Embedded Costs in SelfConstructed Assets

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Embedded Costs in Self-Constructed Assets

• AGA/INGA Taxation Committee Meeting
• June 26, 2006
• Newport, RI

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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.
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Presenters

• Andrew Miller, PartnerErnst Young National Tax
  
• National Director - Utility Sector Tax
  Services314-290-1205
• Andrew Robertson, Executive DirectorErnst
  Young, Chicago312-879-4686

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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

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Research Development Section 174
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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

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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

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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

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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

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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

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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

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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

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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

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Repairs Maintenance
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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

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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

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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

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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.

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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

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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).

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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

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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

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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

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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

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Regional Storage along Transmission Pipeline
Reproduced with permission from KeySpan Energy
presentation to AGA Intro to the Energy Industry,
March 2004
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Gas Distribution Network Brooklyn/Queens Low
Pressure System
Reproduced with permission from KeySpan Energy
presentation to AGA Intro to the Energy Industry,
March 2004
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Pressure Delivery Systems
Reproduced with permission from KeySpan Energy
presentation to AGA Intro to the Energy Industry,
March 2004
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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.

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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

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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.