acquire.
(D) Employee compensation and overhead costs--(1) In general. For
purposes of this paragraph (d)(3), amounts paid for employee
compensation (within the meaning of Sec. 1.263(a)-4(e)(4)(ii)) and
overhead are treated as amounts that do not facilitate the acquisition
of real or personal property. See section 263A for the treatment of
employee compensation and overhead costs required to be capitalized to
property produced by the taxpayer or to property acquired for resale.
(2) Election to capitalize. A taxpayer may elect to treat amounts
paid for employee compensation or overhead as amounts that facilitate
the acquisition of property. The election is made separately for each
acquisition and applies to employee compensation or overhead, or both.
For example, a taxpayer may elect to treat overhead, but not employee
compensation, as amounts that facilitate the acquisition of property. A
taxpayer makes the election by treating the amounts to which the
election applies as amounts that facilitate the acquisition in the
taxpayer's timely filed original Federal income tax return (including
extensions) for the taxable year during which the amounts are paid. In
the case of an S corporation or partnership, the election is made by
the S corporation or by the partnership, and not by the shareholders or
partners. A taxpayer may revoke an election made under this paragraph
(d)(3)(ii)(D)(2) with respect to each acquisition only by filing a
request for a private letter ruling and obtaining the Commissioner's
consent to revoke the election. An election may not be made or revoked
through the filing of an application for change in accounting method or
by an amended Federal income tax return.
(iii) Treatment of transaction costs. All amounts paid to
facilitate the acquisition or production of real or personal property
are capital expenditures. Inherently facilitative amounts allocable to
real or personal property are capital expenditures related to such
property even if the property is not eventually acquired or produced.
Facilitative amounts allocable to real or personal property actually
acquired or produced must be included in the basis of the property
acquired or produced. See paragraph (f) of this section for the
recovery of capitalized amounts.
(iv) Examples. The following examples illustrate the rules of this
paragraph (d)(3):
Example 1. Broker's fees to facilitate an acquisition. X decides
to purchase a building in which to relocate its offices and hires a
real estate broker to find a suitable building. X pays fees to the
broker to find property for X to acquire. Under paragraph (d)(3)(i)
of this section, X must capitalize the amounts paid to the broker
because these costs are inherently facilitative of the acquisition
of real property.
Example 2. Inspection and survey costs to facilitate an
acquisition. X decides to purchase building A and pays amounts to
third-party contractors for a termite inspection and an
environmental survey of building A. Under paragraph (d)(3)(i) of
this section, X must capitalize the amounts paid for the inspection
and the survey of the building because these costs are inherently
facilitative of the acquisition of real property.
Example 3. Moving costs to facilitate an acquisition. X
purchases all the assets of Y and, in connection with the purchase,
hires a transportation company to move storage tanks from Y's plant
to X's plant. Under paragraph (d)(3)(i) of this section, X must
capitalize the amount paid to move the storage tanks from Y's plant
to X's plant because this cost is inherently facilitative to the
acquisition of personal property.
Example 4. Scope of facilitate. X is in the business of
providing legal services to clients. X is interested in acquiring a
new conference table for its office. X hires and incurs fees for an
interior designer to shop for, evaluate, and make recommendations to
X regarding which new table to acquire. Under paragraph (d)(3)(i) of
this section, X must capitalize the amounts paid to the interior
designer to provide these services because they are paid in the
process of investigating or otherwise pursuing the acquisition of
personal property.
Example 5. Transaction costs allocable to other property. X, a
retailer, wants to acquire land for the purpose of building a new
distribution facility for its products. X considers various
properties on highway A in state B. In evaluating the feasibility of
several sites, X incurs fees for the services of an architect to
advise and prepare preliminary plans for a facility that X is
reasonably likely to construct at one of the sites. The architect's
fees are not inherently facilitative to the acquisition of land, but
are inherently facilitative to the acquisition of a building under
paragraph (d)(3)(ii)(B)(10) of this section. In addition, these
costs are allocable as construction costs of the building under
section 263A. Therefore, X does not capitalize these fees as amounts
to acquire the building under paragraph (d)(3)(ii)(B) of this
section, but instead must capitalize these costs as indirect costs
allocable to the production of property under section 263A.
Example 6. Special rule for acquisitions of real property. X
owns several retail stores. X decides to examine the feasibility of
opening a new store in City A. In October 2008, X hires and incurs
costs for a development consulting firm to study City A and perform
market surveys, evaluate zoning and environmental requirements, and
make preliminary reports and recommendations as to areas that X
should consider for purposes of locating a new store. In December
2008, X continues to consider whether to purchase real property in
City A and which property to acquire. X hires, and incurs fees for,
an appraiser to perform appraisals on two different sites to
determine a fair offering price for each site. In March 2009, X
decides to acquire one of these two sites for the location of its
new store. At the same time, X determines not to acquire the other
site. Under paragraph (d)(3)(ii)(C) of this section, X is not
required to capitalize amounts paid to the development consultant in
2008 because the amounts relate to activities performed in the
process of determining whether to acquire real property and which
real property to acquire and the amounts are not inherently
facilitative costs under paragraph (d)(3)(ii)(B) of this section.
However, X must capitalize amounts paid to the appraiser in 2008
because the appraisal costs are inherently facilitative costs under
paragraph (d)(3)(ii)(B)(2) of this section. In 2009, X must include
the appraisal costs allocable to property acquired in the basis of
the property acquired and may recover the appraisal costs allocable
to the property not acquired in accordance with paragraph (f) of
this section.
Example 7. Employee compensation and overhead. X, a freight
carrier, maintains an acquisition department whose sole function is
to arrange for the purchase of vehicles and aircraft from
manufacturers or other parties to be used in its freight carrying
business. As provided in paragraph (d)(3)(ii)(D)(1) of this section,
X is not required to capitalize any portion of the compensation paid
to employees in its acquisition department or any portion of its
overhead allocable to its acquisition department. However, under
paragraph (d)(3)(ii)(D)(2) of this section, X may elect to
capitalize the compensation and overhead costs allocable to the
acquisition of a vehicle or aircraft by treating these amounts as
costs that facilitate the acquisition of that property in its timely
filed original Federal income tax return for the year the amounts
are paid.
(4) De minimis rule--(i) In general. Except as otherwise provided
in this paragraph (d)(4), a taxpayer is not required to capitalize
under paragraph (d) of this section amounts paid for the acquisition or
production (including any amounts paid to facilitate the acquisition or
production) of a unit of property (as determined under Sec. 1.263(a)-
3(d)(2)) if--
(A) The taxpayer has an applicable financial statement (as defined
in Sec. 1.263(a)-2(d)(4)(vi));
[[Page 12855]]
(B) The taxpayer has at the beginning of the taxable year, written
accounting procedures treating as an expense for non-tax purposes the
amounts paid for property costing less than a certain dollar amount;
(C) The taxpayer treats the amounts paid during the taxable year as
an expense on its applicable financial statement in accordance with its
written accounting procedures; and
(D) The total aggregate of amounts paid and not capitalized under
paragraphs (d)(4)(i)(A), (B), and (C) of this section for the taxable
year do not distort the taxpayer's income for the taxable year.
(ii) Exceptions to de minimis rule. The de minimis rule in
paragraph (d)(4)(i) of this section does not apply to the following:
(A) Amounts paid to improve property under Sec. 1.263(a)-3.
(B) Amounts paid for property that is or is intended to be included
in property produced or acquired for resale.
(C) Amounts paid for land.
(iii) Safe harbor. The total aggregate amount that is not required
to be capitalized under the de minimis rule of paragraphs (d)(4)(i)(A),
(B) and (C) of this section for the taxable year is deemed to not
distort the taxpayer's income under paragraph (d)(4)(i)(D) of this
section if this amount, added to the amount the taxpayer deducts in the
taxable year as materials and supplies under the definition provided
under Sec. 1.162-3(d)(1)(iii) (relating to certain property costing
$100 or less), is less than or equal to the lesser of--
(A) 0.1 percent of the taxpayer's gross receipts for the taxable
year; or
(B) 2 percent of the taxpayer's total depreciation and amortization
expense for the taxable year as determined in its applicable financial
statement.
(iv) Additional rules. Property to which a taxpayer applies the de
minimis rule contained in paragraph (d)(4) of this section is not
treated upon sale or disposition as a capital asset under section 1221
or as property used in the trade or business under section 1231.
Property to which a taxpayer applies the de minimis rule contained in
paragraph (d)(4) of this section is not a material or supply under
Sec. 1.162-3. The cost of property to which a taxpayer properly
applies the de minimis rule contained in paragraph (d)(4) of this
section is not required to be capitalized under section 263A to a
separate unit of property, but may be required to be capitalized as a
cost of other property if incurred by reason of the production of the
other property. See, for example, Sec. 1.263A-1(e)(3)(ii)(O) requiring
taxpayers to capitalize repair and maintenance costs allocable to
property produced or acquired for resale.
(v) Election to capitalize. A taxpayer may elect not to apply the
de minimis rule contained in paragraph (d)(4)(i) of this section. An
election made under this paragraph (d)(4)(v) applies to any unit of
property during the taxable year to which paragraphs (d)(4)(i)(A), (B),
and (C) of this section would apply (but for the election under this
paragraph (d)(4)(v)). A taxpayer makes the election by treating the
amount paid as a capital expenditure in its timely filed original
Federal income tax return (including extensions) for the taxable year
in which the amount is paid. In the case of an S corporation or
partnership, the election is made by the S corporation or by the
partnership, and not by the shareholders or partners. A taxpayer may
revoke an election made under this paragraph (d)(4)(v) with respect to
a unit of property only by filing a request for a private letter ruling
and obtaining the Commissioner's consent to revoke the election. An
election may not be made or revoked through the filing of an
application for change in accounting method or by an amended Federal
income tax return.
(vi) Definition of applicable financial statement. For purposes of
this paragraph (d)(4), the taxpayer's applicable financial statement is
the taxpayer's financial statement listed in paragraphs (d)(4)(vi)(A)
through (C) of this section that has the highest priority (including
within paragraph (d)(4)(iv)(B) of this section). The financial
statements are, in descending priority--
(A) A financial statement required to be filed with the Securities
and Exchange Commission (SEC) (the 10-K or the Annual Statement to
Shareholders);
(B) A certified audited financial statement that is accompanied by
the report of an independent CPA (or in the case of a foreign entity,
by the report of a similarly qualified independent professional), that
is used for--
(1) Credit purposes;
(2) Reporting to shareholders, partners, or similar persons; or
(3) Any other substantial non-tax purpose; or
(C) A financial statement (other than a tax return) required to be
provided to the Federal or a state government or any Federal or state
agencies (other than the SEC or the Internal Revenue Service).
(vii) Examples. The following examples illustrate the rule of this
paragraph (d)(4):
Example 1. De minimis rule. X purchases 10 printers at $200 each
for a total cost of $2000. Assume that each printer is a unit of
property under Sec. 1.263(a)-3(d)(2). X has an applicable financial
statement. X has a written policy at the beginning of the taxable
year to expense amounts paid for property costing less than $500. X
treats the amounts paid for the printers as an expense on its
applicable financial statement. Assuming the total aggregate amounts
not capitalized under the de minimis rule for the taxable year do
not distort the taxpayer's income, X is not required to capitalize
the amounts paid for the printers.
Example 2. De minimis rule safe harbor not met. X is a member of
an affiliated group that files a consolidated return. In 2008, X
purchases 300 computers at $400 each for a total cost of $120,000.
Assume that each computer is a unit of property under Sec.
1.263(a)-3(d)(2). X has a written policy at the beginning of the
taxable year to expense amounts paid for property costing less than
$500. X treats the amounts paid for the computers as an expense on
its applicable financial statement. In addition, in 2008 X purchases
300 desk chairs for $50 each for a total cost of $15,000. X intends
to deduct the amounts paid for the desk chairs when used or consumed
as non-incidental materials and supplies under Sec. 1.162-3(a)(1)
and Sec. 1.162-3(d)(1)(iii) because they are units of property
costing less than $100. For its 2008 taxable year, X has gross
receipts of $125,000,000 and reports $7,000,000 of depreciation and
amortization on its applicable financial statement. Thus, in order
to meet the de minimis rule safe harbor for 2008, the sum of the
amounts not required to be capitalized under the de minimis rule for
2008 ($120,000) plus the amounts X intends to deduct as materials
and supplies under Sec. 1.162-3(a)(1) and Sec. 1.162-3(d)(1)(iii)
for 2008 ($15,000), must be less than or equal to $125,000 (0.1% of
X's total gross receipts of $125,000,000), which is less than
$140,000 (2% of X's total depreciation and amortization of
$7,000,000). Because $135,000 ($120,000 + $15,000) exceeds $125,000,
X will not meet the de minimis rule safe harbor for its 2008 taxable
year. As a result, to apply the de minimis rule to the $120,000 paid
to acquire the computers, X will have to otherwise establish that
this amount does not distort the taxpayer's income in 2008.
Example 3. De minimis rule safe harbor met. Assume the same
facts as in Example 2, except X makes an election under paragraph
(d)(4)(v) of this section to capitalize the $10,000 paid to acquire
25 of the 300 computers at $400 each. In this case, X is not
required to capitalize the $110,000 paid to acquire the remaining
275 computers under paragraph (d)(4)(i) because this amount, when
added to the $15,000 that X intends to deduct in 2008 as materials
and supplies under Sec. 1.162-3(a)(1) and Sec. 1.163-3(d)(1)(iii),
does not exceed the de minimis rule safe harbor of $125,000 for
2008.
Example 4. De minimis rule safe harbor; election to capitalize.
Assume the same facts as in Example 2, except X does not otherwise
establish that the deduction of amounts in excess of the $125,000
safe harbor do not distort X's income in 2008. Rather, X makes an
election under Sec. 1.162-3(d) to capitalize
[[Page 12856]]
$10,000 paid to acquire 200 of the 300 desk chairs at $50 each. In
this case, X is not required to capitalize the $120,000 paid to
acquire the 300 computers under paragraph (d)(4)(i) of this section
because this amount, when added to the $5000 (the remaining 100 desk
chairs at $50 each) that X intends to deduct in 2008 as materials
and supplies under Sec. 1.162-3(a)(1) and Sec. 1.162-3(d)(1)(iii),
does not exceed the de minimis rule safe harbor of $125,000 for
2008.
(e) Treatment of capital expenditures. Amounts required to be
capitalized under this section are capital expenditures and must be
taken into account through a charge to capital account or basis, or in
the case of property that is inventory in the hands of a taxpayer,
through inclusion in inventory costs. See section 263A for the
treatment of amounts referred to in this section as well as other
amounts paid in connection with the production of real property and
personal property, including films, sound recordings, video tapes,
books, or similar properties.
(f) Recovery of capitalized amounts--(1) In general. Amounts that
are capitalized under this section are recovered through depreciation,
cost of goods sold, or by an adjustment to basis at the time the
property is placed in service, sold, used, or otherwise disposed of by
the taxpayer. Cost recovery is determined by the applicable Code and
regulation provisions relating to the use, sale, or disposition of
property.
(2) Examples. The following examples illustrate the rule of this
paragraph (f)(1). Assume that X does not apply the de minimis rule
under paragraph (d)(4) of this section.
Example 1. Recovery when property placed in service. X owns a
10-unit apartment building. The refrigerator in one of the
apartments stops functioning and X purchases a new refrigerator to
replace the old one. X pays for the acquisition, delivery, and
installation of the new refrigerator to replace the old
refrigerator. Assume that the refrigerator is the unit of property,
as determined under Sec. 1.263(a)-3(d)(2), and is not a material or
supply under Sec. 1.162-3. Under paragraph (d) of this section, X
is required to capitalize the amounts paid for the acquisition,
delivery, and installation of the refrigerator. Under this paragraph
(f), the capitalized amounts are recovered through depreciation when
the refrigerator is placed in service by X.
Example 2. Recovery when property used in the production of
property. X operates a plant where it manufactures widgets. X
purchases a tractor/loader to move raw materials into and around the
plant for use in the manufacturing process. Assume that the tractor/
loader is a unit of property, as determined under Sec. 1.263(a)-
3(d)(2), and is not a material or supply under Sec. 1.162-3. Under
paragraph (d) of this section, X is required to capitalize the
amounts paid to acquire the tractor/loader. Under this paragraph
(f), the capitalized amounts are recovered through depreciation when
the tractor/loader is placed in service by X. However, because the
tractor/loader is used in the production of property, under section
263A the cost recovery (that is, the depreciation) on the
capitalized amounts must be capitalized to X's property produced,
and consequently, recovered through cost of goods sold. See Sec.
1.263A-1(e)(3)(ii)(I).
(g) [Reserved]
(h) Effective/applicability date. The rules in this section apply
to taxable years beginning on or after the date of publication of the
Treasury decision adopting these rules as final regulations in the
Federal Register.
Par. 8. Section 1.263(a)-3 is revised to read as follows:
Sec. 1.263(a)-3 Amounts paid to improve tangible property.
(a) Overview. This section provides rules for applying section
263(a) to amounts paid to improve tangible property. Paragraph (b) of
this section provides definitions. Paragraph (c) of this section
provides rules for coordinating this section with other provisions of
the Internal Revenue Code (Code). Paragraph (d) of this section
provides rules for determining the treatment of amounts paid to improve
tangible property, including rules for determining the appropriate unit
of property. Paragraph (e) of this section provides a safe harbor for
routine maintenance costs. Paragraph (f) of this section provides rules
for determining whether amounts paid result in betterments to the unit
of property. Paragraph (g) of this section provides rules for
determining whether amounts paid restore the unit of property.
Paragraph (h) of this section provides rules for amounts paid to adapt
the unit of property to a new or different use. Paragraph (i) of this
section provides an optional regulatory accounting method safe harbor.
Paragraph (j) of this section provides an optional repair allowance.
Paragraphs (k) through (m) of this section provide additional rules
related to these provisions. Paragraph (n) of this section provides the
applicability date of the rules in this section.
(b) Definitions. For purposes of this section, the following
definitions apply:
(1) Amount paid. In the case of a taxpayer using an accrual method
of accounting, the terms amounts paid and payment mean a liability
incurred (within the meaning of Sec. 1.446-1(c)(1)(ii)). A liability
may not be taken into account under this section prior to the taxable
year during which the liability is incurred.
(2) Personal property means tangible personal property as defined
in Sec. 1.48-1(c).
(3) Real property means land and improvements thereto, such as
buildings or other inherently permanent structures (including items
that are structural components of the buildings or structures) that are
not personal property as defined in paragraph (b)(2) of this section.
Any property that constitutes other tangible property under Sec. 1.48-
1(d) is also treated as real property for purposes of this section.
Local law is not controlling in determining whether property is real
property for purposes of this section.
(4) Applicable financial statement. The applicable financial
statement is the taxpayer's financial statement listed in paragraphs
(b)(4)(i) through (iii) of this section that has the highest priority
(including within paragraph (b)(4)(ii) of this section). The financial
statements are, in descending priority--
(i) A financial statement required to be filed with the Securities
and Exchange Commission (SEC) (the 10-K or the Annual Statement to
Shareholders);
(ii) A certified audited financial statement that is accompanied by
the report of an independent CPA (or in the case of a foreign entity,
by the report of a similarly qualified independent professional), that
is used for--
(A) Credit purposes,
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose; or
(iii) A financial statement (other than a tax return) required to
be provided to the Federal or a state government or any Federal or
state agencies (other than the SEC or the Internal Revenue Service).
(c) Coordination with other provisions of the Internal Revenue
Code--(1) In general. Nothing in this section changes the treatment of
any amount that is specifically provided for under any provision of the
Code or regulations (other than section 162(a) or section 212 and the
regulations under those sections). See, for example, Sec. 1.263A-
1(e)(3), requiring taxpayers to capitalize costs that directly benefit
or are incurred by reason of the performance of the production or
resale activities, including repair and maintenance costs allocable to
property produced or acquired for resale.
(2) Example. The following example illustrates the rules of this
paragraph (c):
Example. Railroad rolling stock. X is a railroad that properly
treats amounts paid for the rehabilitation of railroad rolling stock
as deductible expenses under section 263(d). X is not required to
capitalize the amounts paid
[[Page 12857]]
because nothing in this section changes the treatment of amounts
specifically provided for under section 263(d).
(d) Improved property--(1) Capitalization rule. Except as provided
in the optional regulatory accounting method in paragraph (i) of this
section or under any repair allowance method published in accordance
with paragraph (j) of this section, a taxpayer must capitalize the
aggregate of related amounts paid to improve a unit of property,
whether the improvements are made by the taxpayer or by a third party,
and whether the taxpayer is an owner or lessee of the property. For
purposes of this section, a unit of property includes units of property
for which the acquisition or production costs were deducted as
materials and supplies under Sec. 1.162-3(a)(1) or under the de
minimis rule in Sec. 1.263(a)-2(d)(4). See section 263A for the costs
required to be capitalized to property produced by the taxpayer or to
property acquired for resale; section 1016 for adding capitalized
amounts to the basis of the unit of property; and section 168 for the
treatment of additions or improvements for depreciation purposes. For
purposes of this section, a unit of property is improved if the amounts
paid for activities performed after the property is placed in service
by the taxpayer--
(i) Result in a betterment to the unit of property (see paragraph
(f) of this section); or
(ii) Restore the unit of property (see paragraph (g) of this
section); or
(iii) Adapt the unit of property to a new or different use (see
paragraph (h) of this section).
(2) Determining the appropriate unit of property--(i) In general.
The unit of property rules in this paragraph (d)(2) apply only for
purposes of section 263(a) and Sec. Sec. 1.263(a)-1, 1.263(a)-2,
1.263(a)-3, and 1.162-3(d). In general, the unit of property
determination is based upon the functional interdependence standard
provided in paragraph (d)(2)(iii)(A) of this section. However, special
rules are provided for buildings (see paragraph (d)(2)(ii) of this
section), plant property (see paragraph (d)(2)(iii)(B) of this
section), and network assets (see paragraph (d)(2)(iii)(C) of this
section). Additional rules are provided if a taxpayer has assigned
different financial statement economic useful lives or MACRS classes or
depreciation methods to components of property (see paragraph
(d)(2)(iii)(D) of this section). Property that is aggregated and
subject to a general asset account election or accounted for in a
multiple asset account (that is, pooled) may not be treated as a single
unit of property. In addition, an improvement to a unit of property as
determined under this section, other than a leasehold improvement, is
not a unit of property separate from the unit of property improved.
(ii) Buildings and structural components. In the case of a building
(as defined in Sec. 1.48-1(e)(1)), the building and its structural
components (as defined in Sec. 1.48-1(e)(2)) are a single unit of
property. In the case of a leasehold improvement made by a lessee and
that is section 1250 property, the leasehold improvement is a separate
unit of property. In the case of a taxpayer that owns or occupies an
individual unit in a building with multiple units (such as a
condominium or cooperative), the unit of property is the individual
unit owned and/or occupied by the taxpayer.
(iii) Property other than buildings--(A) In general. Except as
provided in paragraph (d)(2)(iii)(B), (C) and (D) of this section, in
the case of real or personal property other than property described in
paragraph (d)(2)(ii) of this section, all the components that are
functionally interdependent comprise a single unit of property.
Components of property are functionally interdependent if the placing
in service of one component by the taxpayer is dependent on the placing
in service of the other component by the taxpayer.
(B) Plant property--(1) Definition. For purposes of this paragraph
(d)(2) of this section, the term plant property means functionally
interdependent machinery or equipment, other than network assets, used
to perform an industrial process, such as manufacturing, generation,
warehousing, distribution, automated materials handling in service
industries, or other similar activities.
(2) Unit of property for plant property. In the case of plant
property, a unit of property is comprised of each component (or group
of components) within the unit of property determined under the general
rule of paragraph (d)(2)(iii)(A) of this section that performs a
discrete and major function or operation within the functionally
interdependent machinery or equipment.
(C) Network assets--(1) Definition. For purposes of this paragraph
(d)(2), the term network assets means railroad track, oil and gas
pipelines, water and sewage pipelines, power transmission and
distribution lines, and telephone and cable lines that are owned or
leased by taxpayers in each of those respective industries. The term
includes, for example, trunk and feeder lines, pole lines, and buried
conduit. It does not include property that would be included as a
structural component of a building under paragraph (d)(2)(ii) of this
section, nor does it include separate property that is adjacent to, but
not part of a network asset, such as bridges, culverts, or tunnels.
(2) [Reserved]
(D) Additional rules. Notwithstanding the unit of property
determination under paragraphs (d)(2)(iii)(A), (B), and (C) of this
section, a component (or a group of components) of a unit property must
be treated as a separate unit of property if--
(1) At the time the unit of property (as determined under paragraph
(d)(2)(iii)(A), (B), and (C) of this section) is placed in service by
the taxpayer (without regard to subsequent improvements), the taxpayer
has recorded on its books and records for financial or regulatory
accounting purposes an economic useful life for the component that is
different from the economic useful life of the unit of property of
which the component is a part; or
(2) The taxpayer has properly treated the component as being within
a different class of property under section 168(e) (MACRS classes) than
the class of the unit of property of which the component is a part or,
the taxpayer, at the time the component was placed in service by the
taxpayer, has properly depreciated the component using a different
depreciation method under section 167 or section 168 than the
depreciation method of the unit of property of which the component is a
part.
(iv) Examples. The rules of this paragraph (d)(2) are illustrated
by the following examples, in which it is assumed that the taxpayer has
not made a general asset account election with regard to property or
accounted for property in a multiple asset account.
Example 1. Buildings and structural components; plant property.
X owns a building containing various types of manufacturing
equipment that are not structural components of the building.
Because the property is a building, as defined in Sec. 1.48-
1(e)(1), the unit of property for the building must be determined
under paragraph (d)(2)(ii) of this section. Under the rules of that
paragraph, X must treat the building and all its structural
components as a single unit of property. In addition, because the
manufacturing equipment contained within the building constitutes
property other than a building, the units of property for the
manufacturing equipment are initially determined under the general
rule in paragraph (d)(2)(iii)(A) of this section and are therefore
comprised of all the components that are functionally
interdependent. Moreover, because the manufacturing equipment is
plant property, under
[[Page 12858]]
paragraph (d)(2)(iii)(B) of this section, the units of property
under the general rule are further divided into smaller units of
property by determining the components (or groups of components)
that perform discrete and major functions within the plant. Finally,
X must apply the additional rules in paragraph (d)(2)(iii)(D) of
this section to determine whether any of the units of property
determined under paragraphs (d)(2)(iii)(A) and (B) of this section
contain components that must be treated as separate units of
property.
Example 2. Buildings and structural components; property other
than plants. X, a manufacturer, owns a building adjacent to its
manufacturing facility that contains office space and related
facilities for X's employees that manage and administer X's
manufacturing operations. The office building contains equipment,
such as desks, chairs, computers, telephones, and bookshelves, that
are not structural components of the building. Because the office
building is a building, as defined in Sec. 1.48-1(e)(1), the unit
of property for the building must be determined under paragraph
(d)(2)(ii) of this section. Under the rules of that paragraph, X
must treat the office building and all its structural components as
a single unit of property. In addition, because the equipment
contained within the office building constitutes property other than
a building, the units of property for the office equipment are
initially determined under the general rule in paragraph
(d)(2)(iii)(A) of this section and are comprised of the groups of
components that are functionally interdependent. X then must apply
the additional rules in paragraph (d)(2)(iii)(D) of this section to
determine whether any of the units of property determined under
paragraph (d)(2)(iii)(A) of this section contain components that
must be treated as separate units of property.
Example 3. Plant property; discrete and major function. X is an
electric utility company that operates a power plant to generate
electricity. The power plant includes a structure that is not a
building under Sec. 1.48-1(e)(1), four pulverizers that grind coal,
one boiler that produces steam, one turbine that converts the steam
into mechanical energy, and one generator that converts mechanical
energy into electrical energy. In addition, the turbine contains a
series of blades that cause the turbine to rotate when affected by
the steam. When X placed the plant into service, X recorded all the
components of the plant as having the same economic useful life on
its books and records for financial and regulatory accounting
purposes. X also treated all the components of the plant as being
within the same class of property under section 168(e) and has
depreciated all the components using the same depreciation methods.
Because the plant is composed of real and personal tangible property
other than a building, the unit of property for the generating
equipment is initially determined under the general rule in
paragraph (d)(2)(iii)(A) of this section and is comprised of all the
components that are functionally interdependent. Under this rule,
the initial unit of property is the entire plant because the
components of the plant are functionally interdependent. However,
because the power plant is plant property under paragraph
(d)(2)(iii)(B) of this section, the initial unit of property is
further divided into smaller units of property by determining the
components (or groups of components) that perform discrete and major
functions within the plant. Under this paragraph, X must treat the
structure, the boiler, the turbine, and the generator each as a
separate unit of property, and each of the four pulverizers as a
separate unit of property because each of these components performs
a discrete and major function within the power plant. X is not
required to treat components, such as the turbine blades, as
separate units of property because each of these components does not
perform a discrete and major function within the plant.
Example 4. Plant property; discrete and major function. X is
engaged in a uniform and linen rental business that operates a plant
to treat and launder items used in its business. Within the plant X
utilizes an assembly line-like process that incorporates many
different machines and equipment to launder and prepare the items to
be returned to customers. X utilizes two laundering lines in its
plant, each of which can operate independently. One line is used for
uniforms and another line is used for linens. Both lines incorporate
several sorters, boilers, washers, dryers, ironers, folders, and
waste water treatment systems. Because the laundering equipment
contained within the plant is personal property, the unit of
property for the laundering equipment is initially determined under
the general rule in paragraph (d)(2)(iii)(A) of this section and is
comprised of all the components that are functionally
interdependent. Under this rule, the initial units of property are
each laundering line because each line is functionally independent
and is comprised of components that are functionally interdependent.
However, because each line is comprised of plant property under
paragraph (d)(2)(iii)(B) of this section, the initial units of
property are further divided into smaller units of property by
determining the components (or groups of components) that perform
discrete and major functions within the line. Under paragraph
(d)(2)(iii)(B) of this section, X must treat each sorter, boiler,
washer, dryer, ironer, folder, and waste water treatment system in
each line as a separate unit of property because each of these
components performs a discrete and major function within the line.
Finally, X must apply the additional rules in paragraph
(d)(2)(iii)(D) of this section to determine whether any of the units
of property determined under paragraph (d)(2)(iii)(B) of this
section contain components that must be treated as separate units of
property.
Example 5. Plant property; industrial process. X operates a
restaurant that prepares and serves food to retail customers. Within
its restaurant, X has a large piece of equipment that uses an
assembly line-like process to prepare and cook tortillas that X
serves to its customers. Because the tortilla-making equipment is
personal property, the unit of property for the equipment is
initially determined under the general rule in paragraph
(d)(2)(iii)(A) of this section and is comprised of all the
components that are functionally interdependent. Under this rule,
the initial unit of property is the entire tortilla-making equipment
because the various components of the equipment are functionally
interdependent. Although the equipment is used to perform a
manufacturing process, the equipment is not being used in an
industrial process, as it performs a small-scale function as part of
X's retail restaurant operations. Therefore, the equipment is not
plant property under paragraph (d)(2)(iii)(B) of this section.
Finally, X must apply the additional rules in paragraph
(d)(2)(iii)(D) of this section to determine whether the equipment
contains components that must be treated as separate units of
property.
Example 6. Personal property. X owns locomotives that it uses in
its railroad business. Each locomotive consists of various
components, such as an engine, generators, batteries and trucks. X
acquired a locomotive with all its components and recorded all the
components as having the same economic useful life on its books and
records for financial and regulatory accounting. X also treated all
the components of the locomotive as being within the same class of
property under section 168(e) and has depreciated all the components
using the same depreciation methods. Because X's locomotive is
property other than a building, the initial unit of property is
determined under paragraph (d)(2)(iii)(A) of this section. Under
this paragraph, the locomotive is a single unit of property because
it consists entirely of components that are functionally
interdependent. Because the additional rules under paragraph
(d)(2)(iii)(D) of this section do not apply under these facts, the
locomotive is a single unit of property.
Example 7. Personal property. X is engaged in the business of
transporting freight throughout the United States. To conduct its
business, X owns a fleet of tractors and trailers. Each tractor and
trailer is comprised of various components, including tires. X
purchases a truck trailer with all of its components, including 16
tires. At the time the trailer was placed in service by X, X treated
the trailer and the tires as being within the same class of property
under section 168(e) and has depreciated all the components using
the same depreciation methods. However, on its books and records for
financial accounting purposes, X recorded economic useful lives for
the tires that were different from the economic useful life that it
recorded for the trailer. Because X's trailer is property other than
a building, the initial units of property for the trailer are
determined under the general rule in paragraph (d)(2)(iii)(A) of
this section and are comprised of all the components that are
functionally interdependent. Under this rule, the truck trailer,
including its 16 tires, is a single unit of property because the
trailer and the tires are functionally interdependent (that is, the
placing in service of the tires is dependent upon the placing in
service of the trailer). X then must apply the additional rules in
paragraph (d)(2)(iii)(D) of this section to determine whether the
initial unit of property determined under paragraph
[[Page 12859]]
(d)(2)(iii)(A) of this section contains components that must be
treated as separate units of property. Under paragraph
(d)(2)(iii)(D)(1) of this section, because X recorded on its books
and records economic useful lives for the tires that are different
from the economic useful lives that it recorded for the trailer, the
tires must be treated as separate units of property.
Example 8. Personal property. X provides legal services to
customers. X purchased a laptop computer and a printer to be used by
its employees in providing services. When X placed the computer and
printer into service, X recorded both items and all their components
as having the same economic useful life on its books and records for
financial accounting purposes. X also treated the computer and
printer and all their components as being within the same class of
property under section 168(e) and has depreciated all the components
using the same depreciation methods. Because the computer and
printer are property other than a building, the initial units of
property are determined under the general rule in paragraph
(d)(2)(iii)(A) of this section and are comprised of the components
that are functionally interdependent. Under this paragraph
(d)(2)(iii)(A), the computer and the printer are separate units of
property because the computer and the printer are not components
that are functionally interdependent (that is, the placing in
service of the computer is not dependent on the placing in service
of the printer). The additional rules in paragraph (d)(2)(iii)(D) of
this section do not apply under these facts. Accordingly, the
computer and the printer each constitute separate units of property.
(3) Compliance with regulatory requirements. For purposes of this
section, a Federal, state, or local regulator's requirement that a
taxpayer perform certain repairs or maintenance on a unit of property
to continue operating the property is not relevant in determining
whether the amount paid improves the unit of property.
(4) Repairs and maintenance performed during an improvement--(i) In
general. A taxpayer must capitalize all the direct costs of an
improvement and all the indirect costs (including otherwise deductible
repair costs) that directly benefit or are incurred by reason of an
improvement in accordance with the rules under section 263A. Repairs
and maintenance that do not directly benefit or are not incurred by
reason of an improvement are not required to be capitalized under
section 263(a), regardless of whether they are made at the same time as
an improvement.
(ii) Exception for individuals' residences. A taxpayer who is an
individual may capitalize amounts paid for repairs and maintenance that
are made at the same time as substantial capital improvements to
property not used in the taxpayer's trade or business or for the
production of income if the repairs are done as part of a remodeling of
the taxpayer's residence.
(5) Aggregate of related amounts. For purposes of paragraph (d)(1)
of this section, the aggregate of related amounts paid to improve a
unit of property may be incurred over a period of more than one taxable
year. Whether amounts are related to the same improvement depends on
the facts and circumstances of the activities being performed and
whether the costs are incurred by reason of a single improvement or
directly benefit a single improvement.
(e) Safe harbor for routine maintenance--(1) In general. An amount
paid for routine maintenance performed on a unit of property is deemed
to not improve that unit of property. Routine maintenance is the
recurring activities that a taxpayer expects to perform as a result of
the taxpayer's use of the unit of property to keep the unit of property
in its ordinarily efficient operating condition. Routine maintenance
activities include, for example, the inspection, cleaning, and testing
of the unit of property, and the replacement of parts of the unit of
property with comparable and commercially available and reasonable
replacement parts. The activities are routine only if, at the time the
unit of property is placed in service by the taxpayer, the taxpayer
reasonably expects to perform the activities more than once during the
class life (as defined in paragraph (e)(4) of this section) of the unit
of property. Among the factors to be considered in determining whether
a taxpayer is performing routine maintenance are the recurring nature
of the activity, industry practice, manufacturers' recommendations, the
taxpayer's experience, and the taxpayer's treatment of the activity on
its applicable financial statement (as defined in paragraph (b)(4) of
this section). With respect to a taxpayer that is a lessor of a unit of
property, the taxpayer's use of the unit of property includes the
lessee's use of the unit of property.
(2) Exceptions. Routine maintenance does not include the
following--
(i) Amounts paid for the replacement of a component of a unit of
property if the taxpayer has properly deducted a loss for that
component (other than a casualty loss under Sec. 1.165-7);
(ii) Amounts paid for the replacement of a component of a unit of
property if the taxpayer has properly taken into account the adjusted
basis of the component in realizing gain or loss resulting from the
sale or exchange of the component;
(iii) Amounts paid for the repair of damage to a unit of property
for which the taxpayer has taken a basis adjustment as a result of a
casualty loss under section 165 or relating to a casualty event
described in section 165; and
(iv) Amounts paid to return a unit of property to its former
ordinarily efficient operating condition, if the property has
deteriorated to a state of disrepair and is no longer functional for
its intended use.
(3) Rotable or temporary spare parts. For purposes of paragraph
(e)(1) of this section, amounts paid for routine maintenance include
routine maintenance performed on (and with regard to) rotable and
temporary spare parts. But see Sec. 1.162-3(b), which provides that
rotable and temporary spare parts are used or consumed by the taxpayer
in the taxable year in which the taxpayer disposes of the part.
(4) Class life. The class life of a unit of property is the
recovery period prescribed for the property under section 168(g)(2) and
(3) for purposes of the alternative depreciation system, regardless of
whether the property is depreciated under section 168(g). For purposes
of determining class life under this paragraph (e), section
168(g)(3)(A) (relating to tax-exempt use property subject to lease)
does not apply.
(5) Examples. The following examples illustrate the rules of this
paragraph (e).
Example 1. Routine maintenance on rotable component. (i) X is a
commercial airline engaged in the business of transporting
passengers and freight throughout the United States and abroad. To
conduct its business, X owns or leases various types of aircraft. As
a condition of maintaining its airworthiness certification for these
aircraft, X is required by the Federal Aviation Administration (FAA)
to establish and adhere to a continuous maintenance program for each
aircraft within its fleet. These programs, which are designed by X
and the aircraft's manufacturer and approved by the FAA, are
incorporated into each aircraft's maintenance manual. The
maintenance manuals require a variety of periodic maintenance visits
at various intervals. One type of maintenance visit is an engine
shop visit (ESV), which X expects to perform on its aircraft engines
approximately every 4 years in order to keep its aircraft in its
ordinarily efficient operating condition. In 2004, X purchased a new
aircraft and four new engines to use in that aircraft and later, in
other aircraft in its fleet. The aircraft engines are rotable spare
parts because they are removable from the aircraft, and repaired and
reinstalled on other aircraft or stored for later installation on
other aircraft. See Sec. 1.162-3(b) (treatment of materials and
supplies). In 2008, X performs its first ESV on the aircraft
engines. The ESV includes disassembly, cleaning, inspection, repair,
replacement, reassembly, and testing of the
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engine and its component parts. During the ESV, the engine is
removed from the aircraft and shipped to an outside vendor who
performs the ESV. If inspection or testing discloses a discrepancy
in a part's conformity to the specifications in X's maintenance
program, the part is repaired, or if necessary, replaced with a
comparable and commercially available and reasonable replacement
part. After the ESVs the engines are returned to X to be reinstalled
on another aircraft or stored for later installation. Assume the
unit of property for X's aircraft is the entire aircraft, including
the aircraft engines, and that the class life for X's aircraft is 12
years. Assume that none of the exceptions set out in paragraph
(e)(2) of this section applies to the costs of performing the ESVs.
(ii) Because the ESVs involve the recurring activities that X
expects to perform as a result of its use of the aircraft to keep
the aircraft in ordinarily efficient operating condition, and
consist of maintenance activities that X expects to perform more
than once during the 12 year class life of the aircraft, X's ESVs
are within the routine maintenance safe harbor under paragraph (e)
of this section. Accordingly, the amounts paid by X for the ESVs are
deemed not to improve the aircraft and are not required to be
capitalized under paragraph (d)(1) of this section. For the
treatment of costs to acquire the engines, see Sec. 1.162-3.
Example 2. Routine maintenance after economic useful life.
Assume the same facts as in Example 1, except that X incurs costs to
perform an ESV on one of its aircraft engines in 2024, after the end
of the economic useful life that X anticipated for the aircraft.
Because this ESV involves the same routine maintenance activities
that were performed on aircraft engines in Example 1, this ESV also
is within the routine maintenance safe harbor under paragraph (e) of
this section. Accordingly, the amounts paid by X for this ESV, even
though performed after the economic useful life of the aircraft, are
deemed not to improve the aircraft and are not required to be
capitalized under paragraph (d)(1) of this section.
Example 3. Routine maintenance resulting from prior owner's use.
(i) In January 2008, X purchases a used machine for use its
manufacturing operations. Assume that the machine is the unit of
property and has a class life of 10 years. The machine is fully
operational at the time it is purchased by X and is immediately
placed in service in X's business. At the time it is placed in
service by X, X expects to perform manufacturer recommended
scheduled maintenance on the machine approximately every three
years. The scheduled maintenance includes the cleaning and oiling of
the machine, the inspection of parts for defects, and the
replacement of minor items such as springs, bearings, and seals with
comparable and commercially available and reasonable replacement
parts. At the time the machine is purchased, it is approaching the
end of a three-year scheduled maintenance period. As a result, in
February 2008, X incurs costs to perform the manufacturer
recommended scheduled maintenance. Assume that none of the
exceptions set out in paragraph (e)(2) of this section apply to the
amounts paid for the scheduled maintenance.
(ii) The majority of the costs incurred by X do not qualify
under the routine maintenance safe harbor in paragraph (e) of this
section because the costs were primarily incurred as a result of the
prior owner's use of the property and not X's use. The condition of
the machine at the time that it was placed in service by X was that
of a machine nearing the end of a scheduled maintenance period.
Accordingly, the amounts paid by X for the scheduled maintenance
resulting from the prior owner's use of the property must be
capitalized if those amounts result in a betterment under paragraph
(f) of this section, including the amelioration of a material
condition or defect, or otherwise result in an improvement under
paragraph (d)(1) of this section. See also section 263A requiring
taxpayers to capitalize the direct and allocable share of indirect
costs of property produced or acquired for resale.
Example 4. Routine maintenance resulting from new owner's use.
Assume the same facts as in Example 3, except that after X incurs
costs for the maintenance in 2008, X continues to operate the
machine in its manufacturing business. In 2011, X incurs costs to
perform the next scheduled manufacturer recommended maintenance on
the machine. Assume that the scheduled maintenance activities
performed are the same as those performed in Example 3 and that none
of the exceptions set out in paragraph (e)(2) of this section apply
to the amounts paid for the scheduled maintenance. Because the
scheduled maintenance performed in 2011 involves the recurring
activities that X performs as a result of its use of the machine,
keeps the machine in an ordinarily efficient operating condition,
and consists of maintenance activities that X expects to perform
more than once during the 10 year class life of the machine, X's
scheduled maintenance costs are within the routine maintenance safe
harbor under paragraph (e) of this section. Accordingly, the amounts
paid by X for the scheduled maintenance in 2011 are deemed not to
improve the machine and are not required to be capitalized under
paragraph (d)(1) of this section. However, because the amounts paid
for the scheduled maintenance are incurred by reason of X's
manufacturing operations, X is required to capitalize the amounts
paid for the maintenance to products produced by X. See Sec.
1.263A-1(e)(3)(ii).
Example 5. Routine maintenance; replacement of substantial
structural part. X is in the business of producing commercial
products for sale. As part of the production process, X places raw
materials into lined containers in which a chemical reaction is used
to convert raw materials into the finished product. The lining is a
substantial structural part of the container, and comprises 60% of
the total physical structure of the container. Assume that each
container, including its lining, is the unit of property and that a
container has a class life of 12 years. At the time that X placed
the container into service, X was aware that approximately every
three years, X would be required to replace the lining in the
container with comparable and commercially available and reasonable
replacement materials. At the end of that period, the container will
continue to function, but will become less efficient and the
replacement of the lining will be necessary to keep the container in
an ordinarily efficient operating condition. In 2003, X acquired 10
new containers and placed them into service. In 2006, 2009, 2011,
and 2014, X pays amounts to replace the containers' linings with
comparable and commercially available and reasonable replacement
parts. Assume that none of the exceptions set out in paragraph
(e)(2) of this section apply to the amounts paid for the replacement
linings. Because the replacement of the linings involves recurring
activities that X expects to perform as a result of its use of the
containers to keep the containers in their ordinarily efficient
operating condition, and consists of maintenance activities that X
expects to perform more than once during the 12 year class lives of
the containers, X's lining replacement costs are within the routine
maintenance safe harbor under paragraph (e) of this section.
Accordingly, the amounts paid by X for the replacement of the
container linings are deemed not to improve the containers and are
not required to be capitalized under paragraph (d)(1) of this
section. However, because the amounts paid to replace the container
linings are incurred by reason of X's manufacturing operations, X is
required to capitalize the amounts paid for the replacements to
products produced by X. See Sec. 1.263A-1(e)(3)(ii).
Example 6. Routine maintenance once during class life. X is a
Class I railroad that owns a fleet of freight cars. Assume that a
freight car, including all its components, is a unit of property and
has a class life of 14 years. At the time that X places a freight
car into service, X expects to perform cyclical reconditioning to
the car every 8 to 10 years in order to keep the freight car in
ordinarily efficient operating condition. During this
reconditioning, X incurs costs to disassemble, inspect, and
recondition and/or replace components of the freight car with
comparable and commercially available and reasonable replacement
parts. Ten years after the freight car is placed in service by X, X
incurs costs to perform a cyclical reconditioning on the car.
Because X expects to perform the reconditioning only once during the
14 year class life of the freight car, the costs incurred for
reconditioning do not qualify for the routine maintenance safe
harbor under paragraph (e) of this section. Accordingly, X must
capitalize the amounts paid for the reconditioning of the freight
car if these amounts result in an improvement under paragraph (d)(1)
of this section.
Example 7. Routine maintenance on non-rotable part. X is a
towboat operator that owns and leases a fleet of towboats. Each
towboat is equipped with two diesel-powered engines. Assume that
each towboat, including its engines, is the unit of property and
that a towboat has a class life of 18 years. At the time that X
places its towboats into service, X is aware that approximately
every three to four years, X will need to perform scheduled
maintenance on the two towboat engines to keep the engines in their
[[Page 12861]]
ordinarily efficient operating condition. This maintenance is
completed while the engines are attached to the towboat and involves
the cleaning and inspecting of the engines to determine which parts
are within acceptable operating tolerances and can continue to be
used, which parts must be reconditioned to be brought back to
acceptable tolerances, and which parts must be replaced. Engine
parts replaced during these procedures are replaced with comparable
and commercially available and reasonable replacement parts. Assume
the towboat engines are not rotable spare parts under Sec. 1.162-
3(b). In 2005, X acquired a new towboat, including its two engines,
and placed the towboat into service. In 2009, X incurs amounts to
perform scheduled maintenance on both engines in the towboat. Assume
that none of the exceptions set out in paragraph (e)(2) of this
section apply to the scheduled maintenance costs. Because the
scheduled maintenance involves recurring activities that X expects
to perform more than once during the 18 year class life of the
towboat. This maintenance results from X's use of the towboat, and
is performed to keep the towboat in an ordinarily efficient
operating condition, the scheduled maintenance on X's towboat is
within the routine maintenance safe harbor under paragraph (e) of
this section. Accordingly, the amounts paid by X for the scheduled
maintenance to its towboat engines in 2009 are deemed not to improve
the towboat and are not required to be capitalized under paragraph
(d)(1) of this section.
Example 8. Routine maintenance with betterments. Assume the same
facts as Example 7, except that in 2013, X's towboat engines are due
for another scheduled maintenance visit. At this time X decides to
upgrade the engines to increase their horsepower and propulsion,
which would permit the towboats to tow heavier loads. Accordingly,
in 2013 X incurs costs to perform many of the same activities that
it would perform during the typical scheduled maintenance activities
such as cleaning, inspecting, reconditioning, and replacing minor
parts, but at the same time, X incurs costs to upgrade certain
engine parts to increase the towing capacity of the boats in excess
of the capacity when the boats were placed in service by X. Both the
scheduled maintenance procedures and the replacement of parts with
new and upgraded parts are necessary to increase the horsepower of
the engines and the towing capacity of the boat. Thus, the work done
on the engines encompasses more than the recurring activities that X
expected to perform as a result of its use of the towboats and did
more than keep the towboat in its ordinarily efficient operating
condition. In addition, the scheduled maintenance procedures
directly benefit and are incurred by reason of the upgrades.
Therefore, the amounts paid by X in 2013 for the maintenance and
upgrade of the engines do not qualify for the routine maintenance
safe harbor described under paragraph (e) of this section. These
amounts must be capitalized if they result in a betterment under
paragraph (f) of this section, including a material increase in the
capacity of the towboat, or otherwise result in an improvement under
paragraph (d)(1) of this section. See also section 263A requiring
taxpayers to capitalize all the direct costs of an improvement to
property and all the indirect costs that directly benefit or are
incurred by reason of an improvement to property.
Example 9. Exceptions to routine maintenance. X owns and
operates a farming and cattle ranch with an irrigation system that
provides water for crops. Assume that each canal in the irrigation
system is a single unit of property and has a class life of 20
years. When X placed the canals into service, X expected to have to
perform major maintenance on the canals every 3 years to keep the
canals in their ordinarily efficient operating condition. This
maintenance included draining the canals, and then cleaning,
inspecting, repairing, reconditioning or replacing parts of the
canal with comparable and commercially available and reasonable
replacement parts. X placed the canals into service in 2005 and did
not perform any maintenance on the canals until 2010. At that time,
the canals had fallen into a state of disrepair and no longer
functioned for irrigation. In 2010, X paid amounts to drain the
canals, and do extensive cleaning, repairing, reconditioning and
replacing parts of the canals with comparable and commercially
available and reasonable replacement parts. Although the work
performed on X's canals was similar to the activities that X
expected to perform, but did not perform, every three years, the
costs of these activities do not fall within the routine maintenance
safe harbor. Specifically, under paragraph (e)(2)(iv) of this
section, routine maintenance does not include amounts paid to return
a unit of property to its former ordinary efficient operating
condition if the property has deteriorated to a state of disrepair
and is no longer functional for its intended use. Accordingly,
amounts paid by X for work performed on the canals in 2010 must be
capitalized if they result in improvements under paragraph (d)(1) of
this section (for example, restorations under paragraph (g) of this
section).
(f) Capitalization of betterments--(1) In general. A taxpayer must
capitalize amounts paid that result in the betterment of a unit of
property. An amount paid results in the betterment of a unit of
property only if it--
(i) Ameliorates a material condition or defect that either existed
prior to the taxpayer's acquisition of the unit of property or arose
during the production of the unit of property, whether or not the
taxpayer was aware of the condition or defect at the time of
acquisition or production;
(ii) Results in a material addition (including a physical
enlargement, expansion, or extension) to the unit of property; or
(iii) Results in a material increase in capacity (including
additional cubic or square space), productivity, efficiency, strength,
or quality of the unit of property or the output of the unit of
property.
(2) Application of general rule--(i) Facts and circumstances. To
determine whether an amount paid results in a betterment described in
paragraph (f)(1) of this section, it is appropriate to consider all the
facts and circumstances including, but not limited to, the purpose of
the expenditure, the physical nature of the work performed, the effect
of the expenditure on the unit of property, and the taxpayer's
treatment of the expenditure on its applicable financial statement (as
described in paragraph (b)(4) of this section).
(ii) Unavailability of replacement parts. If a taxpayer needs to
replace part of a unit of property that cannot practicably be replaced
with the same type of part (for example, because of technological
advancements or product enhancements), the replacement of the part with
an improved but comparable part does not, by itself, result in a
betterment to the unit of property.
(iii) Appropriate comparison--(A) In general. In cases in which a
particular event necessitates an expenditure, the determination of
whether an expenditure results in a betterment of the unit of property
is made by comparing the condition of the property immediately after
the expenditure with the condition of the property immediately prior to
the circumstances necessitating the expenditure.
(B) Normal wear and tear. If the expenditure is made to correct the
effects of normal wear and tear to the unit of property (including the
amelioration of a condition or defect that existed prior to the
taxpayer's acquisition of the unit of property resulting from normal
wear and tear), the condition of the property immediately prior to the
circumstances necessitating the expenditure is the condition of the
property after the last time the taxpayer corrected the effects of
normal wear and tear (whether the amounts paid were for maintenance or
improvements) or, if the taxpayer has not previously corrected the
effects of normal wear and tear, the condition of the property when
placed in service by the taxpayer.
(C) Particular event. If the expenditure is made as a result of a
particular event, the condition of the property immediately prior to
the circumstances necessitating the expenditure is the condition of the
property immediately prior to the particular event.
(3) Examples. The following examples illustrate solely the rules of
this paragraph (f). Even if capitalization is not required in an
example under this paragraph (f), the amounts paid in the example may
be subject to capitalization
[[Page 12862]]
under a different provision of this section.
Example 1. Amelioration of pre-existing material condition or
defect. In 2008, X purchases a store located on a parcel of land
that contained underground gasoline storage tanks left by prior
occupants. Assume that the parcel of land is the unit of property.
The tanks had leaked, causing soil contamination. X is not aware of
the contamination at the time of purchase. In 2009, X discovers the
contamination and incurs costs to remediate the soil. The
remediation costs incurred by X result in a betterment to the land
under paragraph (f)(1)(i) of this section because the costs were
incurred to ameliorate a material condition or defect that existed
prior to the taxpayer's acquisition of the land.
Example 2. Not amelioration of pre-existing condition or defect.
X owned a building that was constructed with insulation that
contained asbestos. The health dangers of asbestos were not widely
known when the building was constructed. In 2008, X determined that
certain areas of asbestos-containing insulation had begun to
deteriorate and could eventually pose a health risk to employees.
Therefore, X decided to remove the asbestos-containing insulation
from the building and replace it with new insulation that was safer
to employees, but no more efficient or effective than the asbestos
insulation. Assume the building and its structural components
(including the asbestos insulation) is the unit of property. The
amounts paid to remove and replace the asbestos insulation are not
required to be capitalized as a betterment under paragraphs
(f)(1)(i) and (f)(2)(i) of this section because the asbestos,
although later determined to be unsafe under certain circumstances,
was not an inherent and material defect to the property. In
addition, the removal and replacement of the asbestos did not result
in any material additions to the building or material increases in
capacity, productivity, efficiency, strength or quality of the
building or the output of the building under paragraphs (f)(1)(ii)
and (f)(1)(iii) of this section.
Example 3. Not amelioration of pre-existing material condition
or defect. (i) In January 2008, X purchases a used machine for use
its manufacturing operations. Assume that the machine is a unit of
property and it has a class life of 10 years. The machine is fully
operational at the time it is purchased by X and is immediately
placed in service in X's business. At the time it is placed in
service by X, X expects to perform manufacturer recommended
scheduled maintenance on the machine every three years. The
scheduled maintenance includes the cleaning and oiling of the
machine, the inspection of parts for defects, and the replacement of
minor items such as springs, bearings, and seals with comparable and
commercially available and reasonable replacement parts. The
scheduled maintenance does not result in any material additions or
material increases in capacity, productivity, efficiency, strength
or quality of the machine or the output of the machine. At the time
the machine is purchased, it is approaching the end of a three-year
scheduled maintenance period. As a result, in February 2008, X
incurs costs to perform the manufacturer recommended scheduled
maintenance to keep the machine in its ordinarily efficient
operating condition.
(ii) The majority of the costs incurred by X do not qualify
under the routine maintenance safe harbor in paragraph (e) of this
section because the costs were primarily incurred as a result of the
prior owner's use of the property and not the taxpayer's use. The
condition of the machine at the time that it was placed in service
by X was that of a machine nearing the end of a scheduled
maintenance period. Accordingly, the amounts paid by X for the
scheduled maintenance resulting from the prior owner's use of the
property ameliorate conditions or defects that existed prior to X's
ownership of the machine. Nevertheless, considering the facts and
circumstances under paragraph (f)(2)(i) of this section, including
the purpose and minor nature of the work performed, those amounts do
not ameliorate a material condition or defect under paragraph
(f)(1)(i) of this section and accordingly do not result in a
betterment that must be capitalized under this paragraph (f).
Example 4. Not amelioration of pre-existing material condition
or defect. In 2008, X purchases a used ice resurfacing machine for
use in the operation of its ice skating rink. To comply with local
regulations, X is required to routinely monitor the air quality in
the ice skating rink. One week after X places the machine into
service, during a routine air quality check, X discovers that the
operation of the machine is adversely affecting the air quality in
the skating rink. As a result, X incurs costs to inspect and retune
the machine, which includes replacing minor components of the
engine, which had worn out prior to X's acquisition of the machine.
Assume the resurfacing machine, including the engine, is the unit of
property. The routine maintenance safe harbor in paragraph (e) of
this section does not apply to the amounts paid because the
activities performed do more than return the machine to the
condition that existed at the time it was placed in service by X.
The amounts paid by X to inspect, retune, and replace minor
components of the ice resurfacing machine ameliorated a condition or
defect that existed prior to X's acquisition of the equipment.
Nevertheless, considering the facts and circumstances under
paragraph (f)(2)(i) of this section, including the purpose and minor
nature of the work performed, these amounts do not ameliorate a
material condition or defect under paragraph (f)(1)(i) of this
section, result in a material addition to the machine under
paragraph (f)(1)(ii) of this section, or result in a material
increase in the capacity, productivity, efficiency, strength or
quality of the machine or the output of the machine. Accordingly,
the amounts paid by X to inspect, retune, and replace minor
components of the machine do not result in a betterment that must be
capitalized under this paragraph (f).
Example 5. Amelioration of material condition or defect;
increase in quality. (i) In January 2009, X acquires a building for
use in its business of providing assisted living services. Before
and after the purchase, the building functions as an assisted living
facility. However, at the time of the purchase, X is aware that the
building is in a condition that is below the standards that X
requires for facilities used in its business. Beginning in 2009 and
over the next two years, while X continues to use the building as an
assisted living facility, X incurs costs for repairs, maintenance,
and the acquisition of new property to bring the facility into the
high-quality condition for which X's facilities are known. The work
includes repainting; replacing flooring materials, windows, and
tiling and fixtures in bathrooms; replacing window treatments,
furniture, and cabinets; and repairing or replacing roofing
materials, heating and cooling systems. On its applicable financial
statements, X capitalizes the costs of the repairs, maintenance, and
acquisitions over the remaining economic useful life recorded for
the building. Assume that the building, including its structural
components, is a single unit of property and that each section 1245
property is a separate unit of property.
(ii) Considering the facts and circumstances under paragraph
(f)(2)(i) of this section, including the purpose of the
expenditures, the effect of the expenditures on the building, and
the treatment of the expenditures in X's applicable financial
statements, the amounts paid by X for repairs and maintenance to the
building and its structural components ameliorated material
conditions and defects that existed prior to X's acquisition of the
building. In addition, these amounts materially increased the
quality of the building as compared to the condition of the building
when it was placed in service by X. Accordingly, the amounts paid by
X for repairs and maintenance to the building and its structural
components (that is, repainting, replacing windows, replacing
bathroom fixtures, repairing and replacing roofing materials and
heating and cooling systems) result in betterments that must be
capitalized under this paragraph (f). Moreover, X is required to
capitalize the amounts paid to acquire and install each section 1245
property, including the flooring materials, tiling, each window
treatment, each item of furniture, and each cabinet, in accordance
with Sec. 1.263(a)-2(d).
Example 6. Not a betterment. X owns a nationwide chain of retail
stores that sell a wide variety of items. To remain competitive in
the industry, X periodically changes the layout and appearance of
its stores. These changes include the reconfiguration of the stores
to provide better exposure of the merchandise and cosmetic
alterations to keep the store modern and attractive to customers.
The work is not undertaken for the purpose of repairing damaged
property but rather to renew the appearance of the property. X
incurs costs to update 50 stores during the taxable year. In its
applicable financial statement, X capitalizes all the costs of the
updates over a 5-year period until which X anticipates it would have
to update again. Assume that each store building, including its
structural components, is a unit of property and that each section
1245 property within the store is a separate unit of property. Also
assume that the work performed did not ameliorate any material
conditions or defects that existed when X acquired the store
[[Page 12863]]
buildings or result in any material additions to the store
buildings.
(ii) Considering the facts and circumstances under paragraph
(f)(2)(i) of this section, including the purpose of the expenditure,
the nature of the work performed, and the treatment of the work on
X's applicable financial statements, the amounts paid by X for
updates to its store buildings (including their structural
components) do not result in material increases in capacity,
productivity, efficiency, strength or quality of the store
buildings. Accordingly, the amounts paid by X for the updates on the
store buildings (including their structural components) do not
result in betterments that must be capitalized under this paragraph
(f). However, X is required to capitalize the amounts paid to
acquire and install each section 1245 property in accordance with
Sec. 1.263(a)-2(d).
Example 7. Betterment; regulatory requirement. X owns a hotel in
City that includes five foot high unreinforced terra cotta and
concrete parapets with overhanging cornices around the entire roof
perimeter. The parapets and cornices are in good condition. In 2008,
City passes an ordinance setting higher safety standards for
parapets and cornices because of the hazardous conditions caused by
earthquakes. To comply with the ordinance, X replaces the old
parapets and cornices with new ones made of glass fiber reinforced
concrete, which makes them lighter and stronger than the original
ones. They are attached to the hotel using welded connections
instead of wire supports, making them more resistant to damage from
lateral movement. Assume the hotel building and its structural
components are the unit of property. The event necessitating the
expenditure was the 2008 City ordinance. Prior to the ordinance, the
old parapets and cornices were in good condition, but were
determined by City to create a potential hazard. After the
expenditure, the new parapets and cornices materially increased the
structural soundness (that is, the strength) of the hotel building.
Therefore, the amounts paid by X to replace the parapets and
cornices must be capitalized because they resulted in a betterment
to the hotel. City's requirement that X correct the potential hazard
to continue operating the hotel is not relevant in determining
whether the amount paid improved the hotel. See paragraph (d)(3) of
this section.
Example 8. Not a betterment; regulatory requirement. X owns a
meat processing plant. In 2008, X discovers that oil was seeping
through the concrete walls of the plant, creating a fire hazard.
Federal meat inspectors advise X that it must correct the seepage
problem or shut down its plant. To correct the problem, X incurs
costs to add a concrete lining to the walls from the floor to a
height of about four feet and also to add concrete to the floor of
the plant. Assume the plant building and its structural components
are the unit of property. The event necessitating the expenditure
was the seepage of the oil. Prior to the seepage, the plant did not
leak and was functioning for its intended use. The expenditure did
not result in a material addition or material increase in capacity,
productivity, efficiency, strength or quality of the plant or its
output of compared to the condition of the plant prior to the
seepage of the oil. Therefore, the amounts paid by X to correct the
seepage do not result in a betterment to the plant. X is not
required to capitalize as an improvement under this paragraph (f)
amounts paid to correct the seepage problem. The Federal meat
inspectors' requirement that X correct the seepage to continue
operating the plant is not relevant in determining whether the
amount paid improved the plant. See paragraph (d)(3) of this
section.
Example 9. Not a betterment; replacement with same part. X owns
a small retail shop. In 2008, a storm damages the roof of X's shop
by displacing numerous wooden shingles. X decides to replace all the
wooden shingles on the roof and hires a contractor to replace all
the shingles on the roof with new wooden shingles. Assume the shop
building and its structural components are the unit of property. The
event necessitating the expenditure was the storm. Prior to the
storm, the retail shop was functioning for its intended use. The
expenditure did not result in a material addition, or material
increase in the capacity, productivity, efficiency, strength or
quality of the shop or the output of the shop compared to the
condition of the shop prior to the storm. Therefore, the amounts
paid by X to reshingle the roof with wooden shingles do not result
in betterment to the shop building. X is not required to capitalize
as an improvement under this paragraph (f) amounts paid to replace
the shingles.
Example 10. Not a betterment; replacement with comparable part.
Assume the same facts as in Example 9, except that wooden shingles
are not available on the market. X decides to replace all the wooden
shingles with comparable asphalt shingles. The amounts paid by X to
reshingle the roof with asphalt shingles do not result in a
betterment to the shop, even though the asphalt shingles may be
stronger than the wooden shingles. Because the wooden shingles could
not practicably be replaced with new wooden shingles, the
replacement of the old shingles with comparable asphalt shingles
does not, by itself, result in an improvement to the shop. X is not
required to capitalize as an improvement under this paragraph (f)
amounts paid to replace the shingles.
Example 11. Betterment; replacement with improved parts. Assume
the same facts as in Example 9, except that, instead of replacing
the wooden shingles with asphalt shingles, X decides to replace all
the wooden shingles with shingles made of lightweight composite
materials that are maintenance-free and do not absorb moisture. The
new shingles have a 50-year warranty and a Class A fire rating. The
expenditure for these shingles resulted in a material increase in
the quality of the shop building as compared to the condition of the
shop building prior to the storm. X must capitalize amounts paid to
reshingle the roof as an improvement under this paragraph (f)
because they result in a betterment to the shop.
Example 12. Material increase in capacity. X owns a factory
building with a storage area on the second floor. In 2008, X
replaces the columns and girders supporting the second floor to
permit storage of supplies with a gross weight 50 percent greater
than the previous load-carrying capacity of the storage area. Assume
the factory building and its structural components are the unit of
property. X must capitalize as an improvement amounts paid for the
columns and girders because they result in a material increase in
the load-carrying capacity of the building. The comparison rule in
paragraph (f)(2)(iii) of this section does not apply to these
amounts paid because the expenditure was not necessitated by a
particular event.
Example 13. Material increase in capacity. In 2008, X purchases
harbor facilities consisting of a slip for the loading and unloading
of barges and a channel leading from the slip to the river. At the
time of purchase, the channel is 150 feet wide, 1,000 feet long, and
10 feet deep. To allow for ingress and egress and for the unloading
of its barges, X needs to deepen the channel to a depth of 20 feet.
X hires a contractor to dredge the channel to the required depth.
Assume the channel is the unit of property. X must capitalize as an
improvement amounts paid for the dredging because it resulted in a
material increase in the capacity of the channel. The comparison
rule in paragraph (f)(2)(iii) of this section does not apply to
these amounts paid because the expenditure was not necessitated by a
particular event.
Example 14. Not a material increase in capacity. Assume the same
facts as in Example 13, except that the channel was susceptible to
siltation and, by 2009, the channel depth had been reduced to 18
feet. X hired a contractor to redredge the channel to a depth of 20
feet. The event necessitating the expenditure was the siltation of
the channel. Both prior to the siltation and after the redredging,
the depth of the channel was 20 feet. Therefore, the amounts paid by
X for redredging the channel did not result in a material addition
to the unit of property or a material increase in the capacity,
productivity, efficiency, strength or quality of the unit of
property or the output of the unit of property. X is not required to
capitalize as a betterment under paragraph (f) of this section
amounts paid to redredge the channel.
Example 15. Not a material increase in capacity. X owns a
building used in its trade or business. The first floor has a drop-
ceiling. X decides to remove the drop-ceiling and repaint the
original ceiling. Assume the building and its structural components
are the unit of property. The removal of the drop-ceiling does not
create additional capacity in the building that was not there prior
to the removal. Therefore, the amounts paid by X to remove the drop-
ceiling and repaint the original ceiling did not result in a
material addition or a material increase to the capacity,
productivity, efficiency, strength or quality of the unit of
property or output of the unit of property. X is not required to
capitalize as a betterment under this paragraph (f) amounts paid
related to removing the drop-ceiling. The comparison rule in
paragraph (f)(2)(iii) of this section does not apply to these
amounts paid because the expenditure was not necessitated by a
particular event.
[[Page 12864]]
(g) Capitalization of restorations--(1) In general. A taxpayer must
capitalize amounts paid to restore a unit of property, including
amounts paid in making good the exhaustion for which an allowance is or
has been made. An amount is paid to restore a unit of property if it--
(i) Is for the replacement of a component of a unit of property and
the taxpayer has properly deducted a loss for that component (other
than a casualty loss under Sec. 1.165-7);
(ii) Is for the replacement of a component of a unit of property
and the taxpayer has properly taken into account the adjusted basis of
the component in realizing gain or loss resulting from the sale or
exchange of the component;
(iii) Is for the repair of damage to a unit of property for which
the taxpayer has properly taken a basis adjustment as a result of a
casualty loss under section 165, or relating to a casualty event
described in section 165;
(iv) Returns the unit of property to its ordinarily efficient
operating condition if the property has deteriorated to a state of
disrepair and is no longer functional for its intended use;
(v) Results in the rebuilding of the unit of property to a like-new
condition after the end of its economic useful life (see paragraph
(g)(2) of this section); or
(vi) Is for the replacement of a major component or a substantial
structural part of the unit of property (see paragraph (g)(3) of this
section).
(2) Rebuild to like-new condition--(i) In general. For purposes of
paragraph (g)(1)(v) of this section, the following definitions apply:
(1) Like-new condition. A unit of property is rebuilt to a like-new
condition if it is brought to the status of new, rebuilt,
remanufactured, or similar status under the terms of any Federal
regulatory guideline or the manufacturer's original specifications.
(2) Economic useful life. The economic useful life of a unit of
property is not necessarily the useful life inherent in the property
but is the period over which the property may reasonably be expected to
be useful to the taxpayer or, if the taxpayer is engaged in a trade or
business or an activity for the production of income, the period over
which the property may reasonably be expected to be useful to the
taxpayer in its trade or business or for the production of income, as
applicable. See Sec. 1.167(a)-1(b) for the factors to be considered in
determining this period.
(ii) Exception. An amount paid is not required to be capitalized
under paragraph (g)(1)(v) of this section if it is paid during the
recovery period prescribed in section 168(c) (taking into account the
applicable convention) for the property, regardless of whether the
property is depreciated under section 168(a).
(3) Replacement of a major component or a substantial structural
part--(i) In general. For purposes of paragraph (g)(1)(vi) of this
section, the replacement of a major component or a substantial
structural part means the replacement of--
(1) A part or a combination of parts of the unit of property, the
cost of which comprises 50 percent or more of the replacement cost of
the unit of property; or
(2) A part or a combination of parts of the unit of property that
comprise 50 percent or more of the physical structure of the unit of
property.
(ii) Exception. An amount paid is not required to be capitalized
under paragraph (g)(1)(vi) of this section if it is paid during the
recovery period prescribed in section 168(c) (taking into account the
applicable convention) for the property, regardless of whether the
property is depreciated under section 168(a).
(4) Examples. The following examples illustrate solely the rules of
this paragraph (g). Even if capitalization is not required in an
example under the cited subparagraph under this paragraph (g), the
amounts paid in the example may be subject to capitalization under a
different provision of this section, or under a different subparagraph
in this paragraph (g).
Example 1. Replacement of loss component. X owns a manufacturing
building containing various types of manufacturing equipment. X does
a cost segregation study of the manufacturing building and properly
determines that a walk-in freezer in the manufacturing equipment is
section 1245 property as defined in section 1245(a)(3). The freezer
is not part of the HVAC system that relates to the general operation
or maintenance of the building. The components of the walk-in
freezer cease to function and X decides to replace them. X abandons
the freezer components and properly recognizes a loss from the
abandonment of the components. X replaces the abandoned freezer
components with new components and incurs costs to acquire and
install the new components. Under paragraph (g)(1)(i) of this
section, X must capitalize the amounts paid to acquire and install
the new freezer components because X replaced components for which
it had properly deducted a loss.
Example 2. Replacement of sold component. Assume the same facts
as in Example 1 except that X did not abandon the components, but
instead sold them to another party and properly recognized a loss on
the sale. Under paragraph (g)(1)(ii) of this section, X must
capitalize the amounts paid to acquire and install the new freezer
components because X replaced components for which it had property
taken into account the adjusted basis of the components in realizing
a loss from the sale of the components.
Example 3. Restoration after casualty loss. X owns an office
building that it uses in its trade or business. A storm damages the
office building at a time when the building has an adjusted basis of
$500,000. X deducts under section 165 a casualty loss in the amount
of $50,000 and properly reduces its basis in the office building to
$450,000. X hires a contractor to repair the damage to the building
and pays the contractor $50,000 for the work. Under paragraph
(g)(1)(iii) of this section, X must capitalize the $50,000 amount
paid to the contractor because X properly adjusted its basis as a
result of a casualty loss under section 165.
Example 4. Restoration after casualty event. Assume the same
facts as in Example 3, except that X receives insurance proceeds of
$50,000 after the casualty to compensate for its loss. X cannot
deduct a casualty loss under section 165 because its loss was
compensated by insurance. However, X properly reduces its basis in
the property by the amount of the insurance proceeds. Under
paragraph (g)(1)(iii) of this section, X must capitalize the $50,000
amount paid to the contractor because X has properly taken a basis
adjustment relating to a casualty event described in section 165.
Example 5. Restoration of property in a state of disrepair. X
owns and operates a farm with several barns and outbuildings. One of
the outbuildings is not used or maintained by X on a regular basis
and falls into a state of disrepair. The outbuilding previously was
used for storage but can no longer be used for that purpose because
the building is not structurally sound. X decides to restore the
outbuilding and incurs costs to shore up the walls and replace the
siding. Under paragraph (g)(1)(iv) of this section, X must
capitalize the amounts paid to restore the outbuilding because they
return the outbuilding to its ordinarily efficient operating
condition after it had deteriorated to a state of disrepair and was
no longer functional for its intended use.
Example 6. Rebuild of property to like-new condition before end
of economic useful life. X is a Class I railroad that owns a fleet
of freight cars. Freight cars have a recovery period of 7 years
under section 168(c) and an economic useful life of 30 years. Every
8 to 10 years, X rebuilds its freight cars. Ten years after the
freight car is placed in service by X, X performs a rebuild, which
includes a complete disassembly, inspection, and reconditioning and/
or replacement of components of the suspension and draft systems,
trailer hitches, and other special equipment. X modifies the car to
upgrade various components to the latest engineering standards. The
freight car essentially is stripped to the frame, with all of its
substantial components either reconditioned or replaced. The frame
itself is the longest-lasting part of the car and is reconditioned.
The walls of the freight car are replaced or are sandblasted and
repainted. New wheels
[[Page 12865]]
are installed on the car. All the remaining components of the car
are restored before they are reassembled. At the end of the rebuild,
the freight car has been restored to rebuilt condition under the
manufacturer's specifications. Assume the freight car is the unit of
property. X is not required to capitalize under paragraph (g)(1)(v)
of this section the amounts paid to rebuild the freight car because,
although the amounts paid restore the freight car to like-new
condition, the amounts were not paid after the end of the economic
useful life of the freight car.
Example 7. Rebuild of property to like-new condition after end
of economic useful life. Assume the same facts as in Example 6,
except that X rebuilds the freight car 40 years after it is placed
in service by X. Under paragraph (g)(1)(v) of this section, X must
capitalize the amounts paid to rebuild the freight car because the
amounts paid restore the freight car to like-new condition after the
end of the economic useful life of the freight car.
Example 8. Replacement of major component. X is a common carrier
that owns a fleet of petroleum hauling trucks. X replaces the
existing engine, cab, and petroleum tank with a new engine, cab, and
tank. The new engine and cab cost $25,000; the new tank costs
$10,000. The cost of a new tractor is $50,000 and the cost of a new
trailer is $30,000. Assume the tractor of the truck (which includes
the cab and the engine) is a separate unit of property from the rest
of the truck, and that the trailer (which contains the petroleum
tank) is a separate unit of property from the rest of the truck.
Also assume that X replaced the components after the end of the
recovery periods under section 168(c) for the tractor and the
trailer. The amounts paid for the new engine and cab comprise 50% of
the cost of a new tractor and must be capitalized under paragraph
(g)(1)(vi) of this section. The amounts paid for the new petroleum
tank do not comprise 50% or more of the cost of a new trailer;
however, the tank comprises more than 50% of the physical structure
of the trailer. Therefore, the amounts paid for the new tank also
must be capitalized under paragraph (g)(1)(vi) of this section.
Example 9. Repair performed during a restoration. Assume the
same facts as in Example 8, except that, at the same time the engine
and cab of the tractor are replaced, X paints the cab of the tractor
with its company logo and fixes a broken taillight on the tractor.
The repair of the broken taillight and the painting of the cab
generally are deductible expenses under Sec. 1.162-4. However,
under paragraph (d)(4)(i) of this section, a taxpayer must
capitalize all the direct costs of an improvement and all the
indirect costs that directly benefit or are incurred by reason of an
improvement in accordance with the rules under section 263A. Repairs
and maintenance that do not directly benefit or are not incurred by
reason of an improvement are not required to be capitalized under
section 263(a), regardless of whether they are made at the same time
as an improvement. Therefore, all amounts paid that directly benefit
or are incurred by reason of the tractor restoration must be
capitalized, including amounts paid for activities that usually
would be deductible maintenance expenses, such as the painting of
the cab. Amounts paid to repair the broken taillight, however, are
not incurred by reason of the restoration of the tractor, nor do the
amounts paid directly benefit the tractor restoration, despite that
the repair was performed at the same time as the restoration. Thus,
X must capitalize to the restoration of the tractor the amounts paid
to paint the cab, but X is not required to capitalize to the
restoration of the tractor the amounts paid to repair the broken
taillight.
Example 10. Not a replacement of substantial structural part. X
owns a large retail store. X discovers a leak in the roof of the
store and hires a contractor to inspect and fix the roof. The
contractor discovers that a major portion of the sheathing and
rafters has rotted, and recommends the replacement of the entire
roof. X pays the contractor to replace the roof. Assume the store
and its structural components are the unit of property and that the
roof does not comprise 50% or more of the physical structure of the
store. Also assume the cost of the roof does not comprise 50% or
more of the cost to acquire a new store. Consequently, the new roof
is not a major component or substantial structural part of the
store. Therefore, X is not required to capitalize under paragraph
(g)(1)(vi) of this section the amounts paid to replace the roof.
Example 11. Related amounts to replace major component. (i) X
owns a retail gasoline station, consisting of a paved area used for
automobile access to the pumps and parking areas, a building used to
market gasoline, and a canopy covering the gasoline pumps. The
premises also consist of underground storage tanks (USTs) that are
connected by piping to the pumps and are part of the machinery used
in the immediate retail sale of gas. To comply with regulations
issued by the Environmental Protection Agency, X is required to
remove and replace leaking USTs. In 2008, X hires a contractor to
perform the removal and replacement, which consists of removing the
old tanks and installing new tanks with leak detection systems. The
removal of the old tanks includes removing the paving material
covering the tanks, excavating a hole large enough to gain access to
the old tanks, disconnecting any strapping and pipe connections to
the old tanks, and lifting the old tanks out of the hole.
Installation of the new tanks includes placement of a liner in the
excavated hole, placement of the new tanks, installation of a leak
detection system, installation of an overfill system, connection of
the tanks to the pipes leading to the pumps, backfilling of the
hole, and replacement of the paving. Assume the new tanks comprise
50% or more of the physical structure of the gasoline distribution
system. X also is required to pay a permit fee to the county to
undertake the installation of the new tanks.
(ii) X pays the permit fee to the county on October 15, 2008.
The contractor performs all of the required work and, on November 1,
2008, bills X for the costs of removing the old USTs. On November
15, 2008, the contractor bills X for the remainder of the work.
Assume the gasoline distribution system is the unit of property. The
USTs are major components of the gasoline distribution system.
Therefore, under paragraphs (d)(5) and (g)(1)(vi) of this section, X
must capitalize as an improvement to the distribution system the
aggregate of related amounts paid to replace the USTs, which related
amounts include the amount paid to the county, the amount paid to
remove the old USTs, and the amount paid to install the new USTs
(regardless that the amounts were separately invoiced and paid to
two different parties).
Example 12. Minor part replacement; coordination with section
263A. X is in the business of smelting aluminum. X's aluminum
smelting facility includes a plant where molten aluminum is poured
into molds and allowed to solidify. Because of the potential of fire
from a molten metal explosion, the plant's roof must be made of
fire-resistant material. The roof must also be without leaks because
rain water hitting the molten aluminum could cause an explosion.
During 2008, X removed and replaced a major portion of the plant's
roof decking and roofing material. Assume the plant building and its
structural components are the unit of property and that the portion
of the roof that is replaced is not a major component or substantial
structural part of the building. X is not required to capitalize
under paragraph (g)(1)(vi) of this section the amounts paid to
remove and replace the roof decking and materials. However, under
section 263A, all direct and indirect costs, including otherwise
deductible costs, that directly benefit or are incurred by reason of
X's manufacturing activities must be capitalized to the property
produced by X. Therefore, because the amounts paid for the roof
decking and materials are incurred by reason of X's manufacturing
operations, the amounts paid must be capitalized under section 263A
to the property produced by X.
(h) Capitalization of amounts to adapt property to a new or
different use--(1) In general. Taxpayers must capitalize amounts paid
to adapt a unit of property to a new or different use. In general, an
amount is paid to adapt a unit of property to a new or different use if
the adaptation is not consistent with the taxpayer's intended ordinary
use of the unit of property at the time originally placed in service by
the taxpayer.
(2) Examples. The following examples illustrate solely the rules of
this paragraph (h). Even if capitalization is not required in an
example under this paragraph (h), the amounts paid in the example may
be subject to capitalization under a different provision of this
section.
Example 1. New or different use. X is a manufacturer and owns a
manufacturing facility that it has used for manufacturing since
1970, when it was placed in service by X. Assume the manufacturing
facility is a unit of property. In 2008, X incurred costs to convert
its manufacturing facility into a showroom for its business. To
convert the facility, X replaces various structural components to
provide a better layout for the
[[Page 12866]]
showroom and its offices. X also rewires and repaints the building
as part of the conversion. None of the materials used, such as the
wiring, are better than existing materials in the building. Under
this paragraph (h), the amounts paid by X to convert the
manufacturing facility into a showroom are paid to adapt the
building to a new or different use because the conversion is not
consistent with X's intended ordinary use of the property at the
time it was placed in service. Therefore, X is required to
capitalize these amounts under paragraph (h)(1) of this section.
Example 2. Not a new or different use. X owns a building, which
is a unit of property, consisting of twenty retail spaces. The space
was designed to be reconfigured; that is, adjoining spaces could be
combined into one space. In 2008, one of the tenants expanded its
occupancy to include two adjoining retail spaces. To facilitate the
new lease, X incurred costs to remove the walls between the three
retail spaces. Under this paragraph (h), the amounts paid by X to
convert three retail spaces into one larger space for an existing
tenant do not adapt X's building to a new or different use because
the combination of retail spaces is consistent with X's intended,
ordinary use of the building. Therefore, the costs are not required
by this paragraph (h) to be capitalized.
Example 3. Not a new or different use. X owns a building, which
is a unit of property, consisting of twenty retail spaces. X decides
to sell the building. In anticipation of selling the building, X
repaints the interior walls and refinishes the hardwood floors.
Preparing the building for sale does not constitute a new or
different use for the building. Therefore, amounts paid in preparing
the building for sale are not required by this paragraph (h) to be
capitalized.
Example 4. New or different use. Since 1930, X has owned a
parcel of land on which it previously operated a manufacturing
facility. Assume that the land is the unit of property. During the
course of X's operation of the manufacturing facility, the land
became contaminated with wastes from its manufacturing processes. In
1995, X discontinued manufacturing operations at the site. In 2008,
X decides to sell the property to a developer that intends to use
the property for residential housing. In anticipation of selling the
land, X pays amounts to cleanup the land to a standard that is
required for the land to be used for residential purposes. In
addition, X pays amounts to regrade the land so that it can be used
for residential purposes. Amounts paid by X to cleanup wastes that
were discharged in the course of X's manufacturing operations do not
adapt the land to a new or different use, regardless of the extent
to which the land was cleaned. However, amounts to regrade the land
so that it can be used for residential purposes adapts the land to a
new or different use that is inconsistent with X's intended ordinary
use of the property at the time it was placed in service.
Accordingly, the amounts paid by X to regrade the land must be
capitalized under paragraph (h)(1) of this section.
(i) Optional regulatory accounting method--(1) In general. This
paragraph (i) provides an optional simplified method (the regulatory
accounting method) for regulated taxpayers to determine whether amounts
paid to repair, maintain, or improve tangible property are to be
treated as deductible expenses or capital expenditures. A taxpayer that
elects to use the regulatory accounting method described in paragraph
(i)(3) of this section must use that method for property subject to
regulatory accounting instead of determining whether amounts paid to
repair, maintain, or improve property are capital expenditures or
deductible expenses under the general principles of sections 162(a),
212, and 263(a). Thus, the capitalization rules in Sec. 1.263(a)-3(d)
(and the routine maintenance safe harbor described in paragraph (e) of
this section) do not apply to amounts paid to repair, maintain, or
improve property subject to regulatory accounting by taxpayers that
elect to use the regulatory accounting method under this paragraph (i).
However, section 263A continues to apply to costs required to be
capitalized to property produced by the taxpayer or to property
acquired for resale.
(2) Eligibility for regulatory accounting method. A taxpayer that
is engaged in a trade or business in a regulated industry may use the
regulatory accounting method under this paragraph (i). For purposes of
this paragraph (i), a taxpayer in a regulated industry is a taxpayer
that is subject to the regulatory accounting rules of the Federal
Energy Regulatory Commission (FERC), the Federal Communications
Commission (FCC), or the Surface Transportation Board (STB).
(3) Description of regulatory accounting method. Under the
regulatory accounting method, a taxpayer must follow its method of
accounting for regulatory accounting purposes in determining whether an
amount paid improves property under this section. Therefore, a taxpayer
must capitalize for Federal income tax purposes an amount paid that is
capitalized as an improvement for regulatory accounting purposes. A
taxpayer must not capitalize for Federal income tax purposes under this
section an amount paid that is not capitalized as an improvement for
regulatory accounting purposes. A taxpayer that uses the regulatory
accounting method must use that method for all of its tangible property
that is subject to regulatory accounting rules. The method does not
apply to tangible property that is not subject to regulatory accounting
rules.
(4) [Reserved]
(5) Examples. The rules of this paragraph (i) are illustrated by
the following examples.
Example 1. Taxpayer subject to regulatory accounting rules of
FERC. X is an electric utility company that operates a power plant
to generate electricity. X is subject to the regulatory accounting
rules of FERC and X chooses to use the regulatory accounting method
under this paragraph (i). X does not capitalize on its books and
records for regulatory accounting purposes the cost of repairs made
to its turbines. Under the regulatory accounting method, X must not
capitalize for Federal income tax purposes amounts paid for repairs
made to its turbines.
Example 2. Taxpayer not subject to regulatory accounting rules
of FERC. X is an electric utility company that operates a power
plant to generate electricity. X previously was subject to the
regulatory accounting rules of FERC but, for various reasons, X is
no longer required to use FERC's regulatory accounting rules. X
cannot use the regulatory accounting method provided in this
paragraph (i).
Example 3. Taxpayer subject to regulatory accounting rules of
FCC. X is a telecommunications company that is subject to the
regulatory accounting rules of the FCC. X chooses to use the
regulatory accounting method under this paragraph (i). The assets of
X include a telephone central office switching center, which
contains numerous switches and various switching equipment. X
capitalizes on its books and records for regulatory accounting
purposes the cost of replacing each switch. Under the regulatory
accounting method, X is required to capitalize for Federal income
tax purposes amounts paid to replace each switch.
Example 4. Taxpayer subject to regulatory accounting rules of
STB. X is a Class I railroad that is subject to the regulatory
accounting rules of the STB. X chooses to use the regulatory
accounting method under this paragraph (i). X capitalizes on its
books and records for regulatory accounting purposes the cost of
locomotive rebuilds. Under the regulatory accounting method, X is
required to capitalize for Federal income tax purposes amounts paid
to rebuild its locomotives.
(j) Repair allowance. A taxpayer may use a repair allowance method
of accounting that is identified in published guidance in the Federal
Register or in the Internal Revenue Bulletin (see Sec.
601.601(d)(2)(ii)(b) of this chapter).
(k) Treatment of capital expenditures. Amounts required to be
capitalized under this section are capital expenditures and must be
taken into account through a charge to capital account or basis, or in
the case of property that is inventory in the hands of a taxpayer,
through inclusion in inventory costs. See section 263A for the
treatment of amounts referred to in this section as well as other
amounts paid in connection with the production of real property and
personal property,
[[Page 12867]]
including films, sound recordings, video tapes, books, or similar
properties.
(l) Recovery of capitalized amounts. Amounts that are capitalized
under this section are recovered through depreciation, cost of goods
sold, or by an adjustment to basis at the time the property is placed
in service, sold, used, or otherwise disposed of by the taxpayer. Cost
recovery is determined by the applicable Code and regulation provisions
relating to the use, sale, or disposition of property.
(m) [Reserved]
(n) Effective/applicability date. The rules in this section apply
to taxable years beginning on or after the date of publication of the
Treasury decision adopting these rules as final regulations in the
Federal Register.
Par. 9. Section 1.263A-1 is amended by adding paragraph (b)(14) as
follows:
Sec. 1.263A-1 Uniform capitalization of costs.
* * * * *
(b) * * *
(14) Property subject to de minimis rule. Section 263A does not
apply to the costs of property produced by a taxpayer to which the
taxpayer properly applies the de minimis rule under Sec. 1.263(a)-
2(d)(4). However, the cost of property to which a taxpayer properly
applies the de minimis rule under Sec. 1.263(a)-2(d)(4) may be
required to be capitalized to other property as a cost incurred by
reason of the production of the other property that is subject to
section 263A.
* * * * *
Linda E. Stiff,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E8-4466 Filed 3-7-08; 8:45 am]
BILLING CODE 4830-01-P