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Embedded Costs in SelfConstructed Assets

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Title: Embedded Costs in SelfConstructed Assets


1
Embedded Costs in Self-Constructed Assets
  • AGA/INGA Taxation Committee Meeting
  • June 26, 2006
  • Newport, RI

2
Any U.S. tax advice contained herein was not
intended or written to be used, and cannot be
used, for the purpose of avoiding penalties that
may be imposed under the Internal Revenue Code or
applicable state or local tax law provisions.
3
Presenters
  • Andrew Miller, PartnerErnst Young National Tax
  • National Director - Utility Sector Tax
    Services314-290-1205
  • Andrew Robertson, Executive DirectorErnst
    Young, Chicago312-879-4686

4
Embedded Costs in Self-constructed assets
  • Research Development - Section 174
  • Overview of statutory/regulatory requirements
  • Implementation/adoption issues
  • Pending guidance
  • Repairs and maintenance/Environmental Remediation
  • Overview of regulatory requirements and
    litigation
  • Key criteria to consider
  • Pending guidance
  • Gas operations and the unit of property issue
  • Environmental remediation

5
Research Development Section 174
6
General Discussion of Section 174
  • Costs must be incurred in connection with a
    taxpayers trade or business
  • Pre-operational RD costs may qualify under 174
    if there is some nexus between the research
    activities and a future trade or business.
  • Costs must be reasonable under the circumstances
  • Amounts are reasonable if the amount would
    ordinarily be paid by like enterprises under like
    circumstances

7
General Discussion of Section 174
  • Both direct and indirect costs incurred in
    connection with RD may qualify for deduction
  • Direct Costs
  • Materials and salaries (including fringe benefits
    subject to withholdings) of personnel working on
    eligible activity as well as laboratory
    assistants, technicians, clerical employees, and
    employees who supervise RD activity
  • Indirect Costs
  • Must be properly allocable to the RD activity
  • Includes general overhead attributable to RD,
    facilities costs (including depreciation),
    utilities, maintenance, indirect labor, indirect
    materials and supplies

8
General Discussion of Section 174
  • What qualifies?
  • Uncertainty as to capability, method or
    appropriate design of product
  • Treas. Reg. 1.174-2
  • Rev. Rul. 73-275
  • FSA 200125019
  • TAM 9538008
  • Design uncertainties may relate to both
    functional and nonfunctional aspects of property
  • Special rules - Treas. Reg. 1.174-2(b)(3)
    third-party conducts research on taxpayers
    behalf
  • Costs deductible ONLY IF made at taxpayers order
    and risk
  • Performance guarantees cannot guarantee economic
    utility
  • Liquidating damages

9
Common Examples of Qualifying Activities
  • Resolving design uncertainties involving
  • Engineering Design plant and pollution control
    facilities, considerations of pipe sizing,
    pressure,controls, materials, substation design,
    transmission systems, storage facilities
  • Extreme or unusual climatic conditions
  • Site locationearthquake fault, unusually shaped
    or sloped lot, unusual soil composition
  • Local or federal environmental or regulatory
    requirements
  • Consultation with architects or engineers on
    initial design of construction project

10
Common Examples of Non-Qualifying Activities
  • Examples of common activities that do not
    qualify
  • Any part of the purchase price of an item in
    regular production
  • Cost of supervising construction
  • Actual direct and indirect costs of physically
    constructing and installing property
  • Cost of plans developed for previous projects
  • Cost of drawing plans where no design
    uncertainties are present
  • Cost of purchased designs

11
Implementation Issues
  • An immediate deduction of RD costs is allowed
    under I.R.C. 174 these costs are specifically
    excluded from the I.R.C. 263(a) and I.R.C.
    263A capitalization requirements
  • Taxpayers can accelerate deductions for RD costs
    capitalized to constructed assets through amended
    returns or potentially through an accounting
    method change
  • Amended Returns Rev. Rul. 58-74 - if taxpayer
    has properly adopted expensing method under
    174(a)
  • Only allows recovery of costs from open tax years

12
Implementation Issues
  • Accounting Method Change
  • Automatic accounting method change to deduct RD
    costs prospectively (cutoff basis) under Rev.
    Proc. 2002-9
  • IRS will grant change from capitalization under
    263A with 481(a) adjustment if taxpayer can
    represent the following
  • That taxpayer adopted a proper expensing method
    under 174(a)
  • That RD costs were identified as 174 costs at
    the time capitalized

13
RD Pending Guidance Implications
  • Rev. Rul. 58-74
  • Expect revocation of ruling
  • IRS business plan for FY 2006
  • Ability to file amended returns may be eliminated
  • Treat as an accounting method
  • Ability to get Section 481(a) adjustment is
    uncertain IRS may adopt cut-off method
  • Taxpayers considering filing protective claims
    (amended returns) prior to revocation

14
Repairs Maintenance
15
Repair and Maintenance CostsOverview
  • Treas. Reg. Sec. 1.263(a)-1(b) Requires
    capitalization for amounts that
  • Add value or substantially prolong useful life
  • Adapt property to new or different use
  • Treas. Reg. Sec. 1.162-4 permits a deduction
    for amounts that
  • Neither materially increase value nor appreciably
    prolong life, but keep property in an ordinary
    efficient operating condition

16
Repair and Maintenance CostsOverview
  • Incidental repairs that neither materially add to
    the value of nor appreciably prolong the useful
    life of property are deductible expenses Treas.
    Reg. 1.162-4
  • Deductible repair expenses include costs incurred
    to keep property in ordinary operating condition
    over its expected useful life Illinois
    Merchants Trust Co. v. Commr, 4 B.T.A.103 (1926)
  • Repairs that are in the nature of replacements,
    or that are made as part of an overall plan of
    rehabilitation, are capital expenditures
  • Whether the plan of rehabilitation doctrine
    applies is a fact-specific inquiry

17
Repairs
  • Key Concepts
  • Unit of Property
  • Material increase in propertys value
  • Material increase in propertys life
  • Repairs in nature of replacements
  • Adaptation to new or different use

18
Repair and Maintenance CostsSelected Litigation
  • Repairs the unit of property subject to repair
    or maintenance
  • Ingram Industries v. Commissioner
  • Smith v. Commissioner
  • Recent district court opinion in FedEx
  • Taken together, Ingram and Smith indicate the
    factors a court should consider in identifying
    the appropriate unit of property to which to
    apply the Repair Regulations. First, the court
    should consider whether the taxpayer and the
    industry treat the component part as part of the
    larger unit of property for regulatory, market,
    management, or accounting purposes. Second, the
    court should determine whether the economic
    useful life of the component part is coextensive
    with the economic useful life of the larger unit
    of property. Third, the court should determine
    whether the larger unit of property and the
    smaller unit of property can function without
    each other. Finally, the court should weigh
    whether the component part can be and is
    maintained while affixed to the larger unit of
    property.

19
Repair v. Capitalized criteria from the Courts
  • Material Increase in propertys value
  • Key Questions
  • Compare status of the asset after the expenditure
    to status of asset before the expenditure
  • Compliance with laws or regulations

20
Repair v. Replacement (contd)
  • Material Increase in propertys life
  • General Plan of Rehabilitation
  • Airplane example Rev Rule 2001-4
  • US v. Wehrli, 400 F.2d 686 (10th Cir. 1968).

21
Repair v. Replacement (contd)
  • Repairs in the nature of replacements
  • Major v. Minor
  • Relative size or importance in relation to unit
    of property
  • See Buckland v. US, 66 F.Supp. 681 (1946)
  • Adaptation to new or different use
  • Coors Porcelain Co. v. Commr
  • West Va. Steel Corp. v. Commr

22
Repairs and Maintenance Costs
  • Notice 2004-6 The IRS intends to propose
    regulations to clarify the treatment of repair,
    rehabilitation, and improvement expenses of
    tangible property under Sections 162 and 263
  • Requesting comments from interested parties to be
    received by March 1, 2004 on a series of issues
    such as
  • What general principles of capitalization should
    apply to repair or improve tangible property?
  • In applying these general principles, what is the
    appropriate "unit of property"?
  • In determining whether an expenditure materially
    increases the value of property or substantially
    prolongs the useful life of property, what is the
    proper starting point for the comparison?
  • Pending IIR Status
  • Less specific guidance

23
Repair and Maintenance Costs
  • What is the proper unit for determining changes
    in value / life / use
  • FedEx v. Commr
  • When to determine changes in value / life / use
  • Whether sudden casualties should be treated
    differently from wear and tear

24
Repair and Maintenance Costs
  • Rev. Proc. 2003-63
  • Fiber optic cable and asset classification for
    depreciation
  • Unit of property includes cable and node
  • Recent developments
  • Notice 2004-6
  • Comment Letters Proposed
  • De minimimis amount
  • Bright line increase in value test -- 25 of
    assets revenue producing capability
  • Clarification of Plan of Rehabilitation Doctrine
  • TD assets may not be covered in guidance
  • Method change to secure definition of unit of
    property?
  • Casualty loss or repair? Interaction with
    casualty losses

25
Regional Storage along Transmission Pipeline
Reproduced with permission from KeySpan Energy
presentation to AGA Intro to the Energy Industry,
March 2004
26
Gas Distribution Network Brooklyn/Queens Low
Pressure System
Reproduced with permission from KeySpan Energy
presentation to AGA Intro to the Energy Industry,
March 2004
27
Pressure Delivery Systems
Reproduced with permission from KeySpan Energy
presentation to AGA Intro to the Energy Industry,
March 2004
28
Environmental remediation costs
  • Revenue Ruling 2004-18
  • The Service has issued Rev. Rul. 2004-18,
    modifying and amplifying Rev. Rul. 94-38, to
    provide that a taxpayer with inventories must
    apply Section 263A to determine whether the
    otherwise deductible costs (or the depreciation
    on the capitalized costs) is properly includible
    in inventory.
  • Revenue Ruling 2005-42
  • Service reiterates that environmental remediation
    costs incurred to clean up land that a taxpayer
    contaminated with hazardous waste by operating
    its manufacturing activities are incurred by
    reason of production activities and, thus, are
    properly allocable under Section 263A to the
    inventory produced during the tax year the costs
    are incurred.
  • This new ruling significantly extends the holding
    of Rev. Rul. 2004-18.

29
Environmental Remediation and Other Liabilities
in Purchase Accounting
  • Reg. 1.338-5(b)(2)(iii) - Example 2
  • Target company is acquired in which there are
    environmental remediation liabilities
  • Satisfaction of those liabilities for would be
    tax basis when paid/incurred since economic
    performance had not occurred at the sale date
  • Despite holding that the liabilities are deemed
    satisfied to the seller in the hypothetical sale
  • See PLRs re nuclear decommissioning
  • PLR 200302013, PLR 200229009, PLR 200121028

30
Environmental Remediation and Other Liabilities
in Purchase Accounting
  • Temporary and Proposed regulations issued
    effective September 15, 2004
  • Treatment of nuclear decommissioning funds in
    purchase price allocations in certain deemed and
    actual asset acquisitions under Sections 338 and
    1060
  • Liability is not taken into account in
    determining basis by a purchaser until the
    liability satisfies the all-events test and
    economic performance
  • The preamble to the regulations clarifies that
    the purchase price that the purchaser allocates
    to the acquired assets will not include the
    decommissioning liability because the economic
    performance test will not be satisfied until
    decommissioning occurs.
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