KPMG Comments on 'Repair' Regs Target De Minimis Rule, Improvement Standards

Dear Sir/Madam:

On behalf of KPMG LLP,¹ we are pleased to provide comments on the proposed regulations under Section 263(a) relating to capitalization and deduction of expenditures related to tangible property (the "proposed regulations").

Although KPMG represents a wide range of clients in various industries that will be affected by the proposed regulations, we are not submitting our comments on behalf of any particular client. Rather, our comments focus on the implications of the proposed regulations with respect to taxpayers in general.

The proposed regulations were issued on December 27, 2011, along with temporary regulations that are effective for tax years beginning on or after January 1, 2012.² We believe that in general the proposed regulations, although lengthy and complex, are fundamentally workable and are an important step towards decreasing the uncertainty and controversy in this area. The purpose of this letter is to highlight certain aspects of the proposed rules that may lead to unintended consequences and to recommend modifications to the rules that address these issues. Our comments focus on three principal areas: (i) the proposed de minimis rule; (ii) the proposed improvement standards, including the routine maintenance safe harbor as well as the treatment of store "refreshes"; and (iii) the proposed "optional method" for rotable and temporary spare parts.

We appreciate the efforts of the Treasury Department and the Internal Revenue Service in attempting to provide clearer guidelines in what unquestionably is an inherently factual and complex area of the tax law. In that regard, we hope that our comments will be helpful in finalizing the proposed regulations.

I. De Minimis Rule

The proposed regulations provide a de minimis expensing rule that permits a current deduction for otherwise capital expenditures if: (1) the taxpayer has an applicable financial statement ("AFS"); (2) the taxpayer has a written accounting policy as of the beginning of the taxable year that expenses (for non-tax purposes) amounts paid for property that costs less than a specified dollar amount; (3) the taxpayer treats the amounts as expenses on its AFS in accordance with its written policy; and (4) the aggregate tax deduction does not exceed the greater of 0.1 percent of the taxpayer's gross receipts for federal income tax purposes, or 2 percent of the taxpayer's depreciation and amortization expense as determined in its AFS (the "ceiling"). The proposed regulations provide that if the taxpayer is a member of an affiliated group that files a consolidated U.S. federal income tax return (a "Consolidated Group") and the member's financial results are reported on the AFS for the Consolidated Group, then the written accounting procedures used for the Consolidated Group's AFS may be treated as the written accounting procedures of the member.

We have discussed the de minimis rule with hundreds of companies since the issuance of the regulations, and our comments in this regard reflect input from a wide variety of taxpayers and industries. We support the use of a taxpayer's financial reporting minimum capitalization policy as the starting point for determining the expenses that may be deducted under the de minimis rule. Almost every company that we talked to uses a book minimum capitalization policy under which the costs of immaterial items that fall below a certain threshold (for example, $3,000) are expensed for financial reporting purposes. However, based on our discussions with these companies, we have several suggested changes to the de minimis rule.

First, we recommend that the ceiling limitation be removed from the de minimis rule. Nearly all companies that we talked to are very concerned with the practical aspects of complying with the aggregate ceiling limitation imposed by the rule. In addition to acquisitions of property, these companies often expense repair and maintenance costs, labor costs, and materials and supplies under their book minimum capitalization policies. These costs are often grouped together in numerous (sometimes hundreds) of general ledger expense accounts. The ceiling will require taxpayers to spend countless hours and resources to determine the portion of the expenses in these accounts that relate to acquisitions of tangible property and therefore count towards the ceiling. The ceiling will therefore force taxpayers to track down thousands of journal entries or invoices that are likely not maintained because the amounts are treated as immaterial for financial reporting purposes. In addition, the ceiling will require taxpayers to create "tax-only" depreciable accounts for acquisitions of property that are in excess of the ceiling and therefore cannot be deducted in the year purchased. Moreover, taxpayers cannot readily provide this information to examining agents if requested on examination.

The preamble states that the use of a ceiling provides an objective and administrable limit on a taxpayer's total de minimis expense deduction and does not require an independent analysis to determine whether the amount clearly reflects the taxpayer's income. Although we understand the government's concern that strict conformity with the financial accounting treatment, without the imposition of a ceiling, at least theoretically might be susceptible to manipulation, we believe that as a practical matter this risk is extremely remote. Instead, we believe that the requirement to conform with the AFS, coupled with the clear reflection of income standard under Section 446, provides an effective backstop against abuse. In the vast majority of cases, it would not be feasible, nor would a taxpayer desire, to adjust minimum capitalization thresholds for purposes of increasing aggregate AFS deductions solely to increase tax deductions.

For these reasons, we recommend that the regulations, when finalized, retain the AFS-based de minimis rule but remove the ceiling limitation from the rule. In order to provide more transparency and enable the Service to monitor the application of the rule, the Service could require, either in the regulations or administrative guidance, that a taxpayer attach an election statement in the year in which a de minimis threshold is established, and require a change in method of accounting in the year that the AFS threshold increases or is changed.

If the ceiling is not removed, we submit that the regulations should clarify that the ceiling may be applied to a group of entities that file a single AFS (an "AFS Group") as a whole (whether or not a Consolidated Group), and should be based on the combined gross receipts or depreciation and amortization expenses of all members of the AFS Group. Requiring that members of an AFS Group calculate their ceiling based on their individual items would pose a significant administrative challenge to taxpayers even above that which the existence of a ceiling generally poses. Generally, financial data for an AFS is not always collected on a separate member basis. As noted above, the preamble indicates the ceiling was intended to be an administrable limit on a taxpayer's total de minimis expense deduction. This intention would be thwarted if members of an AFS Group are required to calculate their ceiling based on their individual items, which generally will not have been separately determined in connection with the AFS, and, therefore, will require taxpayers to track down information that is not readily available.³ It is important to emphasize, however, that even if this recommendation is adopted in the final regulations it would not resolve the practical problem of having to isolate the accounts and properties that are subject to the ceiling.

In addition to the concerns raised above, the presence of a ceiling may be difficult to reconcile with the intent of the regulations as expressed in the preamble, which indicates that the intent of IRS and Treasury is to allow taxpayers to deduct amounts in excess of the ceiling if they are subject to a prior agreement with the taxpayer's exam team. Although the IRS and Treasury evidently did not intend to impose a ceiling in these cases, the plain language of the regulations is difficult to reconcile with this intent. Another question posed by the discussion in the preamble is whether the intent of the discussion is to relax the application of the ceiling overall, and permit new agreements for amounts in excess of the ceiling, or only to grandfather existing agreements with exam. Thus, if an absolute ceiling is retained, it would be helpful for the government to clarify within the final regulations that taxpayers may continue to rely on other administrative practices applying a de minimis rule that clearly reflects income.

Finally, we do not believe the provision that allows a member of a Consolidated Group to treat the written accounting procedures used by the Consolidated Group's AFS adequately addresses the apparent intent of the provision. Presumably, this provision was intended to address a situation where individual members of a group may not have their own procedures. By limiting the provision to Consolidated Groups, however, the provision fails to address a situation in which the members of an AFS Group are not in a single Consolidated Group. It is likely that entities in an AFS Group likewise will not have their own procedures, yet they are not covered in the proposed regulations provision. Therefore, we believe this provision in 1.263(a)-2T(g)(7) should be expanded to provide that if the taxpayer is a member of an AFS Group and the member's financial results are reported on the AFS for the AFS Group, then the written accounting procedures used for the AFS Group's AFS may be treated as the written accounting procedures of the member.

II. Improvement Standards

The routine maintenance safe harbor provides that a taxpayer may deduct the costs of recurring activities that a taxpayer expects to perform more than once during a unit of property's ADS class life as a result of the taxpayer's use of the unit to keep it in its ordinarily efficient operating condition. The routine maintenance safe harbor provides an exception to the rebuild to like-new condition and replacement of major component restoration standards but cannot be used with respect to betterments or to work performed on buildings and structural components.

We recommend that, in order to be consistent with prior law, the regulations permit the use of the routine maintenance safe harbor on building property. Because the improvement standards under the proposed regulations must now be applied to each building system and the building structure separately, as opposed to the entire building, the smaller components are now more analogous to the Section 1245 property examples in which the routine maintenance safe harbor is permitted as an exception to the major component or substantial structural part rule. Clearly, routine maintenance activities are performed on building systems such as HVACs, escalators and elevators, and plumbing in order to keep them in ordinarily efficient operating condition. It seems inequitable to require a retailer, for example, to capitalize the cost of replacing a sink, toilet, and faucet due to ordinary wear and tear, but to allow an owner of plant property to currently deduct the cost of major components or replacement parts installed as part of routine maintenance activities. If the government is concerned that the ADS class life of building property is too long for purposes of determining whether an activity is expected to be performed more than once, we suggest that a shorter period, such as 20 years, be used in applying the safe harbor on building property.

Our final recommendation with respect to the restoration standards relates to the replacement of major components or substantial structural parts. This rule changed significantly from the 2008 regulations in that it is no longer based on a bright-line test, but rather, is more subjective. The 2008 regulations defined "major component or substantial structural part" as a part (or combination of parts) the cost of which comprised 50 percent or more of the replacement cost of the unit of property or the replacement of which comprised 50 percent or more of the physical structure of the unit of property; however, the amount was not required to be capitalized as a restoration if it was paid during the recovery period prescribed in Section 168(c).

The preamble to the proposed regulations explains that the 50 percent thresholds and recovery period limitation, although objective, were inconsistent with existing authority and would have led to deductions for amounts that would have been capital under the case law and rulings in this area. Treasury and the IRS seem to have reached this conclusion in part because under the 2008 regulations the unit of property encompassed the entire building, including all the structural components and building systems. Given that under the proposed regulations the improvement standards now are applied separately to the eight "building systems" and to the "building structure" as opposed to the entire building, the application of a bright-line rule to the smaller component would not appear to raise the same concerns.

Therefore, we suggest that the 50 percent thresholds from the 2008 regulations be included in the final regulations as part of the definition of what constitutes the replacement of a major component or substantial structural part of a unit (possibly as a safe harbor), but instead be applied to the individual building system or structure to coincide with the requirement to apply the restoration standards to a smaller unit of property. For example, with respect to building systems such as HVAC units, capitalization would be required where 50 percent or more of the HVAC system is replaced or the repair costs are more than 50 percent of the cost of replacing the HVAC system. With respect to the building structure, the examples in the temporary regulations indicate that the major component test is measured by reference to the components of the building structure rather than the entire structure itself (for example, windows, floors, or roof). We recommend that: (1) the thresholds for determining capitalization in those examples be raised to reflect the fact that the unit of property is the entire building structure and not just the individual components, and (2) the regulations include a 50 percent test or safe harbor for the building structure as a more clear and administrable standard than the facts and circumstances standard.

The proposed regulations did not incorporate one commentator's suggestion to provide a per se exception for minor costs incurred with respect to routine building refreshes and remodels; rather, they expand on the examples provided in the 2008 regulations, and include additional examples addressing the refreshing and remodeling of retail buildings. The preamble to the proposed regulations notes that the application of a per se exception to capitalization for costs incurred as part of a recurring store refresh or remodel would be inappropriate, for example, in situations where a taxpayer performs major structural work on the building during a refresh or remodel.

We recognize that the treatment of retail store remodels and refreshes is one of the most difficult areas to resolve through regulations due to the highly factual nature of the inquiry. We appreciate the government's attempt to provide clarity through the issuance of additional examples related to retail store remodels. Notwithstanding the additional examples, however, we are aware that a significant number of retail taxpayers are very frustrated with the analysis contained in the new examples and with the lack of a bright-line, objective rule for the treatment of retail store remodels or refreshes. As discussed above, we believe that the application of the routine maintenance safe harbor to building property would be helpful in reducing the controversy that these new examples may create with respect to replacing major components. In addition, we urge the IRS and Treasury to work with the retail industry through the Industry Issue Resolution Program to develop safe harbors that may be more easily applied to these fact patterns.

III. Rotable and Temporary Spare Parts

The proposed regulations provide an "optional method" of accounting for rotable and temporary spare parts ("rotables") that may be elected in place of the default method of deducting the cost of the rotables when disposed of. Unlike the annual election to selectively capitalize and depreciate the cost of other materials and supplies on a property-by-property basis, a taxpayer who chooses to use the optional method must apply that method to all rotables in a trade or business. The taxpayer may, however, elect to apply the de minimis rule, selectively, where the optional method is used. Thus, under the proposed regulations, taxpayers have the choice to use (1) the optional method, if elected for all rotables, while applying the de minimis rule selectively, or (2) the default method of deducting such parts only upon final disposition, while preserving the ability to elect, on a property-by-property basis, to capitalize and depreciate, or apply the de minimis rule.

We recommend that the final regulations remove the requirement that the optional method must be applied to all rotables in a trade or business, both to provide more parity with the treatment of other materials and supplies generally and to prevent taxpayers from being forced to use the default method as the general method to retain the flexibility to capitalize and depreciate rotables. Moreover, for tax purposes, most companies want to follow their GAAP treatment for rotables under which no such limitation exists.

We also recommend that the final regulations provide a rule that would allow a taxpayer using the optional method to accelerate the recovery of the remaining adjusted basis, if any, of any part that is exchanged for a rotable part in circumstances where the removed part did not originate from the rotable pool. For example, if the removed part had been installed on the unit at the time the unit was first place in service, then that part would have been subject to a depreciation method, which would be inconsistent with the optional method. To maintain consistency within the optional method, the remaining adjusted basis of such a part should be deducted at the time it is removed and repaired.

IV. Conclusion

We appreciate your consideration of our comments and concerns described herein. If you have any questions or would like to discuss this letter, please do not hesitate to contact any of the authors at the numbers listed below.

² T.D. 9564, 76 Fed. Reg. 81060 (December 27, 2011).

³ Of course, if the members of the AFS Group file more than one tax return, the aggregate benefit of the ceiling should not exceed the amount deductible if the members were a single entity or a Consolidated Group. Thus, if the aggregate approach is adopted, members of an AFS Group that file more than one tax return should be eligible for an aggregate ceiling only if they elect to apply the ceiling at the AFS Group level, and agree to an allocation of the AFS Group ceiling to members of the AFS Group. For example, if P and S together file an AFS and, calculated based on their individual items, the ceiling for P would be $50 and the ceiling for S would be $50, we believe the ceiling for P and S together should be $100. If P and S file separate U.S. federal income tax returns, to be eligible to make the election to apply a combined ceiling, they would have to enter into an agreement whereby (i) P claims all $100 of the ceiling and S claims $0, (ii) S claims the full $100 ceiling and P claims $0; (iii) P and S each claim $50 of the ceiling; or (iv) some other allocation between P and S wherein P and S together are limited to the $100 ceiling. We acknowledge that this allocation requirement could undermine the aim of applying the ceiling at the AFS Group-level (i.e., easing the administrative burden of AFS Group members that do not track their individual attributes) in certain cases. For example, if the aggregate tax deduction for an AFS Group that files separate returns exceeds the AFS Group's ceiling, the members may still have to determine their individual items in order to allocate the ceiling. However, we believe applying the ceiling on an AFS Group-level will limit the administrative burden to the greatest extent possible short of removing the ceiling entirely (which, as noted above, is our primary recommendation).