An overview of the proposed "tangibles" regulations.

• Author: Atkinson, James L.

The proposed "tangibles regulations" published in the Federal Register on August 21, 2006 (1) largely refine and clarify rather than fundamentally change the decades-old criteria for distinguishing between deductible expenses incurred to repair and maintain tangible property and capitalized costs incurred to acquire, produce, or improve such property. Significantly, however, the proposed regulations include a number of new provisions and definitions intended to further simplify the application of these existing standards. These changes include a "12-month rule" applicable to costs incurred to acquire many types of short-lived tangible assets, as well as a new "repair allowance" safe harbor and a much needed definition of "unit of property."

Acquisition and Production Costs

In general, the proposed regulations' treatment of costs incurred to acquire or produce tangible property largely restates existing law. As under the current regulations, costs incurred to acquire or produce real or tangible personal property having a useful life substantially beyond the end of the taxable year must be capitalized. (2) The definitions of real and tangible personal property are intended to have the same definitions used for depreciation purposes. (3)

The proposed regulations do update the current section 263(a) regulations, however, by clarifying their interaction with the uniform capitalization rules under section 263A of the Internal Revenue Code. While the proposed regulations do not necessarily reflect a change in the government's view of the interaction of these two capitalization provisions, this is the first time since the enactment of section 263A as part of the Tax Reform Act of 1986 that Treasury has updated the much older regulations under section 263(a) to explicitly reflect this interaction in the context of tangible property.

For example, the proposed regulations incorporate the expansive definition of "production" found in the uniform capitalization rules of section 263A. Under this standard, "production" means to build, install, manufacture, develop, create, raise, or grow. In addition to explicitly adopting the section 263A definition of "production," the proposed regulations emphasize the potential application of the uniform capitalization rules where a cost is otherwise deductible under the proposed regulations. Thus, for taxpayers engaged in production and resale activities, many of the benefits of the proposed regulations may prove elusive, as costs seemingly deductible under the proposed regulations (for example, under the new 12-month rule) nonetheless may be treated as inventoriable production costs under the uniform capitalization rules as benefiting or being incurred by reason of production or resale activities. The proposed regulations provide a number of examples of such situations. (4)

The proposed regulations provide specific rules and examples regarding costs incurred to defend or perfect title to tangible property, (5) as well as the treatment of transaction costs such as shipping costs, bidding costs, commissions, sales and transfer taxes, and similar charges. (6) A separate section provides rules governing costs incurred to sell tangible property. (7)

12-Month Rule. Potentially resolving a long-standing dispute about whether "substantially beyond the end of the taxable year" is synonymous with an asset's having a useful life of more than 12 months, (8) the proposed regulations adopt a 12-month rule applicable to the costs of acquiring many types of tangible personal property. Under this rule, amounts paid to acquire or produce a unit of property having an "economic useful life" of no more than 12 months is not a capital expenditure. (9) For this purpose, an asset's economic useful life is determined by reference to the taxpayer's treatment of the item as capital or expense in its "applicable financial statement" if it has one (such as an SEC filing or another certified financial statement produced for a substantive, non-tax purpose). If the taxpayer does not have an applicable financial statement, the property's economic useful life is the period over which it is reasonably expected to be useful to the taxpayer in its trade or business.

The 12-month rule is not applicable, however, to the acquisition or production of inventory property, land, components of a unit of property, or to costs incurred to improve rather than acquire or produce tangible property.

De Minimis Rule. Unfortunately, the proposed rules applicable to acquisition costs do not include a de minimis rule. Many taxpayers had requested that the tangibles regulations permit a current deduction for relatively small amounts, recognizing the administrative costs and record keeping burden of accounting for numerous relatively small expenditures. Treasury implicitly acknowledged its authority to adopt a de minimis rule for the acquisition costs of tangible property, as well as the potential benefits of such a rule, in Rev. Proc. 2002-12 (providing a de minimis rule for certain costs incurred by restaurants in purchasing "small wares"). (10)

The preamble to the proposed regulations states that Treasury considered including a de minimis rule in the proposed tangibles regulations as well but ultimately decided not to do so. Instead, the preamble describes the de minimis rule that Treasury contemplated (essentially a book/tax conformity requirement for taxpayers with applicable financial statements, and a dollar threshold for those without), and requests additional comments on the need for this or another formulation of a de minimis rule, as well as certain mechanical aspects of such a rule. Significantly, the preamble to the proposed regulations acknowledges that some taxpayers develop de facto de minimis rules with their IRS examination teams and states that Treasury intentionally chose not to disallow this practice. Treasury has requested comments on whether--if the final regulations do contain a de minimis rule--the Examination team should be allowed to develop higher thresholds for certain taxpayers on a case-by-case basis, based on materiality and risk analysis.

Costs of Repairs or Improvements

The majority of the proposed regulations is devoted to costs to repair or improve tangible property. The treatment of "repair costs" has been the source of seemingly endless controversy between the IRS and taxpayers since the Code's inception, (11) and was the principal impetus behind development of the proposed regulations. As with the acquisition and production cost provisions, the proposed regulations' treatment of repair costs is largely evolutionary, building upon and refining existing standards rather than attempting an entirely new conceptual approach.

The "repair or improvements" section of the proposed regulations can be divided into four key segments: (i) the operative rule, requiring the capitalization of costs incurred either to materially increase the value of a unit of property, or to restore a unit of property, (ii) standards for determining whether the value of a unit of property has been materially increased, (iii) standards for determining whether the unit of property has been restored, and (iv) an elective repair allowance method.

Unit of Property. A highlight of the proposed regulations is a long-awaited and badly needed definition of "unit of property." As under current law, the threshold issue in applying the repair rules is identifying the relevant unit of property. Taxpayers, the IRS, and courts have wrestled with this critical term for many years, with nothing approaching consistency. The government specifically requested comments on the appropriate definition of "unit of property" in Notice 2004-6. (12) In response, some taxpayers suggested adopting the "functional interdependence test" applied for purposes of section 263A(f) in determining whether and how much interest to capitalize in connection with a capital improvement project. Others suggested using the criteria adopted by the court in FedEx Corp. v. United States. (13) The proposed regulations take a middle ground, but focus more heavily on the facts and circumstances approach for most taxpayers.

Determining the unit of property under the proposed regulations is a three-step process. In step one, the taxpayer makes an "initial determination" of the unit of property by applying the functional interdependence standard of Treas. Reg. [section] 1.263A-10. Apart from preserving the potential whip-saw situation discussed below, it is unclear what practical purpose this "initial determination" serves.

In step two, the taxpayer determines which of four specific categories applies, based on the nature of the taxpayer's business in some cases, and the nature of the property in all others.

Category One includes all property owned by taxpayers in a regulated industry (other than "network assets," as discussed below). For these taxpayers, the unit of property is the "USOA unit of property," meaning the unit of property determined...