AICPA Comments on Reproposed Regs on Capitalization of Tangible Assets

Dear Sir/Madam:

The American Institute of Certified Public Accountants (AICPA) Tax Division is writing in response to Notice of Proposed Rulemaking (REG-168745-03),¹ which requested comments regarding proposed regulations under section 263(a) of the Internal Revenue Code, relating to the deduction and capitalization of expenditures related to tangible property. These comments were developed by the Section 263(a) Task Force of the AICPA's Tax Methods and Periods Technical Resource Panel, and approved by the Tax Executive Committee.

The AICPA is the national professional organization of certified public accountants comprised of approximately 370,000 members. Our members advise clients on federal, state and international tax matters and prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and medium-sized businesses, as well as America's largest businesses.

The AICPA commends the Internal Revenue Service ("IRS") and the Department of the Treasury ("Treasury") for issuing the proposed regulations, which provide much needed guidance regarding the capitalization of expenditures related to tangible property. The guidance, once finalized, will be helpful to our members.

Our attached comments cover a variety of key considerations as Treasury and IRS work on guidance in this area. In particular, our comments address the following sections of the proposed regulations:

A. Materials and Supplies

The AICPA recommends (i) removing the clear reflection of income requirement from Prop. Reg. § 1.162-3(a)(2), (ii) revising Prop. Reg. § 1.162-3(d)(1)(iii) to clarify that only de minimis materials and supplies must be included in the de minimis capitalization threshold test for tangible property provided in Prop. Reg. § 1.263(a)-2(d)(4), and (iii) increasing the de minimis limit from $100 to $1,000.

B. Capitalized Costs

The AICPA believes that Prop. Reg. § 1.263(a)-1(c)(5) should be modified to provide that an interest in land does not include any franchise granted by a governmental unit (including an agency or instrumentality thereof), such that any amount paid by a taxpayer to the governmental unit that is properly allocable to the franchise (e.g., the right to operate a toll road, airport, seaport, or similar facility) would not be subject to capitalization as an amount paid to acquire or create an interest in land.

C. Transaction Costs

The AICPA suggests that Prop. Reg. § 1.263(a)-2(d)(3)(ii)(C) be modified to extend the special rule for real property acquisition costs to include tangible personal property that is acquired as part of the same transaction.

D. De Minimis Rule

For a taxpayer with an applicable financial statement ("AFS"), the AICPA suggests the de minimis rule in Prop. Reg. § 1.263(a)-2(d)(4)(i) be modified by removing requirement (D). For a taxpayer without an AFS, the AICPA proposes that a modified version of the safe harbor provided in Prop. Reg. § 1.263(a)-2(d)(4)(iii) be developed to establish whether the amounts currently deducted under a de minimis threshold distort taxable income. The AICPA also recommends that the final regulations provide, for purposes of applying the capitalization threshold, a definition of "taxpayer" that would permit a taxpayer with an AFS to determine the capitalization threshold consistent with the determination of the capitalization threshold used in its AFS. For a taxpayer without an AFS, the definition of "taxpayer" should be sufficiently broad to determine such threshold at the entity level or the consolidated group level, but require the modified safe harbor test to be applied at the same level as the capitalization threshold.

E. Unit of Property

The AICPA recommends including an example to illustrate clearly whether a taxpayer may treat all section 1250 leasehold improvements that are part of the same building as a single unit of property. The AICPA also recommends including an example of a building and its structural components that are considered to be a single unit of property consistent with the rule in Prop. Reg. § 1.263(a)-3(d)(2)(ii). The AICPA believes the final regulations should include examples of what does and does not constitute plant property and examples of the unit of property in typical manufacturing processes. In addition, the AICPA recommends the final regulations provide a clearer definition of the terms "industrial process" and "discrete and major function or operation" in order to assist taxpayers in applying the special rule applicable to plant property. In addition, AICPA recommends that Prop. Reg. § 1.263(a)-3(d)(2)(iii)(D)(1) (i.e., the financial accounting rule for unit of property determinations) be omitted from the final regulations.

F. Betterment

The AICPA believes that the final regulations should provide an exception to the general rule requiring capitalization of amounts paid or incurred to remediate a pre-existing condition for a taxpayer that reacquires property that it previously contaminated. The AICPA also believes that an exception should be provided to allow a taxpayer to deduct the cost of environmental remediation to correct contamination caused by the taxpayer on property owned by another party. With respect to materiality, the AICPA recommends that, similar to the bright-line tests under the restoration provisions, the final regulations include bright-line rules for determining whether an expenditure results in a betterment. In addition, the AICPA recommends that the final regulations provide consistency between capitalizable improvements under section 263(a) and substantial renovations under section 199.

G. Restoration

The AICPA recommends that the substantive rules and related examples in Prop. Reg. § 1.263(a)-3(g)(1)(iii) and Prop. Reg. §§ 1.263(a)-3(g)(1)(i)-(ii) be omitted from the final regulations.

H. Routine Maintenance Safe Harbor

The AICPA suggests that the term "routine" be defined by reference to economic useful life and that the government provide objective rules in administrative guidance for taxpayers to follow in determining the appropriate economic useful life for the various major categories of property. The AICPA also recommends that the safe harbor affirmatively apply to both real and personal property and the safe harbors provided in existing guidance remain available to taxpayers.

I. Repair Allowance

The AICPA suggests the final regulations include an elective repair allowance method utilizing the "one-divided-by-the-MACRS-class-life" methodology proposed in the 2006 regulations without the 50 percent reduction. Taxpayers in specific industries where the general guideline percentages provided in the final regulations are determined to be inadequate relative to actual experience should be encouraged to seek industry-specific relief from the IRS through the Industry Issue Resolution program.

J. Effective Dates/Method Changes

The AICPA suggests that a taxpayer be permitted to change its method of accounting for amounts paid or incurred in taxable years prior to the taxable year in which the final regulations are issued, and that automatic consent be provided for a taxpayer to change its method of accounting to comply with the final regulations with a waiver of the scope limitations under Section 4.02 of Rev. Proc. 2011-14 for the first taxable year following the issuance of the final regulations. The AICPA recommends that the final regulations apply the general rules of section 481(a) and provide that taxpayers are to make the change to comply with the final regulations by computing a section 481(a) adjustment. To the extent that the books and records necessary to compute a section 481(a) adjustment are not readily available, the AICPA recommends that the final regulations provide that reasonable estimates and reasonable estimation techniques, similar to those in Treas. Reg. § 1.263A-7, be permitted in computing the section 481(a) adjustment. If, however, the IRS and Treasury determine that changes to comply with the final regulations should be made on a cut-off or modified cut-off basis, taxpayers should be permitted to change to the law applicable to the years preceding the effective date of the final regulations. The AICPA also recommends that the general audit protection provisions under the accounting method change procedural guidance apply to changes made to comply with the final regulations. Additionally, to the extent that an issue under consideration relates to a method of accounting that is consistent with the rules in the final regulations, the AICPA recommends that the issue not be pursued by IRS examining agents ("Exam").

Each of the above areas is addressed in detail in the attachment.

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Executive Summary

In general, the AICPA recommends:

A. Materials and Supplies

The AICPA recommends (i) removing the clear reflection of income requirement from Prop. Reg. § 1.162-3(a)(2), (ii) revising Prop. Reg. § 1.162-3(d)(1)(iii) to clarify that only de minimis materials and supplies must be included in the de minimis capitalization threshold test for tangible property provided in Prop. Reg. § 1.263(a)-2(d)(4), and (iii) increasing the de minimis limit from $100 to $1,000.

B. Capitalized Costs

The AICPA believes that Prop. Reg. § 1.263(a)-1(c)(5) should be modified to provide that an interest in land does not include any franchise granted by a governmental unit (including an agency or instrumentality thereof), such that any amount paid by a taxpayer to the governmental unit that is properly allocable to the franchise (e.g., the right to operate a toll road, airport, seaport, or similar facility) would not be subject to capitalization as an amount paid to acquire or create an interest in land.

C. Transaction Costs

The AICPA suggests that Prop. Reg. § 1.263(a)-2(d)(3)(ii)(C) be modified to extend the special rule for real property acquisition costs to include tangible personal property that is acquired as part of the same transaction.

D. De Minimis Rule

For a taxpayer with an applicable financial statement ("AFS"), the AICPA suggests the de minimis rule in Prop. Reg. § 1.263(a)-2(d)(4)(i) be modified by removing requirement (D). For taxpayers without an AFS, the AICPA proposes that a modified version of the safe harbor provided in Prop. Reg. § 1.263(a)-2(d)(4)(iii) be developed to establish whether the amounts currently deducted under a de minimis threshold distort taxable income. The AICPA also recommends that the final regulations provide, for purposes of applying the capitalization threshold, a definition of "taxpayer" that would permit a taxpayer with an AFS to determine the capitalization threshold consistent with the determination of the capitalization threshold used in its AFS. For a taxpayer without an AFS, the definition of "taxpayer" should be sufficiently broad to determine such threshold at the entity level or the consolidated group level, but require the modified safe harbor test to be applied at the same level as the capitalization threshold.

E. Unit of Property

The AICPA recommends including an example to illustrate clearly whether a taxpayer may treat all section 1250 leasehold improvements that are part of the same building as a single unit of property ("UOP"). The AICPA also recommends including an example of a building and its structural components that are considered to be a single UOP consistent with the rule in Prop. Reg. § 1.263(a)-3(d)(2)(ii). The AICPA believes the final regulations should include examples of what does and does not constitute plant property and examples of the UOP in typical manufacturing processes. In addition, the AICPA recommends the final regulations provide a clearer definition of the terms "industrial process" and "discrete and major function or operation" in order to assist taxpayers in applying the special rule applicable to plant property. In addition, the AICPA recommends that Prop. Reg. § 1.263(a)-3(d)(2)(iii)(D)(1) (i.e., the financial accounting rule for UOP determinations) be omitted from the final regulations.

F. Betterment

The AICPA believes that the final regulations should provide an exception to the general rule requiring capitalization of amounts paid or incurred to remediate a pre-existing condition for a taxpayer that re-acquires property that it previously contaminated. The AICPA also believes that an exception should be provided to allow a taxpayer to deduct the cost of environmental remediation to correct contamination caused by the taxpayer on property owned by another party. With respect to materiality, the AICPA recommends that, similar to the bright-line tests under the restoration provisions, the final regulations include bright-line rules for determining whether an expenditure results in a betterment. In addition, the AICPA recommends that the final regulations provide consistency between capitalizable improvements under section 263(a) and substantial renovations under section 199.

G. Restoration

The AICPA recommends that the substantive rules and related examples in Prop. Reg. § 1.263(a)-3(g)(1)(iii) and Prop. Reg. §§ 1.263(a)-3(g)(1)(i)-(ii) be omitted from the final regulations.

H. Routine Maintenance Safe Harbor

The AICPA suggests that the term "routine" be defined by reference to economic useful life and that the government provide objective rules in administrative guidance for taxpayers to follow in determining the appropriate economic useful life for the various major categories of property.

The AICPA also recommends that the safe harbor affirmatively apply to both real and personal property and the safe harbors provided in existing guidance remain available to taxpayers.

I. Repair Allowance

The AICPA suggests the final regulations include an elective repair allowance method utilizing the "one-divided-by-the-MACRS-class-life" methodology proposed in the 2006 regulations without the 50 percent reduction. Taxpayers in specific industries where the general guideline percentages provided in the final regulations are determined to be inadequate relative to actual experience should be encouraged to seek industry-specific relief from the Internal Revenue Service ("IRS") through the Industry Issue Resolution ("IIR") program.

J. Effective Dates/Method Changes

The AICPA suggests that a taxpayer be permitted to change its method of accounting for amounts paid or incurred in taxable years prior to the taxable year in which the final regulations are issued, and that automatic consent be provided for a taxpayer to change its method of accounting to comply with the final regulations with a waiver of the scope limitations under Section 4.02 of Rev. Proc. 2011-14 for the first taxable year following the issuance of the final regulations. The AICPA recommends that the final regulations apply the general rules of section 481(a) and provide that a taxpayer is to make the change to comply with the final regulations by computing a section 481(a) adjustment. To the extent that the books and records necessary to compute a section 481(a) adjustment are not readily available, the AICPA recommends that the final regulations provide that reasonable estimates and reasonable estimation techniques, similar to those in Treas. Reg. § 1.263A-7, be permitted in computing the section 481(a) adjustment. If, however, the IRS and the Department of the Treasury ("Treasury") determine that changes to comply with the final regulations should be made on a cut-off or modified cut-off basis, taxpayers should be permitted to change to the law applicable for costs paid or incurred in the years preceding the effective date of the final regulations. The AICPA also recommends that the general audit protection provisions under the accounting method change procedural guidance apply to changes made to comply with the final regulations. Additionally, to the extent that an issue under consideration relates to a method of accounting that is consistent with the rules in the final regulations, the AICPA recommends that the issue not be pursued by IRS examining agents ("Exam").

These areas are addressed in detail below.

A. Materials and Supplies

Prop. Reg. § 1.162-3(a)(2) -- Incidental Materials

The AICPA commends the Treasury and the IRS in their effort to coordinate the current materials and supplies rules found in Treas. Reg. § 1.162-3 with the proposed regulations. Prop. Reg. § 1.162-3(a)(2) provides that "[a]mounts 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 tax year in which these amounts are paid, provided taxable income is clearly reflected." The AICPA offers the following comments and suggestions with respect to the proposed material and supply provisions.

The AICPA first recommends removing the clear reflection of income requirement from Prop. Reg. § 1.162-3(a)(2). Pursuant to section 446(b), the Secretary of the Treasury and the Commissioner of the IRS possess broad authority to recompute taxable income in the event that, in the Commissioner's opinion, a taxpayer's method of accounting does not clearly reflect income. Thus, the AICPA feels that it is unnecessary to include a clear reflection of income requirement in this proposed regulation as such requirement is included in section 446(b). Furthermore, including a separate clear reflection of income test in this regulation might lead to unintended controversy as some taxpayers or Exam might conclude that the regulation provides an "additional" clear reflection income requirement above and beyond section 446(b). The AICPA therefore suggests omitting the phrase "provided taxable income is clearly reflected" from the final regulation.

Rotable Spare Parts

The AICPA recommends clarifying the rule in Prop. Reg. § 1.162-3(b) and accompanying Example 2 under Prop. Reg. § 1.162-3(f). Prop. Reg. § 1.162-3(b) provides that a rotable spare part is used or consumed in a taxpayer's business during the taxable year in which a taxpayer disposes of the spare part. The fact that the regulation and accompanying example indicate that the cost of the rotable spare part is recovered upon disposition could be misinterpreted to imply that the rotable spare parts may not be depreciated when they first are placed in service in the rotable pool in accordance with Rev. Proc. 2007-48, 2007-2 C.B. 110. To prevent such a misinterpretation, the AICPA suggests adding a reference to the fact that the rotable spare parts may be depreciable, including a cross reference to section 167, section 168 or Rev. Proc. 2007-48 in the final regulations.

Priority Rule for Prop. Reg. § 1.162-3(d)(1)(ii) and -3(d)(1)(iii)

The AICPA recommends modifying Prop. Reg. §§ 1.162-3(d)(1)(ii) and -3(d)(1)(iii) to eliminate potential ambiguities. A UOP is defined by reference to Prop. Reg. § 1.263(a)-3(d)(2), regarding a UOP with a useful life of 12 months or less or a cost of $100 or less in both Prop. Reg. §§ 1.162-3(d)(1)(ii) and -3(d)(1)(iii). The distinction between a classification under -3(d)(1)(ii) versus -3(d)(1)(iii) is meaningful for purposes of the proposed de minimis rule safe harbor set forth in Prop. Reg. § 1.263(a)-2(d)(4)(iii). Materials and supplies included in Prop. Reg. § 1.162-3(d)(1)(ii) are not included in the de minimis safe harbor computation, whereas those included in Prop. Reg. § 1.162-3(d)(1)(iii) are included. However, because of the possibility that a UOP can be described in both Prop. Reg. §§ 1.162-3(d)(1)(ii) and -3(d)(1)(iii) (i.e., the material and supply has an economic life of 12 months or less and a cost of $100 or less) there is uncertainty as to whether the UOP is included in the de minimis safe harbor of Prop. Reg. § 1.263(a)-2(d)(4)(iii). Accordingly, to eliminate the potential for ambiguity and improve administrability, the AICPA suggests that the government revise Prop. Reg. § 1.162-3(d)(1)(iii) to specifically exclude a UOP described in Prop. Reg. § 1.162-3(d)(1)(ii). The AICPA suggests that Prop. Reg. § 1.162-3(d)(1)(iii) be modified to read as follows:

Proposed Reg. § 1.162-3(d)(1)(iii) includes in the definition of a material or supply a UOP consumed in the taxpayer's operations that has an acquisition or production cost of $100 or less. Many taxpayers purchase de minimis units of property for consumption in their operations that cost more than $100. Accordingly, the AICPA recommends that the $100 limit be increased to $1,000. The AICPA also recommends that if the $1,000 dollar value is not chosen, that the $100 limit be indexed for inflation annually. We also recommend that the inflation adjusted limit be published annually.

B. Capitalized Costs

Proposed Reg. § 1.263(a)-1(c) provides a list of expenditures that must be capitalized. Specifically, Prop. Reg. § 1.263(a)-1(c)(5) provides that a capital expenditure includes "[a]n 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."

The AICPA believes that for purposes of clarification, Prop. Reg. § 1.263(a)-1(c)(5) should be modified to provide the following:

The AICPA notes with approval the addition of the rule that, if finalized, would permit a taxpayer to deduct costs incurred to investigate whether to acquire real property, and which real property to acquire. Specifically, Prop. Reg. § 1.263(a)-2(d)(3)(ii)(C) provides that "[e]xcept 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." This "whether and which" rule was provided in response to commentators who suggested that, with respect to the rules requiring the capitalization of facilitative transaction costs, an exception should be provided for transaction costs that are pre-decisional investigatory costs, similar to the exception provided with respect to certain intangibles.

The AICPA understands that IRS and Treasury believe 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. However, in many cases the real property in such transactions includes tangible personal property that is an integral part of the real property to which the "whether and which" provision applies. Accordingly, the AICPA suggests that Prop. Reg. § 1.263(a)-2(d)(3)(ii)(C) be modified to provide the following:

D. De Minimis Rule

Proposed Reg. § 1.263(a)-2(d)(4)(i) generally provides that a taxpayer may currently deduct an amount paid for the acquisition or production of a UOP if:

With respect to the capitalization rule, the AICPA has concerns regarding the --

• Potential disruption of current administrative practice;

• Exclusion of taxpayers without an AFS from eligibility for the capitalization threshold;

• Definition of "taxpayer" for purposes of applying the capitalization threshold; and,

• Clarification of exceptions to the de minimis rule.

Potential Disruption of Current Administrative Practice

In the preamble to the proposed regulations, IRS and Treasury acknowledge that many taxpayers reach informal agreements with Exam to permit the use of a de minimis rule that conforms to those thresholds used by the taxpayers for financial accounting purposes ("financial statement conformity"), and that this widespread practice has not been generally altered. These informal agreements benefit both the government and the taxpayers, as they balance resources and administration for both taxpayers and the IRS. The preamble clearly communicates that this regulation project is not intended to disrupt this balance.

The AICPA believes that the addition of the "does not distort taxable income" requirement in the proposed regulations will increase audit controversy and create uncertainty for taxpayers, notwithstanding the preamble language noted above. Most taxpayers have established financial statement capitalization thresholds that balance the administrative burdens of accounting for all individual depreciable assets with the need to accurately reflect their financial accounting income. The AICPA believes that if a taxpayer's capitalization threshold is appropriate for financial statement purposes, then conforming to that threshold for federal income tax purposes likewise will not result in a distortion of that taxpayer's taxable income.

Accordingly, for a taxpayer with an AFS, the AICPA suggests the de minimis rule in Prop. Reg. § 1.263(a)-2(d)(4)(i) be modified in the final regulations by removing requirement (D). This modification essentially requires financial statement conformity for such taxpayers, and the AICPA believes that such conformity will prevent any potential distortion of a taxpayer's taxable income. By modifying the final regulations in this manner, IRS and Treasury would prevent disturbance of current agreements between taxpayers and their examining agents, and would provide certainty to taxpayers that their capitalization thresholds are permissible for federal income tax purposes. Moreover, the recommended changes avoid the additional administrative burden of tracking de minimis assets to ascertain whether the aggregate amounts deducted exceed the applicable thresholds.

Exclusion of Taxpayers Without an AFS

The AICPA believes the capitalization threshold provisions of the proposed regulations inappropriately exclude from eligibility a taxpayer that does not have an AFS (primarily small businesses). The AICPA believes that, at a minimum, the definition of AFS in the final regulations should be expanded to include a compilation or reviewed, but unaudited, financial statements.

The AICPA believes that all taxpayers, not just one with an AFS, should be eligible for the capitalization threshold provisions. However, the AICPA understands the government's concerns that a taxpayer's capitalization threshold clearly reflect income. Accordingly, the AICPA proposes that a modified version of the safe harbor provided in Prop. Reg. § 1.263(a)-2(d)(4)(iii) be developed to establish whether the amounts currently deducted under a de minimis threshold distort taxable income for a taxpayer without an AFS.

The safe harbor provided in Prop. Reg. § 1.263(a)-2(d)(4)(iii) states that the amount not required to be capitalized by a taxpayer under the de minimis rule is deemed to not distort taxable income if the amount, when added to the amount the taxpayer deducts as materials and supplies under Prop. Reg. § 1.162-3, is equal to or less than 0.1 percent of the taxpayer's gross receipts for the year or two percent of the taxpayer's total depreciation and amortization expense for the taxable year as determined in the taxpayer's AFS. The AICPA believes that this safe harbor requires information that taxpayers do not have readily available, and will therefore be burdensome to taxpayers and difficult for the IRS to administer. Taxpayers generally currently deduct the amounts below their capitalization threshold and therefore do not account for those amounts. Similarly, taxpayers do not account for amounts deducted as materials and supplies. The safe harbor is further burdensome in that it can only be computed after year-end, thus denying taxpayers certainty until after year-end as to whether they satisfy the safe harbor.

The AICPA suggests a modified safe harbor that would apply only to taxpayers without an AFS. Under this safe harbor, the de minimis capitalization threshold would be deemed to not distort taxable income if the amount deducted is less than or equal to 0.1 percent of the taxpayer's average annual gross receipts reported on its federal income tax returns for the 3 taxable years immediately prior to the current taxable year (or, if shorter, the taxable years during which such taxpayer was in existence). The operative rules could be similar to the gross receipts tests under section 263A (for small resellers), section 448 (cash method for certain corporations), and section 460 (use of the completed contract method by certain homebuilders). The AICPA believes that this approach addresses the concerns of the government and meets the government's stated goal of ease of administration.

Definition of Taxpayer

As noted above, the capitalization threshold eligibility is determined for a "taxpayer." However, the proposed regulations do not provide a definition of "taxpayer" for purposes of applying the provision and any related safe harbor tests. In the absence of a specific definition, the general definitional rules apply. Section 7701(a)(14) defines "taxpayer" as "any person subject to any internal revenue tax." Section 7701(a)(1) defines "person" as "an individual, a trust, estate, partnership, association, company or corporation." It does not include a "consolidated group" or a "combined reporting" group.

The lack of a definition of "taxpayer" for purposes of applying this section may lead to unnecessary confusion and controversy. Accordingly, the AICPA recommends that the final regulations provide, for purposes of applying the capitalization threshold, a definition of "taxpayer" that would permit a taxpayer with an AFS to determine the capitalization threshold consistent with the determination of the capitalization threshold used in its AFS. For taxpayers without an AFS, the definition of "taxpayer" should be sufficiently broad to determine such threshold at the entity level or the consolidated group level, but require the modified safe harbor test be applied at the same level as the capitalization threshold.

Clarification of Exceptions to De Minimis Rule

Proposed Reg. § 1.263(a)-2(d)(4)(ii) provides that the de minimis rule in Prop. Reg. § 1.263(a)-4(d)(4)(i) does not apply to the following:

E. Unit of Property

The proposed regulations provide guidance concerning the appropriate UOP to which the betterment and restoration rules should be applied. We commend the IRS and Treasury in their efforts to modify and simplify these rules from the 2006 Proposed Regulations in response to the concerns raised by commentators. Prop. Reg. § 1.263(a)-3(d)(2) provides UOP rules that generally are based on the functional interdependence standard, and include special rules for buildings, leasehold improvements, and plant property.

Leasehold Improvements

A building and its structural components are generally treated as a single UOP under Prop. Reg. § 1.263(a)-3(d)(2)(ii). Where a taxpayer leases, rather than owns, a building or portion thereof and makes a leasehold improvement that constitutes section 1250 property, the leasehold improvement is a separate UOP. Section 1250 property that is part of the same building generally may not be componentized for depreciation purposes. The proposed regulations do not clearly indicate whether a taxpayer may treat all section 1250 leasehold improvements that are part of the same building as a single UOP. The AICPA recommends including the following illustrative example:

As noted above, a building (as defined in Treas. Reg. § 1.48-1(e)(1)) and its structural components (as defined in Treas. Reg. § 1.48-1(e)(2)) are treated as a single UOP under Prop. Reg. § 1.263(a)-3(d)(2)(ii). The AICPA agrees with this UOP determination as it is consistent with all other areas of the tax law. However, the AICPA believes that the inclusion of examples of specific structural components of a building that are included in the UOP of the building would be illustrative, instructive and reduce controversy. The AICPA recommends modifying Prop. Reg. § 1.263(a)-3(d)(2)(iv), Example 1, to read as follows:

Plant Property

Under the functional interdependence criterion in Prop. Reg. § 1.263(a)-3(d)(2)(iii)(A), components that are functionally interdependent generally comprise a single UOP. In the case of functionally interdependent machinery or equipment used to perform an industrial process ("plant property"), the UOP is separated into smaller units that consist of each component that performs a discrete and major function or operation within the functionally interdependent machinery or equipment (e.g., the boiler, turbine, generator, and pulverizers in an electric power plant, even though they are all functionally interdependent because each of these components performs a discrete and major function within the power plant).

The proposed regulations provide examples of activities constituting a discrete and major function at extreme ends of the spectrum with respect to production activities, and do not necessarily provide sufficient information for a majority of taxpayers to evaluate the application of the rules to typical production equipment. The example regarding the process to prepare and cook tortillas at a restaurant provides no guidance for taxpayers as it is clearly not an "industrial process" and would not be subject to the regulations. The laundry example is at the other end of the spectrum -- a process that is clearly an "industrial process" with significant, clearly delineated discrete and major functions. Most production processes fall somewhere between these two examples and the final regulations should provide illustrations of how the rule would apply to more typical production processes.

The AICPA believes the final regulations should include examples of what does and does not constitute plant property as well as additional examples of UOP determinations in typical manufacturing processes. The AICPA further recommends the final regulations provide a clearer definition of the terms "industrial process" and "discrete and major function or operation" to assist taxpayers in applying the special rule applicable to plant property. In this regard, members of the AICPA task force would be happy to meet with government officials to discuss relevant real-world examples.

Limiting Rules

Proposed Reg. § 1.263(a)-3(d)(2)(iii)(D) provides --

The AICPA anticipates that this concern will be especially true for companies complying with International Financial Reporting Standards ("IFRS") because IFRS requires an asset to be broken down into its various components for purposes of determining depreciation, repairs and retirements. As a result of this componentization, it is likely that functionally interdependent components could have different economic useful lives for financial accounting purposes. For example, under IFRS, an airplane likely would be broken down into its major components, such as the airframe, landing gear, engines, wheels and brakes. These major components of the airplane likely would have different economic lives and be separate units of property for financial accounting purposes. In our view, requiring a taxpayer to use these financial accounting units of property for functionally interdependent components that make up the airplane would be inappropriate and would be in direct contrast to the Sixth Circuit Court of Appeals' decision in FedEx Corporation v. U.S., 291 F.Supp.2d 699 (2003) aff'd 412 F.3d 617 (6^th Cir. 2005).

Another area that could result in a different UOP is a building and major components or systems thereof as discussed above in Section E. Unit of Property. Due to the differing goals and guidelines for financial or regulatory accounting and tax accounting, the AICPA does not believe that financial or regulatory classifications of components of property should control for tax purposes. Accordingly, the AICPA recommends that this rule not be included in the final regulations.

F. Betterment

Proposed Reg. § 1.263(a)-3(f) requires capitalization of expenditures that result in a betterment with respect to the UOP, and describes the factors to be used in determining whether an expenditure results in a betterment of a UOP, including:

• Ameliorates a material condition or defect,

• Results in a material addition, or

• Results in a material increase in capacity, productivity, efficiency, strength, or quality.

Environmental Remediation Costs

Under Prop. Reg. § 1.263(a)-3(f)(1)(i), the remediation of a material defect that either existed prior to the acquisition or arose during the production of the UOP results in a betterment of the UOP. Under this rule, it appears a taxpayer would be required to capitalize the costs incurred to remediate a UOP acquired post-contamination by a taxpayer, even if that taxpayer was the party who contaminated the property. In the preamble to the proposed regulations, the IRS and Treasury requested 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. IRS and Treasury also requested 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.

The AICPA believes that the final regulations should provide an exception to the general rule requiring capitalization of amounts paid or incurred to remediate a pre-existing condition for a taxpayer that re-acquires property that it previously contaminated. (Note for this purpose, we recommend that the term "taxpayer" be defined to include members of the same consolidated group because often times the parent of the group re-acquires the contaminated property for purposes of remediating it.) Such an exception is consistent with the public policy goal of encouraging taxpayers to remediate contaminated property and could be included in Prop. Reg. § 1.263(a)-3(f). This exception could be based on a facts and circumstances determination requiring a taxpayer to maintain sufficient records to support the extent of contamination present at the time of sale to support a deduction for remediation activities following a re-acquisition of the property or based on a safe harbor rule. The AICPA suggests that the exception explicitly provide that sufficient records include:

The AICPA also believes that the final regulations should provide a rule under which a taxpayer is not required to capitalize amounts paid or incurred to remediate a property owned by another party that is contaminated by the taxpayer. For example, if a taxpayer discharges a hazardous substance in a river, the taxpayer should be allowed to currently deduct costs incurred to environmentally remediate downstream portions of the river contaminated by the taxpayer and owned by others. The AICPA suggests that this rule include safe harbors similar to those suggested above for property contaminated and re-acquired by the same taxpayer.

The AICPA recommends including the following examples to illustrate this provision and safe harbor:

As noted above, the determination of whether an expenditure results in a betterment is based on whether a material condition or defect is ameliorated, whether a material addition is added to the UOP or whether there is a material increase in the capacity, productivity, efficiency, strength or quality of the UOP.

The AICPA believes that a lack of specific definition of "materiality" in the proposed regulations will lead to continued uncertainty and controversy. The AICPA recommends that, similar to the bright-line tests under the restoration provisions, the final regulations include safe harbors that contain bright-line rules for determining when an expenditure results in a betterment.

Appropriate Comparison

Proposed Reg. § 1.263(a)-3(f)(2)(iii)(A) provides the general rule for the appropriate comparison to determine if an expenditure results in a betterment. Proposed Reg. § 1.263(a)-3(f)(2)(iii)(B) applies this general rule to normal wear and tear, and Prop. Reg. § 1.263(a)-3(f)(2)(iii)(C) applies this general rule to a particular event. However, the general rule begins with the language "in cases in which a particular event necessitates an expenditure, . . ." The AICPA believes that the phrase "[i]n cases in which a particular event necessitates an expenditure," should be removed from the beginning of Prop. Reg. § 1.263(a)-3(f)(2)(iii)(A) because it is inappropriate to limit the general rule to particular events.

Capitalization Under a Different Provision

Proposed Reg. § 1.263(a)-3(f)(3) provides examples illustrating the rules of Prop. Reg. § 1.263(a)-3(f), and notes that "[e]ven if capitalization is not required in an example under this paragraph (f), the amounts paid in the example may be subject to capitalization under a different provision of this section." The AICPA believes it would be helpful to highlight that capitalization may be required under other provisions of section 263(a) as well as under other sections. The AICPA recommends that Prop. Reg. § 1.263(a)-3(f)(3) be revised to include a reference to section 263A after "of this section."

Consistency with Section 199

The proposed regulations do not include the material increase in value test that was included in the 2006 Proposed Regulations. As a result, the rules lack conformity in determining whether a substantial renovation has occurred for purposes of Treas. Reg. § 1.199-3(m)(5) and whether an improvement has occurred for purposes of the section 263(a) regulations. Under Treas. Reg. § 1.199-3(m)(5), substantial renovation means the renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use. To assist taxpayers in determining whether they are engaged in the active conduct of construction services for purposes of section 199, the AICPA recommends that the final regulations provide consistency between capitalizable improvements under section 263(a) and substantial renovations under section 199.

G. Restoration

Proposed Reg. § 1.263(a)-3(g)(1) provides that "[a] taxpayer must capitalize amounts paid to restore a UOP, including amounts paid in making good the exhaustion for which an allowance is or has been made. An amount is paid to restore a UOP if it --

With respect to Prop. Reg. § 1.263(a)-3(g)(1)(iii), the preamble to the proposed regulations indicates that the IRS and Treasury believe that when a taxpayer properly deducts a casualty loss, the nature of the damage resulting from the casualty is such that any repairs made to restore the property after the casualty should not be treated as ordinary and necessary repair costs under section 162. The proposed regulations require what the IRS and Treasury term "consistent characterization" for two distinct economic costs, the casualty loss and the repair cost, originating from a single event, the casualty. The preamble suggests that this "consistent characterization" is necessary to prevent a taxpayer from obtaining more favorable tax treatment from partial rather than total destruction of a UOP as a result of a casualty.

The preamble further notes that the IRS and Treasury believe that this provision is necessary to eliminate the "dual characterization," or "double deduction," of costs as a casualty loss under section 165 and an ordinary and necessary expense under section 162. Finally, the preamble to the proposed regulations indicates that taxpayers need to take into account the uniqueness of the casualty in determining whether a casualty loss is the appropriate treatment. The preamble cites court decisions holding that in certain types of business, regularly recurring incidents that might nominally qualify as "casualties" are in reality everyday events that call for repair expense treatment, rather than casualty loss treatment.

Addressing first the government's assertion for consistency in the treatment of property that is partially destroyed by a casualty and property that is completely destroyed by a casualty, the AICPA disagrees that such consistency is needed or even warranted based on the legislative history to section 165. Prior to the enactment of the casualty loss provisions, there was no consistency in treatment between partial and total destruction of property as a result of a casualty. In a case where business property is completely destroyed in a casualty, the destruction of the property is considered a realization event for tax purposes and any remaining basis in the property is recovered through the operation of section 165(a), without the need for any special treatment because the property was destroyed in a casualty event. In that type of situation it is clear that, since the destroyed property would be considered abandoned, the cost of any replacement property must be capitalized as the acquisition or construction of an entirely new UOP. In contrast, in the case of property that is only partially damaged in a casualty, prior to the enactment of the casualty loss provisions, no realization event would be deemed to have occurred. As a result, no loss was deductible in the case of the partial destruction of business property. However, a repair of the business property would have been currently deductible, assuming the expenditure met the normal tests for deductibility under the predecessor to section 162.

It is not unreasonable to assume that in enacting special relief provisions for losses due to casualties, Congress intended to provide relief to taxpayers in the partial destruction situation, since that is the only situation where relief was needed. The relief provided in the predecessor to section 165(c)(3) was to permit a deduction to be claimed by a business for the decrease in the value of the damaged property, without regard to the fact that no realization event had occurred in comparison to the complete destruction of the property.

In light of the foregoing background, it is difficult to imagine that in providing a benefit to taxpayers in the case of the partial destruction of property from a casualty, Congress intended to trade a current casualty loss deduction for the capitalization of what would otherwise constitute a currently deductible repair expense. In fact, as has been pointed out by some commentators, since the average remaining depreciable life of the damaged property is likely to be shorter than a new MACRS life for the capitalized repair expenditure, taxpayers repairing property damaged in a casualty would actually be penalized and would be treated worse than if they repaired their property without having experienced a casualty. Such an interpretation in the proposed regulations does not comport with the apparent legislative intent of section 165.

Second, focusing on the premise in the preamble that there needs to be consistency in the treatment of two expenditures growing out of the same event, the AICPA is not aware of any basis in the tax law, and does not believe there is a need, for a rule requiring "consistent characterization" of two distinct expenditures arising from a single event. Moreover, the AICPA does not believe a casualty loss deduction and a repair deduction result in a "double deduction" as the two deductions are for two separate expenditures. A taxpayer is not claiming a double deduction for a single expenditure if the taxpayer deducts subsequent repairs to a UOP with respect to which the taxpayer properly deducted a casualty loss. Rather, the taxpayer has claimed two separate deductions for two separate expenditures, which is permissible under current tax law.

A casualty loss, like a depreciation deduction, is a mechanism to recover the initial investment in, and subsequent capital improvements to, an asset. Under ordinary circumstances, a taxpayer's investment in an asset is recovered over the life of the asset through depreciation deductions. Repairs to such asset that do not rise to the level of capital expenditures are deducted under section 162. Thus, in a given year, a taxpayer may take a depreciation deduction with respect to an asset as well as a deduction for the cost of making repairs to such asset. At the end of that year, the taxpayer has an old asset that has been repaired. The depreciation deduction represents the recovery of a portion of the initial investment in the asset, and the repair deduction represents the cost of making repairs to the asset. They are deductions for separate and distinct expenditures.

In the case of a casualty loss, the taxpayer does not continue to recover its initial investment in the asset through depreciation deductions. Rather, the recovery of all or part of the initial investment is accelerated and recovered in the year of the loss. If a component is disposed of as a result of a casualty event, Treas. Reg. § 1.165-7 requires the taxpayer to claim a loss on the partial disposition of the UOP if (i) there has been a diminution in the fair market value of the UOP, (ii) sufficient basis exists in the UOP, and (iii) there is no reasonable prospect for reimbursement under an insurance contract or otherwise. Upon claiming the casualty loss, the basis of the UOP is adjusted by an amount corresponding to the loss.³ Just as a taxpayer may take a depreciation deduction with respect to an asset, as well as a deduction for the cost of making repairs to such asset, a taxpayer should be entitled to take a casualty loss with respect to the partial destruction of an asset, as well as a deduction for the cost of making a repair to such asset. As in the example above, at the end of that year, the taxpayer has an old asset that has been repaired. The casualty loss, like the depreciation deduction represents the recovery of a portion of the initial investment in the asset, and the repair deduction represents the cost of making repairs to the asset. The deduction for the loss and the deduction of the repairs are deductions for separate and distinct expenditures. The taxpayer is precluded from a "double deduction" by reducing basis in the asset by the amount of casualty loss, as the casualty loss deduction is the cost recovery mechanism utilized in lieu of a depreciation deduction. The casualty loss deduction, determined under section 165 and the repair deduction, determined under section 162, are not taken with respect to the same dollar expenditure.

Further, the AICPA disagrees with the necessity of "consistent characterization" for these two distinct expenditures. Under current tax law, the deduction of a section 165 casualty loss is independent from a determination of whether expenditures to restore property to a pre-casualty state constitute an improvement or a repair. As discussed above, taxpayers determine the necessity of cost recovery through a casualty loss deduction under section 165. The AICPA believes this application of section 165 to capitalized basis should continue to apply separately from determinations of improvement versus repair. The availability of a loss, and required corresponding basis adjustment, under section 165 should not determine the qualification of any subsequent expenditure incurred with respect to the property as a repair or as an improvement.

The AICPA believes that collectively, the major component and substantial structural part rule, the rebuild to like-new condition rule, and the betterment provisions under the proposed regulations serve to preclude a taxpayer from claiming a deduction for a partial destruction (a casualty loss deduction under section 165) as well as an ordinary and necessary repair deduction under section 162. As currently drafted the proposed regulations require consistency with respect to expenditures whether or not there is partial destruction of a UOP. Prop. Reg. § 1.263(a)-3(g)(1)(v) and (vi) require capitalization in all situations where the exceptions of Prop. Reg. § 1.263(a)-3(g)(2)(ii) and Prop. Reg. § 1.263(a)-3(g)(3)(ii) cannot be met and the taxpayer is replacing a major component or substantial structural part or otherwise rebuilding the UOP to a like-new condition. Moreover, even if such expenditures are made within the applicable depreciation recovery period for the UOP, such expenditures may still be capitalized to the extent the expenditures constitute a betterment under Prop. Reg. § 1.263(a)-3(f).

Finally, with respect to the discussion in the preamble of the proposed regulations that casualty events need to be unique and unusual in order to qualify for a casualty loss, the AICPA notes that this "unique and unusual" requirement may be limited to casualty events that are not specifically enumerated in section 165(c)(3). Thus, losses arising from "fire, storm, shipwreck, . . . or theft" should be deductible as casualty losses without regard to the uniqueness or the severity of the event. The casualties in the cases cited in the preamble are typically automobile accidents, which are classified as "other" casualties in the statute. These types of casualties need to satisfy a higher standard for deductibility under section 165(c)(3). Accordingly, the comments in the preamble should be appropriately limited in their application to the residual category of casualty events in the statute.

Based on the above, the AICPA recommends that the substantive rule in Prop. Reg. § 1.263(a)-3(g)(1)(iii) and the related examples be omitted from the final regulations.

Other Restorations

Proposed Reg. § 1.263(a)-3(g)(1)(i) provides that a taxpayer must capitalize the cost of a replacement of a component of a UOP if the taxpayer properly deducted a loss for that component, other than a casualty loss under Treas. Reg. § 1.165-7. Proposed Reg. § 1.263(a)-3(g)(4), Example 1, describes a taxpayer who abandons components of a walk-in freezer and replaces them with new components. In the example, the taxpayer "properly recognizes a loss" on the abandonment of the freezer components. Inherent in this analysis is the concept that the taxpayer has basis in an abandoned component of a UOP.

Similarly, Prop. Reg. § 1.263(a)-3(g)(1)(ii) provides that a taxpayer may not deduct the cost of a replacement of a component of a UOP if the taxpayer properly took into account the adjusted basis of the component in computing gain or loss from the sale or exchange of the component. Proposed Reg. § 1.263(a)-3(g)(4), Example 2, describes a taxpayer who sells malfunctioning components of a walk-in freezer and replaces them with new components. In the example the taxpayer "properly recognizes a loss" on the sale of the freezer components. Inherent in this analysis is the concept that the taxpayer has basis in a sold component of a UOP.

The AICPA believes that the situations delineated in Prop. Reg. §§ 1.263(a)-3(g)(1)(i) and 1.263(a)-3(g)(1)(ii) and the related examples do not occur under current tax law. The AICPA is not aware of the legal basis for the loss deductions as described within Prop. Reg. § 1.263(a)-3(g)(1)(i) and Prop. Reg. § 1.263(a)-3(g)(1)(ii). Treas. Reg. § 1.165-1(b) requires that deductible losses be evidenced by closed and completed transactions and fixed by identifiable events. Treas. Reg. § 1.165-1(c)(1) provides that the amount deductible under section 165(a) be limited to the adjusted basis of the property involved. The AICPA is not aware of any authority that would permit a taxpayer to allocate basis to a component of a UOP and recognize a related loss on the sale or abandonment of such component. Basis generally attaches to a UOP, not to a component thereof. Moreover, the IRS held in Rev. Rul. 2000-7, 2000-1 C.B. 712, that taxpayers may deduct amounts paid to retire and remove a unit of property in connection with the installation of a replacement asset. (Emphasis added.)

Accordingly, the AICPA suggests that the substantive rules in Prop. Reg. §§ 1.263(a)-3(g)(1)(i)-(ii) and the related examples also be omitted from the final regulations.

H. Routine Maintenance Safe Harbor

Proposed Reg. § 1.263(a)-3(e)(1) provides that "[a]n amount paid for routine maintenance performed on a UOP is deemed to not improve that UOP. Routine maintenance is the recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the UOP to keep the UOP in its ordinarily efficient operating condition." However, activities are routine only if, at the time the UOP is placed in service, the taxpayer reasonably expects to perform the activities more than once during the alternative depreciation system ("ADS") class life of the property.

The AICPA commends IRS and Treasury for providing a safe harbor for the deductibility of routine and recurring maintenance expenditures. However, the AICPA believes that the final regulations should include certain changes that would allow the safe harbor to more effectively meet its implied goal of reducing controversy. The AICPA suggests the following three revisions be made to the final regulations --

For example, assets used in a chemical manufacturing activity are generally required to be included in Asset Class 28.0 of Rev. Proc. 87-56 and have a class life of 9.5 years. Included in this class are all assets used in the activity that are not included in the specific asset classes of 00.11 through 00.4. The asset class specifically includes land improvements associated with plant site or production processes. Accordingly, a chemical manufacturer would include its computerized production machinery in this asset class, as well as an effluent pond associated with the production process. The machinery would likely require maintenance more than once during the 9.5-year class life, while the effluent pond would likely not require maintenance more than once during that same class life. However, both assets would likely require routine and recurring maintenance several times during their actual economic useful lives.

As the above example illustrates, use of economic useful life rather than the ADS class life results in a more accurate determination of whether an expenditure is for routine maintenance. The AICPA understands that use of economic useful life would be more difficult to administer because of its subjective nature, and could result in the type of controversy the safe harbor is meant to eliminate. Accordingly, the AICPA suggests that the government use economic useful life as the standard, but provide objective rules for satisfying the standard for the various major categories of property (e.g., permit taxpayers to use the ADS class lives as a safe harbor). We further suggest that these rules be issued in administrative guidance so they can be readily revised to reflect changes in economic conditions.

The AICPA also recommends that the routine maintenance safe harbor explicitly state that it applies to real property, including buildings, as well as personal property. Currently the provisions do not limit the safe harbor to any type of property, but the examples provided include eight examples of the application of the safe harbor to personal property and only one example applying the safe harbor to real property. None of the examples involve the application of the safe harbor to a building. We believe that the inclusion of an example applying the safe harbor to a building such as the following should mitigate future controversy in this area:

I. Repair Allowance

The 2006 Proposed Regulations provided a mechanism for taxpayers to avoid some of the complexities inherent in this area of the tax law by including an elective repair allowance method similar to the class life asset depreciation range ("CLADR") repair allowance method. Upon making this election, the taxpayer deducts under section 162 amounts paid for materials and labor during the tax year to repair, maintain, or improve repair allowance property to the extent of the repair allowance amount. Amounts paid during the tax year in excess of the repair allowance amount must be capitalized. The repair allowance amount is determined separately for each MACRS class of property and is computed by multiplying the repair allowance percentage in effect for that class by the average unadjusted basis of repair allowance property in the same class. In addition, the taxpayer must apply somewhat complex rules with respect to excluded additions.

The repair allowance percentages provided in the 2006 Proposed Regulations equaled 100 percent divided by the MACRS recovery period for each class times 50 percent. For example, the proposed repair allowance percentage for 5-year property was 10 percent ((100 percent/5) times 50 percent). The proposed repair allowance percentage for nonresidential rental property was 1.28 percent ((100 percent/39) times 50 percent). Presumably, these percentages were chosen to approximate a repair allowance cap over the MACRS class life equal to 50 percent of the unadjusted original cost basis. This approach varies significantly from the repair allowance percentages provided under Rev. Proc. 83-35, 1983-1 C.B. 745, which afforded a higher percentage to some repair-intensive industries based upon economic analysis completed by Treasury's Office of Industrial Economics in the 1970s.

The repair allowance percentages greatly reduced controversy in industries where the CLADR repair allowance method was widely used. However, the CLADR repair allowance method cannot be elected for property placed in service after December 31, 1980. Therefore, the method continues to be utilized only in specific industries where long-lived property used and maintained today was originally placed in service under the old ADR cost recovery regime (e.g., electric utilities, gas utilities). The 2006 Proposed Regulations would have, in effect, reinstituted a modified version of the CLADR repair allowance method that could be elected with respect to MACRS property. However, as commentators noted, the repair allowance percentage in the proposed regulations resulted in such an understatement of repair costs that most taxpayers would be unlikely to elect the repair allowance method.

The current proposed regulations withdraw the repair allowance proposal on the basis that taxpayers would not widely use a "one-size-fits-all" approach and that any repair allowance must be tailored to individual industries. As an alternative, the proposed regulations provide authority for issuing industry-specific repair allowance guidance in the future.

The AICPA considers a meaningful repair allowance to be an important element in achieving IRS and Treasury's goal of ease of administration and reduction in controversy. Without including a repair allowance method in the final regulations, taxpayers will have to wait for several years before applicable industry groups are organized and can complete a collaborative process with Treasury and the IRS to draft industry specific guidance. This delay is unnecessary when a workable repair allowance can be adopted in the final regulations with provisions that would allow for future modifications as industries organize and make their case for more specific industry guidance.

The AICPA believes that the concern expressed by many commentators was not an aversion to a "one-size-fits-all approach", but rather was based upon the fact that the repair allowance percentages provided in the 2006 Proposed Regulations were significantly below the percentages provided under the ADR regulations. To address this concern, we suggest the final regulations include an elective repair allowance method utilizing the "one-divided-by-the-MACRS-class-life" methodology included in the 2006 Proposed Regulations without the 50 percent reduction.

Taxpayers in specific industries where the general guideline percentages provided in the final regulations are determined to be inadequate relative to actual experience should be encouraged to seek industry-specific relief from the IRS through the IIR program. Any changes the government deems appropriate may then be made in an update to Rev. Proc. 83-35, or supplemental industry specific guidance (e.g., administrative guidance such as a revenue procedure) issued under the authority provided in the final regulations.

The AICPA believes this approach addresses commentators' concerns regarding the need to update general repair allowance percentage guidelines currently based on old ADR class lives, while affording taxpayers a workable safe harbor that can be adopted at the same time as the final regulations.

J. Effective Dates/Method Changes

The proposed regulations do not provide specific rules for a change in accounting method to implement the new regulations. The preamble to the proposed regulations stipulates that a change in the taxpayer's treatment of an amount to conform to the regulation will be a change in accounting method under section 446(e). In the preamble, IRS and Treasury have requested specific comments regarding whether a change to or from the use of the de minimis rule in Prop. Reg. § 1.263(a)-2(d)(4) is a change in accounting method. The AICPA has comments on the following areas and believe these areas warrant further clarification from the IRS.

Effective Date

The regulations will be effective for tax years beginning on or after the date the final regulations are published in the Federal Register. Consistent with the effective dates in recently issued guidance such as the final regulations under section 263(a) for intangible property, the AICPA suggests that the final regulations be applicable to amounts paid or incurred on or after the date the final regulations are issued.

Section 481(a) Adjustment vs. Cut-off Method

For the reasons outlined below, the AICPA recommends that the final regulations be implemented with a section 481(a) adjustment. If, however, IRS and Treasury believe that a change in accounting method to comply with the final regulations should be implemented using a cut-off, then the AICPA recommends that taxpayers continue to be permitted to change their methods of accounting to comply with pre-effective date law for pre-effective date expenditures. To require taxpayers to change to the final regulations using a cut-off method (without audit protection) and to fail to permit taxpayers the opportunity to comply with pre-effective date law for pre-effective date expenditures, would be, in the AICPA's view, an abuse of discretion.

Generally, accounting methods are required to be implemented with a section 481(a) adjustment to ensure that there is no duplication or omission of income or expense and to mitigate distortions of income that result from an accounting method change. The section 481(a) adjustment is computed as of the first day of the year of change and is equal to the cumulative difference of accounting for the item under the taxpayer's present and proposed methods of accounting. A section 481(a) adjustment generally is computed without regard to whether the change is from a permissible or impermissible method, and without regard to whether the proposed method was available for use in years prior to the year of change.

Requiring taxpayers to implement these regulations using a cut-off (or modified cut-off based on costs incurred after a certain date) creates the potential for increased administrative burdens, increased controversy and examination adjustments related to pre-effective date expenditures, use of improper methods for pre-effective date expenditures, and disparate treatment of similarly situated taxpayers. For example, although the implementation of a change on a cut-off basis may provide administrative simplicity in the short-run, it can result in increased complexity in future years when additional method changes, voluntary or involuntary, are made with respect to the same costs. If a change to comply with the final regulations was made on a cut-off basis, costs capitalized and depreciated prior to the effective date of such regulations will continue to be accounted for under the prior method of accounting and costs incurred after the effective date of the final regulations will be accounted for under the new method of accounting. When making a subsequent change in method of accounting affecting the aggregate basis of the costs with a section 481(a) adjustment, a taxpayer would be required to take additional measures to account for the differences in basis in the assets placed in service before and after the effective date of the section 263(a) regulations. Moreover, requiring the implementation of a change to the final regulations on a cut-off basis would be punitive if a taxpayer overcapitalizes costs under its present method as compared to the proposed method. Finally, because under present law, changes from a method of capitalizing deductible repair costs are currently made with a section 481(a) adjustment, precluding taxpayers from making a virtually identical change after the effective date of the final regulations would result in disparate treatment between those taxpayers that change their methods prior to the issuance of final regulations and those filing after such date.

Despite the AICPA's recommendation that a change in method of accounting be made with a section 481(a) adjustment, the AICPA acknowledges that the computation of a section 481(a) adjustment in certain instances may present administrative challenges to taxpayers and recognizes that the IRS has applied the cut-off method in situations where the government believes it would be impractical to require taxpayers to analyze multiple years of transactions, and apply the new regulations to each transaction in order to compute the impact of converting to a new method of accounting.⁴ Examples of instances that may present challenges include the computation of a section 481(a) adjustment and accompanying basis adjustment for an expenditure erroneously capitalized as long-lived property as well as a taxpayer's lack of records for the year in which an expenditure was incurred. For example, a taxpayer may lack records to support the computation of a section 481(a) adjustment for a repair cost incurred 14 years ago that was erroneously capitalized and depreciated over 15 years.

Rather than require the use of the cutoff method, the AICPA recommends that the regulations provide reasonable section 481(a) adjustment estimation techniques or methodologies to alleviate potential administrative burdens. One reasonable section 481(a) adjustment estimation methodology that the AICPA suggests that IRS and Treasury consider is the section 481(a) estimation methodology provided in Treas. Reg. § 1.263A-7(c)(2)(v) (the 3-year average method). Moreover, to mitigate the potential for future controversy between taxpayers and Exam, the AICPA suggests that the final regulations specify the types of estimation techniques that may be used for this purpose. Whether these permissible estimation techniques are reasonable under a taxpayer's particular facts would remain within the purview of Exam. For example, the regulations should permit a taxpayer to use a multi-year revaluation factor to extrapolate the results of recent years to prior years. If Exam determines that the years used are not reasonably representative of prior years, Exam could require adjustments to those years, or could require that certain years be eliminated from the years used in computing the revaluation factor.

If, however, the IRS and Treasury determine that accounting method changes made to comply with the final regulations are made on a cut-off or modified cut-off basis, the AICPA believes that taxpayers should be permitted to change their methods of accounting to comply with pre-effective date law for pre-effective date expenditures. To require taxpayers to change to the new regulations using a cut-off basis and cease to afford taxpayers the opportunity to comply with pre-effective date law for pre-effective date expenditures, would require taxpayers using erroneous methods for such expenditures to continue to use such erroneous methods without the opportunity to change to a permissible method. In the AICPA's view, precluding a taxpayer from changing from an erroneous method to a permissible method would be an abuse of discretion.

Automatic Change

The AICPA recommends that the final regulations provide automatic consent for a taxpayer to change its method of accounting to comply with the final regulations. To obtain such automatic consent, the AICPA recommends that a taxpayer comply with the procedures under Rev. Proc. 2011-14. However, the AICPA believes that the scope limitations under Section 4.02 should be waived (except those applicable to an issue under consideration as defined in Section 3.09(1) of Rev. Proc. 2011-14), for the first taxable year following the issuance of the final regulations. The AICPA recommends that a taxpayer that has an issue under consideration as part of an IRS examination be precluded from receiving automatic consent to change its method of accounting to comply with the final regulations. However, as described in more detail below, the AICPA also recommends that an issue under consideration that complies with the final regulations should no longer be pursued by IRS exam. After the initial year, IRS and Treasury could assess whether the change to apply the regulations should continue to be made with automatic consent or whether advance consent is appropriate for such changes.

Audit Protection/Examination Activity

A taxpayer generally receives audit protection with respect to the accounting method that is the subject of the change request upon filing the request with the IRS National Office (or, if applicable, the Ogden, UT office). This audit protection is meant to encourage taxpayers to voluntarily change accounting methods so they are not faced with the IRS proposing an adjustment for items that predate the effective date of the change. The issue of audit protection is not specifically addressed in the proposed regulations but should be considered as part of the accounting method change. In order to promote voluntary compliance with the new regulations, the AICPA recommends that the method change provide for audit protection for methods used prior to the effective date of the regulations. Instituting the change with audit protection will encourage taxpayers to file method changes to comply with the final regulations. Allowing the change to be made with audit protection should also reduce the controversies related to the prior methods utilized by taxpayers. Without audit protection, taxpayers would risk the exposure of examination and the potential adjustment related to the capitalization of cost to acquire or create tangible property.

The proposed regulations also do not address what affect, if any, the final regulations will have on pending IRS examinations where capitalization of repair costs (or other items addressed in the final regulations) is an issue under consideration. The capitalization of costs to acquire, produce and improve property has been an area of controversy for several years, and has been designated a Tier I issue.⁵ In an effort to reduce the controversy related to issues addressed in the final regulations, the AICPA recommends to the extent that the issue under consideration relates to a method of accounting that is consistent with the rules in the final regulations, Exam no longer pursue the issue. In other similar situations, the government has agreed not to pursue an issue after the effective date of regulations that addressed the controversy. An example is the issuance of temporary regulations under section 446 during 2003. In a Chief Counsel Notice (CC 2004-007), the IRS stated that it would not litigate or assert that a change in computing depreciation resulting from the reclassification of property is a change in accounting method. The significance of that decision is once the issue had been settled through publication of the regulations, the issue was dropped as an area of focus for prior taxable years. It is the AICPA's recommendation that a similar approach be taken with the finalization of the regulations related to tangible property.

² Using one set of rules to determine the appropriate UOP is also, generally, consistent with the current automatic change in accounting method for retired assets where the IRS requires a taxpayer to state whether the proposed UOP for purposes of determining when an asset is retired is the same UOP used for purposes of determining when depreciation begins and ends or explain any difference. See Section 6.24(2)(b), 6.24(2)(d), 6.25(2)(b) and 6.25(2)(d) of the Appendix of Rev. Proc. 2011-14.

³ This basis adjustment prevents a "double deduction" by preventing a depreciation deduction under section 167 for the full basis of the unit of property.

⁴ For example, the IRS and Treasury provided for a modified cut-off basis for changes to implement the final regulations under section 263(a) addressing the capitalization of intangibles.

⁵ See http://www.irs.gov/businesses/article/0,,id=218751,00.html.