On December 23, 2011, the Treasury Department and the IRS released the long awaited "Repair Regulations." These regulations will likely have a significant impact on companies with large investments in fixed assets including real estate. In fact, taxpayers with conservative capitalization policies may expect to realize major benefits by carefully reviewing their fixed asset records. The regulations also provide for a de minimis rule which allows a taxpayer to expense amounts paid for property below certain dollar amounts if a written accounting policy is in place as of the beginning of the year. In preparation for the release of the Regs, Eric Lucas, former US Treasury Department official who helped draft the Repair Regs, joined KPMGto serve as a technical advisor to our Washington National Tax office. This article analyzes major provisions of the new regulations and provides suggestions for practical action steps that the US subsidiaries of Japanese companies should consider immediately.
The new regulations set forth a framework for analyzing the highly factual and frequently controversial question of whether an expense is currently deductible as an ordinary and necessary repair or must be treated as a "capital" improvement that is depreciated over a longer recovery period.
Issued in proposed and temporary form, the new regulations are generally effective for tax years beginning on or after January 1, 2012. Because the temporary regulations have the same binding effect as a final regulation, taxpayers must take steps to determine that they fully benefit from and comply with the regulations for their 2012 tax year. Changes to comply with the regulations are a change in method of accounting. The IRS is expected to issue more detailed guidance in the near future regarding the implementation of these changes.
Although the regulations follow the same overall format as earlier proposed regulations issued in 2006 and 2008, the temporary regulations also contain a number of significant changes of which taxpayers need to be aware. The highlights include:
- Significant modifications in how the capitalization standards apply to buildings and structural components
- Significant changes in the deductibility of unrecovered costs of structural components following the improvement or retirement of those elements
- New definitions and rules applicable to "materials and supplies"
- Revised de minimis rules
- Clarifications in the application of the capitalization standards to "store remodels"
The following summarizes the key features and concepts in the temporary regulations and, where appropriate, compares the new rules with the 2008 proposed regulations.
The cornerstone of any "repairs" analysis is identifying the unit of property to which the capitalization standards are to be applied. The regulations require a taxpayer to capitalize amounts paid to improve a unit of property if the amount: (1) results in a betterment to the unit of property; (2) results in a restoration of the unit of property; or (3) adapts the unit of property to a new or different use. The definition of the "unit of property" is important because it is the reference point upon which the capitalization standards are applied. The larger the unit of property, the more likely the capitalization standards will result in an expense being treated as a deductible repair. For example, if the unit of property is an entire building, building expenses are more likely to be treated as repairs than capital expenditures because they do not rise to the level of a "material increase in quality or efficiency" or may not amount to a "restoration of a major component or substantial structural part" relative to the entire building.
The regulations define the unit of property for building property as the building and its structural components the same as the 2008 proposed regulations. However, the regulations make very significant changes to the application of the improvement standards to buildings as compared to the 2008 proposed regulations. The temporary regulations now require that a taxpayer apply the improvement standards separately to the major components of the building that is, the building structure and any specifically defined building system. Thus, if the cost is a capital expenditure relative to a defined building component or system, it will be treated as an improvement to the entire building. The temporary regulations define the building structure and building systems as:
- The building structure, which is defined as the building and its structural components other than the following specifically defined building systems
- The heating, ventilation, and air conditioning systems (HVAC)
- The plumbing systems
- The electrical systems
- All escalators
- All elevators
- The fire protection and alarm systems
- The security systems
- The gas distribution systems
Thus, for example, under the temporary regulations, an amount paid to replace the roof of a building is measured against the building structure rather than the entire building and is more likely to be characterized as an improvement. As explained below, however, the regulations now authorize a taxpayer to recognize a retirement loss on the disposition of a structural component of the building.
For property other than buildings, the temporary regulations generally define the unit of property as consisting of all the components of the unit of property that are functionally interdependent unless the taxpayer used a different depreciation method or recovery period for a component at the time it was placed in service.
The temporary regulations require a taxpayer to change its unit of property if the taxpayer, or the IRS, changes the depreciation recovery period or method for a component in a year subsequent to the year it was placed in service. The temporary regulations continue to define a unit of property for plant property based on functional interdependence and "major and discrete function," and leave the definition of network property to industry specific guidance.
The regulations make significant changes to the capitalization standards in some respects but carry over a number of the 2008 standards largely untouched. As mentioned, the capitalization standards require an amount to be capitalized if it (1) results in a betterment to the unit of property; (2) results in a restoration to the unit of property; or (3) adapts the unit of property to a new or different use.
With respect to restorations, the regulations significantly modify the standard that requires the replacement of a major component or substantial structural part to be capitalized. The regulations remove the 2008 proposed rules that provided that this standard did not apply until after the end of the depreciable recovery period and after either: (1) 50% of the physical structure was replaced, or (2) 50% of the replacement value of the unit of property was replaced. Under the new rules, taxpayers are required to apply a facts-and-circumstances analysis to determine if a major component or substantial structural part is replaced.
One last item to note with regard to restorations is that the new rules retain the casualty loss rule that was included in the 2008 proposed rules. The casualty loss rule requires a taxpayer to capitalize a restoration cost to a component if the taxpayer recognized a casualty loss with respect to the damaged or replaced property.
With respect to betterments, the regulations apply a facts-and-circumstances determination as to whether an amount: (1) ameliorates a material condition or defect at the time of acquisition or production; (2) results in a material addition; or (3) results in a material increase in the quality, capacity, efficiency or strength of the unit of property. One of the more controversial areas involving betterments has been the treatment of retail store remodel costs. The regulations do not add specific rules or standards that address store remodels but add several new examples to clarify the application of the betterment standards to these situations.
Like the 2008 proposed regulations, the final capitalization standard requires that amounts paid to adapt the unit of property to a new or different use must be capitalized. Taxpayers may reference several examples in the regulations for guidance in applying this standard as well as the existing case law.
One of the temporary regulations' most significant changes involves the accounting for the unrecovered costs of a disposed structural component of a building. The Internal Revenue Code generally requires capital improvements to be depreciated as a new asset, with its costs recovered over the same period as the property being improved. For example, an improvement to nonresidential building property generally must be recovered over 39 years, regardless of the remaining depreciable life of the building itself. In addition, prior to the issuance of the temporary regulations, the rules did not permit a taxpayer to recognize a loss on the disposition of a structural component of a building. Thus, a taxpayer was often in the situation of having to simultaneously capitalize and depreciate multiple improvements of the same component over lengthy recovery periods (for example, the taxpayer might be simultaneously depreciating over staggered 39-year periods the costs of three separate replacements of the same roof). The temporary regulations minimize the harshness of this result by allowing taxpayers the option for recognizing retirement losses on dispositions of structural components of a building. Thus, for example, when a taxpayer replaces the roof of a building, the taxpayer now may treat the disposed-of roof as a retirement and recognize a loss.
If the taxpayer cannot determine the allocable basis for a component or does not want to separately track dispositions of structural components, the regulations allow the taxpayer to elect "general asset account" treatment. The substantially modified general asset account rules allow the taxpayer to choose not to recognize a loss on a disposition of a structural component and to continue depreciating the original basis of the property. The general asset account rules also provide the mechanism by which a taxpayer may choose not to recognize a casualty loss in the year property is damaged by a casualty and to choose to deduct the repair as an ordinary and necessary repair expense, if it otherwise qualifies. For these reasons, for the first year after the effective date of the regulations, taxpayers should very carefully consider their options under the new regulations for MACRS property.
The regulations clarify that the "plan of rehabilitation" doctrine has been replaced with a section 263A standard for determining which costs must be capitalized once an expense rises to the level of an improvement. Under the section 263A standard, once it is determined that an improvement exists, all indirect costs that directly benefit, or are incurred by reason of, the improvement must be capitalized. Thus, for example, if an amount paid results in a betterment of a taxpayer's plumbing system, all indirect costs that directly benefit, or are incurred by reason of, that improvement must be capitalized to that improvement.
The routine maintenance safe harbor (RMSH) allows repair treatment for an amount paid during the class life of the unit of property to keep the property in ordinary efficient operating condition. The temporary regulations do not alter the application of this rule compared to the 2008 version and thus do not allow the RMSH to be applied to building property; amounts that result in betterments; and certain categories of restorations. For non-building property, this exception becomes much more important (as compared to the 2008 rules) with regard to the replacement of major components and substantial structural parts because it will allow for repair treatment if the requirements of the RMSH are otherwise satisfied. For example, the replacement of a tug boat engine with the same engine during the class life of the tug boat may qualify as routine maintenance and be treated as a repair. On the other hand, the replacement of a tug boat's engine with a more powerful and efficient engine will result in a capitalizable betterment which is not eligible for the routine maintenance safe harbor because it does more than return the property to its ordinary and efficient operating condition.
Non-incidental materials and supplies are deductible in the year that they are used or consumed. The regulations define the following property as materials and supplies:
- Components acquired to maintain, repair, or improve a unit of tangible property
- Fuel, lubricants, water, and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in the taxpayer's operations (a category newly created by the temporary regulations)
- A unit of property with an acquisition cost of $100 or less
- A unit of property with an economic useful life of 12 months or less
- Property designated as materials and supplies by future guidance
- Rotable and temporary spare parts
The 2008 proposed rules defined the first category of materials and supplies as tangible property not constituting a unit of property that was not acquired as part of a single unit of property. Treasury and the IRS indicate in the preamble to the temporary regulations that they modified this definition to clarify that property treated as a single unit of property in the year acquired may qualify as a material and supply if, in a subsequent year, it is treated as a component that is used to maintain, repair, or improve another unit of property. This change could allow for accelerated deductions for property that would have not qualified as materials and supplies under the 2008 proposed definition.
On the other hand, some taxpayers may obtain a greater benefit from treating materials and supplies as depreciable assets. The new regulations provide this option by permitting taxpayers to elect to capitalize and depreciate all types of materials and supplies.
Another important change in the materials and supplies rules is that the new rules allow taxpayers to deduct the cost of materials and supplies in the year purchased if they meet the requirements of the de minimis rule (discussed below). This is a taxpayer-favorable rule that allows for significantly more flexibility in accounting for smaller units of property and materials and supplies. The regulations also confirm that a taxpayer may deduct materials and supplies under the de minimis rule if they are used to improve another unit of property, again as long as the requirements of the de minimis rule are satisfied.
With respect to rotable or temporary spare parts, the temporary regulations greatly expand the options that are available for accounting for such property. Taxpayers may now account for rotable and temporary spare parts under any one of the following methods:
- Treat the parts as disposed of upon final disposition
- Use the optional method of accounting for rotable spare parts, which permits exchange type treatment in that a deduction is allowed upon the installation of a part installed with a corresponding income inclusion equal to the fair market value of the replaced part (this method must be used for all rotable spare parts if elected)
- Deduct when purchased under the de minimis rule, or
- Make an election to capitalize and depreciate
The de minimis rule under the temporary regulations permits a taxpayer to deduct the acquisition cost of property in the year purchased up to a specified threshold if certain requirements are met. The taxpayer must have a written accounting policy in place as of the beginning of the year to expense amounts paid for property below certain dollar amounts, and the taxpayer must expense the amounts on its applicable financial statements (AFS) for the year. However, the new rules impose a ceiling limit on a taxpayer's total deduction under the de minimis rule. The ceiling is defined as the greater of (1) 0.1% of gross receipts, or (2) 2% of book depreciation and amortization. Accordingly, the "no distortion of income" requirement of the 2008 proposed rules has been replaced with an overall ceiling by the temporary regulations. Again, all categories of materials and supplies are now eligible for this rule. It is also important to note that the de minimis rule does not apply to those taxpayers that do not have an AFS.
For purposes of the de minimis rule, the AFS is defined by the regulations as follows:
||A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders);|
||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 person; or
(C) Any other substantial non-tax purpose; or
||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).|
For this purpose, we believe that the Japanese parent company's audited worldwide consolidated financial statements which include the US subsidiary's financial statements would qualify as the AFS even if the US subsidiary does not issue its own stand-alone audited financial statements
The temporary regulations generally apply to tax years beginning on or after January 1, 2012. As mentioned previously, accounting method changes required to conform to the new standards generally must be implemented with a section 481 adjustment rather than on a "cut off" basis. Treasury and the IRS are expected to release two revenue procedures that detail the manner in which the 481 adjustments may be computed and will provide simplification procedures for determining the amount of the adjustment.
We urge our clients to immediately start considering action steps including the following to prepare for implementation of the new standards under the temporary regulations:
- Review major building expenses incurred in the past to re-determine whether the costs should have been capitalized or expensed under the new regulations. Quantify overall impact of favorable and unfavorable section 481 adjustments. Again, taxpayers with conservative capitalization policies may expect to realize major benefits by carefully reviewing their fixed asset records.
- Review capitalization policies for building and non-building expenses and revise them to reflect the new capitalization standards set forth by the temporary regulations.
- Identify unrecovered capitalized costs of structural components of buildings that may qualify for recognition of losses upon future replacement. Also, consider whether it would be advantageous to elect the "general asset account" treatment to continue depreciation instead of recognizing retirement losses.
- Revise capitalization policies to reflect replacement of the "plan of rehabilitation" rule with the section 263A standard.
- Consider implications of applying the routine maintenance safe harbor in order to claim deductions for the costs associated with replacement of major components and substantial structural parts of non-building property.
- Review policies concerning materials and supplies to reflect the changes made by the temporary regulations. Consider whether capitalization and depreciation of materials and supplies would be more beneficial. Consider application of the de minimis rule to materials and supplies. Evaluate the options allowed for rotable and temporary spare parts.
- Adopt a written accounting policy to expense amounts paid for property below specific dollar amount in order to take advantage of the new de minimis rule. Ensure that an AFS exists and the policy is followed for AFS purposes.
If you have any questions about this article, please contact your KPMG tax engagement team, Makoto Nomoto (email@example.com) or Meguru Machida (firstname.lastname@example.org).
ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
The views and opinions are those of the author and do not necessarily represent the views and opinions of KPMG LLP. All information provided is of a general nature and is not intended to address the circumstances of any particular individual or entity.