Firm Seeks Provision Under Bonus Regs for Cancellable Contracts

November 25, 2019

Courier's Desk
Commissioner of Internal Revenue
Internal Revenue Service
Attn: CC:PA:LPD:PR (Reg-106808-18)
1111 Constitution Avenue, NW
Washington, D.C. 20224

Re: Comments on Proposed Regulations under Section 168(k) Reg-106808-18

Dear Sir:

On September 24, 2019, the Treasury Department and the Internal Revenue Service published in the Federal Register proposed and final regulations under section 168(k) of the Internal Revenue Code (“Code”), with a request for comments from interested parties with respect to the proposed regulations.

We are hereby submitting comments on behalf of our clients in response to the request for comments in the proposed regulations. While the final regulations that accompany these proposed regulations also have implications for the subject we address in these comments, our comments mainly relate to one portion of the proposed regulations, namely, a new proposed rule relating to expenditures incurred by taxpayers pursuant to non-binding contracts. In connection with those proposed rules, our comments relate to the treatment of a particular type of non-binding contract.

1. Summary

We are submitting comments with respect to the proposed regulations under section 168(k) dealing with a specific type of contract that is cancelable at any time by the taxpayer/customer without penalty. Instead, under the terms of the contract, the taxpayer is required to reimburse the contractor only for the costs the contractor has incurred, plus the contractor's profit margin, prior to the contractor's receipt of a notice of cancellation from the taxpayer.

Our comments recommend that in these circumstances, the regulations should be clarified to provide that for purposes of the effective date provisions in section 168(k), the taxpayer's contract is bifurcated into a binding contract for the period prior to the effective date of the 100 percent bonus depreciation provisions in section 168(k) and a separate non-binding contract for the period subsequent to the effective date of the 100 percent bonus depreciation provisions in section 168(k). As a result, if more than 10 percent of the costs of the project are paid or incurred by the taxpayer prior to the effective date of the 100 percent bonus depreciation provisions in section 168(k), all the costs incurred prior to that effective date are ineligible for 100 percent bonus depreciation. However, all the costs of the project paid or incurred after the effective date of the 100 percent bonus depreciation provisions in section 168(k) would be eligible for 100 percent bonus depreciation.

Bifurcation of the contract in these circumstances is consistent with the underlying policy of the regulations, which is to permit 100 percent bonus depreciation to be claimed where a taxpayer could be viewed as having been motivated to incur any costs after the effective date by the enactment of the 100 percent bonus provisions. In the case of the type of cancelable contracts we are discussing, the taxpayer could avoid going forward with the contract in light of the enactment of the 100 percent bonus depreciation provisions.

2. Background

The Tax Cuts and Jobs Act (“the Act”) extended and modified the additional first-year bonus depreciation deduction rules under section 168(k) of the Code. Under the Act, the bonus depreciation percentage was increased to 100 percent for property that is acquired and placed in service during specified periods of time.

Section 13201(h)(1) of the Act provides that the Act's amendments to section 168(k) apply only to property that was acquired by the taxpayer after September 27, 2017 (“the effective date”), and that was placed in service after that date. Under this section of the Act, if property was acquired pursuant to a written binding contract, the property is considered to have been acquired on the date the written binding contract was entered into.

Thus, if property was acquired pursuant to a written binding contract that was entered into prior to the effective date, the property is wholly ineligible for 100 percent bonus depreciation. However, these statutory provisions provide no guidance regarding the acquisition date of property that is acquired pursuant to a non-binding contract.

On August 8, 2018, the IRS issued proposed regulations (“the original proposed regulations”) implementing section 13201(h)(1) of the Act. These original proposed regulations interpreted the effective date aspect of the foregoing statutory provision in the following manner.

While the effective date provisions of the Act relating to bonus depreciation do not contain rules relating to self-constructed property, section 168(k)(2)(E)(i) contains rules relating to self-constructed property in the context of the termination of the eligibility period for 100 percent bonus depreciation. The original proposed regulations borrowed these self-constructed property rules for purposes of the effective date rules relating to 100 percent bonus depreciation.

The section of the original proposed regulations dealing with self-constructed property provided that if property is considered to be self-constructed by the taxpayer for its own use, the acquisition rules concerning eligibility for 100 percent bonus depreciation are satisfied if the taxpayer begins construction of the property after the effective date. Former Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iv)(A). The original proposed regulations also provided a safe harbor rule for purposes of the self-constructed property rules under which the taxpayer could treat construction of the property as beginning at the time the taxpayer had incurred more than ten percent of the total cost of the property. Former Prop. Treas. Reg. §1.168(k)-2(b)(5)(iv)(B)(2). This safe harbor rule was modeled on a similar safe harbor rule in the previously existing bonus depreciation regulations.

Correspondingly, under the original proposed regulations, in the case where a taxpayer self-constructed property for its own use and began that construction prior to the effective date, taking into account the ten percent safe harbor rule, the property in its entirety was ineligible for 100 percent bonus depreciation. The original proposed regulations provided that property that is self-constructed by a taxpayer for its own use is in effect treated as having been acquired on the date the taxpayer begins production of the property, taking into account the ten percent safe harbor rule described above.

However, the sentence in the original proposed regulations immediately following the sentence stating the rule regarding self-constructed property in former Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iv)(A) provided that the preceding sentence (the self-constructed property rule) would not apply if another party produced property for the taxpayer pursuant to a written binding contract that was entered into prior to the production of the property. Thus, in effect, in the original proposed regulations, the written binding contract rule (under which the property is considered acquired on the date the contract is entered into) overrode the self-constructed property rule (under which the property is considered to have been acquired on the date the taxpayer begins production of the property, taking into account the ten percent safe harbor rule).

However, the original proposed regulations did not address the question of whether property that is produced by another party for the taxpayer pursuant to a non-binding contract is considered self-constructed by the taxpayer and thus, is subject to the rule that if construction of the property was begun prior to the effective date, taking into account the ten percent safe harbor rule, no portion of the cost of the property is eligible for 100 percent bonus depreciation. In addition, the original proposed regulations did not address the question of when property produced for the taxpayer by another party under a non-binding contract is considered to have been acquired by the taxpayer, for purposes of the effective date provisions in section 168(k), if such property is not considered to be self-constructed by the taxpayer.

The original proposed regulations were not alone in failing to address the issue of the treatment of property that is produced for the taxpayer by another party pursuant to a non-binding contract. The previously issued regulations that applied to bonus depreciation for property acquired during eligibility periods before the period created by the Act likewise did not address this issue.

As noted earlier, final regulations under the 100 percent bonus depreciation provisions were published in the Federal Register on September 24, 2019. These final regulations modified the rules in the original proposed regulations dealing with property that is produced for a taxpayer by another party pursuant to a written binding contract. The preamble to the final regulations explains that change as follows:

The August Proposed Regulations also provide that property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into prior to the manufacture, construction, or production of the property for use by the taxpayer in its trade or business or for its production of income is acquired pursuant to a written binding contract. Many commentators disagreed with this position because it is not supported by the legislative history of section 13201 of the Act, it is a departure from the self-constructed property rules in § 1.168(k)-1(b)(4)(iii) and it is administratively burdensome. The Treasury Department and the IRS have reconsidered their decision. Accordingly, §1.168(k)-2(b)(5)(ii)(A) and (b)(5)(iv) of the final regulations provide that property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into prior to the manufacture, construction or production of the property for use in its trade or business or for the production of income is not acquired pursuant to a written binding contract but is self-constructed property.

84 Fed. Reg. 50116 (Sep. 24, 2019).

In addition, the final regulations retained the ten percent elective safe harbor for determining when production begins in the case of self-constructed property that had been included in the original proposed regulations. Under this safe harbor, the production of self-constructed property may be treated as beginning when more than ten percent of the total cost of the property, excluding the cost of any land and preliminary activities, has been paid or incurred by the taxpayer. Treas. Reg. § 1.168(k)-2(d)(3)(ii)(B), Examples of preliminary activities for this purpose include planning, design, securing financing, exploring or researching. Id. This elective safe harbor provision is favorable to taxpayers, since it potentially enables a taxpayer to qualify for 100 percent bonus depreciation with respect to self-constructed property if construction costs incurred before the effective date do not exceed ten percent of the total cost of the property.

As in the case of the original proposed regulations, these final regulations do not address the issue of whether property produced by another party for a taxpayer pursuant to a non-binding contract is subject to the self-constructed property rules, and if such property is not subject to the self-constructed property rules, what rules do apply in determining when such property is considered to have been acquired for purposes of the effective date provisions in the 100 percent bonus depreciation provisions. However, one of the significant provisions in the new proposed regulations is that for the first time in regulations under the bonus depreciation regime, these proposed regulations address the treatment of property that is produced for the taxpayer by another party pursuant to a non-binding contract.

The new proposed regulations do not treat property that is produced for a taxpayer by another party pursuant to a non-binding contract as being self-constructed by the taxpayer, but the new proposed regulations instead provide that the ten percent safe harbor rule that is optional in the case of self-constructed property is required to be followed in the case of property that is produced for a taxpayer by another party under a non-binding contract. Prop. Treas. Reg. § 1.168(k)-2(b)(5)(v). Thus, property that is produced for the taxpayer by another party pursuant to a non-binding contract is considered to have been acquired on the date when the costs of construction exceed ten percent of the total cost of the property.

3. Potential application of the rule in the proposed regulations to a particular type of non-binding contract

As a general proposition, we have no objection to the rule in the final regulations that treats property that is produced for the taxpayer by another party in a manner that is similar to property that is self-constructed by the taxpayer for its own use. This includes property that is produced for the taxpayer by another party pursuant to a binding contract and is treated as self-constructed property under the rules in the final regulations. Under the rules in the final regulations, the use of a ten percent rule for determining when construction begins is made mandatory for property that is produced pursuant to a non-binding contract, rather than being optional as in the case of self-constructed property. After all, the ten percent safe harbor rule is generally favorable to taxpayers. Thus, for many taxpayers with non-binding contracts, the foregoing rule in the proposed regulations reaches a result that is both fair and reasonable.

However, it should be apparent that a taxpayer that has entered into a non-binding contract is not in the same legal or economic position as a taxpayer that has entered into a binding contract. A taxpayer that entered into a binding contract for the construction of property prior to the effective date for 100 percent bonus depreciation, and incurred more than ten percent of the total cost of the property before the effective date, obviously undertook the project without relying on the expectation that the taxpayer would be entitled to 100 percent bonus depreciation with respect to the property resulting from the project. In these circumstances, it is understandable that 100 percent bonus depreciation would not be permitted with respect to the property constructed pursuant to such a contract.

In contrast, in a situation where a taxpayer entered into a non-binding contract for the construction of property prior to the effective date for 100 percent bonus depreciation, and incurred ten percent of the property's cost before the effective date, the taxpayer could cancel the nonbinding contract at any time prior to the effective date without penalty and undertake a different but similar project after the effective date. In that case, the taxpayer should be in no different position than a taxpayer that first enters into a binding contract for the construction of property after the effective date for 100 percent bonus depreciation.

We represent clients that have entered into a particular type of contract that resembles the foregoing situation. In our clients' type of situation, they have entered into contracts that provide for the construction of property for the taxpayer by another party, but the clients have the right to cancel the contract at any time by giving notice of cancellation to the contractor. In the event the client provides a notice of cancellation to the contractor, the client is obligated to pay only for the work that has been done prior to the date of the notice of cancellation (including the contractor's profit margin on such work), but the client is not liable for any type of penalty or damages relating to future work that will not be performed by the contractor, and potential future profits that will not be earned by the contractor, as a result of the cancellation.

Under the definition of a binding contract in the final regulations, the type of contract described above, if viewed in its entirety as one agreement, would not be considered a binding contract for two reasons. First, this type of contract limits damages to costs incurred prior to the date of notification of cancellation of the contract by the customer. Treas. Reg. § 1.168(k)-2(b)(5)(iii)(A). Second, this type of contract would be viewed as subject to a condition that is under the customer's control. Treas. Reg. § 1.168(k)-2(b)(5)(iii)(B).

However, because the customer in such an agreement is unconditionally obligated to pay the contractor for costs incurred, plus a profit with respect to work performed, before any notice of cancellation is provided to the contractor by the customer, we believe that in this type of situation, the agreement between our clients and their contractors should be viewed as if the agreement consists of two separate contracts — one binding contract and one non-binding contract. The first contract is a binding contract that obligates the client to pay for any work performed by the contractor prior to the date of a notice of cancellation, and the second contract is a separate non-binding agreement for future work that becomes binding only when future work is performed in the absence of a notice of cancellation by the customer.

The way this analysis of the agreement would interact with the eligibility rules for 100 percent bonus depreciation is as follows. If the agreement between the client and the contractor were entered into prior to the effective date for 100 percent bonus depreciation (September 28, 2017), the customer would not be entitled to 100 percent bonus depreciation with respect to any of the costs that were incurred by the contractor prior to September 28, 2017. However, in the case of costs incurred by the contractor after September 27, 2017, those costs would be considered to be incurred pursuant to one or more binding contracts that are entered into as the work is performed by the contractor after September 27, 2017, and thus, these costs would be eligible for 100 percent bonus depreciation.

We believe the new provisions in the final regulations relating to written contracts that are not binding contracts on the date the contract is entered into, but that become binding contracts at a later date, provide support for the treatment of our clients' contracts that is described above. The preamble to the final regulations described these new provisions as follows:

The August Proposed Regulations also provide that if the written binding contract states the date on which the contract was entered into and a closing date, delivery date, or other similar date, the date on which the contract was entered into is the date the taxpayer acquired the property. The Treasury Department and the IRS are aware that some contracts are not binding contracts on the date the contract is entered into (for example, due to a contingency clause). Accordingly, § 1.168(k)-2(b)(5)(ii)(B) of the final regulations provides that the acquisition date of property that the taxpayer acquired pursuant to a written binding contract is the later of (1) the date on which the contract was entered into; (2) the date on which the contract is enforceable under State law; (3) if the contract has one or more cancellation periods, the date on which all cancellation periods end; or (4) if the contract has one or more contingency clauses, the date on which all conditions subject to such clauses are satisfied. For this purpose, a cancellation period is the number of days stated in the contract for any party to cancel the contract without penalty, and a contingency clause is one that provides for a condition (or conditions) or action (or actions) that is within the control of any party or a predecessor.

84 Fed. Reg. at 50116. Since the text of the rule in the final regulations themselves is essentially identical to the description above, we will not quote that rule.

The foregoing rules relating to contracts that are not binding on the date they are entered into but that become binding on a later date are not directly applicable to the types of contracts of our clients that we have described above because of the rule in the final regulations that treats property that is produced for a taxpayer by another party under a written binding contract as being subject to the self-constructed property rules rather than the written binding contract rules. Nevertheless, we believe the policy analysis that is reflected in these rules represents a very similar policy analysis to what we have described with respect to our clients' contracts.

In particular, the portions of the foregoing rules relating to cancellation periods and contingency clauses represent concepts that are very similar to the aspects of our clients' contracts that we have focused on in the discussion in this comment letter. The fact that under these rules, in the case of contracts that contain cancellation periods or contingency clauses, the contract is not treated as becoming a binding contract until all the cancellation periods have expired or all the contingencies have been satisfied represents a very similar policy analysis to the policy analysis we have presented with respect to our clients' contracts.

Under the foregoing rules, the fact that one of the parties has the right to cancel the contract without penalty, as is the case with our clients' contracts, is treated as a very relevant fact for purposes of applying the rules relating to the effective date of the 100 percent bonus depreciation provisions. Under the foregoing rules, the expiration of cancellation periods without the cancellation right having been exercised is treated as a significant event in determining when the property the contract relates to is acquired, just as in the case of our analysis of how our clients' contracts should be treated under the effective date rules for the 100 percent bonus depreciation provisions. Thus, while the foregoing rules are not directly applicable to our clients' contracts for the reason identified above, nevertheless, we believe the foregoing rules provide strong support for the analysis and tax treatment we propose with respect to our clients' contracts.

The analysis we have presented for our clients' contracts is consistent with the longstanding policy underlying the rules governing a taxpayer's eligibility for bonus depreciation. This policy is based on the premise that bonus depreciation is intended to incentivize taxpayers to increase their capital investments over and above the level of capital investments the taxpayer had planned to undertake in the absence of the bonus depreciation provisions.

Since it is not feasible to subjectively evaluate each taxpayer's motivation for making particular capital investments, Congress has adopted the long-standing approach of evaluating a taxpayer's intent with respect to particular capital investments by focusing on the date these investments were made. Thus, if a taxpayer entered into a binding written contract to purchase property prior to the effective date of particular bonus depreciation provisions, or the taxpayer began to self-construct property for its own use before the effective date of particular bonus depreciation provisions, then it is assumed that the taxpayer's investment decision was not motivated by the bonus depreciation provisions, and, therefore, the taxpayer's capital investment should not be eligible for bonus depreciation.

Evaluating our clients' intentions under the foregoing policy, it is clear that since our clients' contracts are binding only if they are not cancelled, our clients would be free to cancel any existing contracts entered into prior to the effective date for 100 percent bonus depreciation and then undertake separate but similar projects after the effective date. Under such an arrangement, our clients' continued participation in existing contracts entered into prior to September 28, 2017, should be viewed as resulting from the decision by the clients to continue incurring costs after September 27, 2017, with the expectation that construction costs incurred after September 27, 2017, would qualify for 100 percent bonus depreciation but that construction costs incurred prior to September 28, 2017, would not qualify. Otherwise, our clients would cancel their existing contracts at no penalty and enter into entirely new contracts after the effective date for separate but similar projects that would be eligible for 100 percent bonus depreciation. That is the principal reason why eligibility rules should differ for binding and non-binding contracts.

This disparity in result between binding and non-binding contracts is similar to the tax treatment for purposes of bonus depreciation that applies in an analogous situation, where a taxpayer enters into a supply agreement with a supplier of goods. In that situation, a supplier agrees to provide specified types of goods to a customer at a specified price agreed to by the parties, but the master supply agreement does not obligate either party to purchase or sell any specific quantity of goods.

Instead, the supply agreement requires the customer to provide the supplier with a specific purchase order for a particular quantity of goods in order for the supplier to be obligated to provide the goods to the customer. In that type of supply arrangement, the final regulations make clear that the supply agreement itself is not a written binding contract. Treas. Reg. § 1.168(k)-2(b)(5)(iii)(E). However, this provision also makes clear that particular purchase orders pursuant to such a supply agreement will be considered written binding contracts if the purchase order specifies the particular type of goods to be provided, the quantity of goods to be provided, and the unit price of the goods to be provided. The rules relating to supply agreements are illustrated by three examples in the final regulations.

The supply agreement rules in the final regulations and the three examples illustrating the supply agreement rules make clear that the way supply agreements are treated under section 168(k) is that if the supply agreement were entered into prior to September 28, 2017, and that agreement included a purchase order for 100 units of a particular type of good that was regularly stocked by the supplier, none of the cost of the 100 units would be eligible for 100 percent bonus depreciation. However, if a second purchase order for 200 units of the same type of goods under the existing supply agreement were entered into after September 27, 2017, all of the costs of those 200 units would be eligible for 100 percent bonus depreciation, assuming all the other requirements for bonus depreciation were satisfied, notwithstanding that the supply agreement itself was entered into prior to September 28, 2017.

We submit that our clients are in the same economic and legal position as the taxpayers in the foregoing situation. Thus, in our clients' case, the costs incurred by the contractor prior to September 28, 2017, would be considered incurred incident to a written binding contract with our clients entered into prior to September 28, 2017, with respect to pre-September 28, 2017, work, and thus would not be eligible for 100 percent bonus depreciation. In contrast, costs incurred by the contractor after September 27, 2017, would be considered incurred incident to a separate written contract that was entered into after September 27, 2017, and thus would be eligible for 100 percent bonus depreciation with respect to costs incurred after September 27, 2017.

One potential objection the IRS and the Treasury might raise with respect to the foregoing approach is that this approach represents an exception to the general approach in the section 168(k) regulations that the eligibility of property for bonus depreciation is normally determined on an all-or-nothing basis, not by allocating costs within one property between eligible and ineligible components. However, in response to such an objection, it should be noted that while all-or-nothing eligibility is the most common approach for determining a property's eligibility for bonus depreciation under section 168(k), an all-or-nothing approach is not the exclusive approach to determining a property's eligibility for bonus depreciation.

For example, the Treasury and the IRS themselves, in section 3.02(2)(b) of Rev. Proc. 2011-26, 2011-16 I.R.B. 664, permitted eligibility for bonus depreciation under the pre-2017 rules to be determined separately for components of a larger unit of self-constructed property that itself was ineligible for bonus depreciation. Thus, under this approach, a portion of the cost of the property was eligible for bonus depreciation and the remainder of the cost of the property was not eligible for bonus depreciation.

Moreover, this type of selective eligibility for bonus depreciation for components of a larger unit of self-constructed property that does not qualify in its entirety for bonus depreciation would be extended to components of certain self-constructed property under the new proposed regulations covering 100 percent bonus depreciation. Thus, under Prop. Treas. Reg. § 1.168(k)-2(c), a portion of the cost of self-constructed property (namely, components of a larger unit of self-constructed property) might be eligible for 100 percent bonus depreciation, whereas the balance of the cost of the self-constructed property would not be eligible for 100 percent bonus depreciation.

While our clients' properties are not eligible for this component election, we mention this election as an example of a situation where part of a cost of property would be eligible for 100 percent bonus depreciation, but the remainder of the cost of the property would be ineligible for 100 percent bonus depreciation. Accordingly, the fact that under our proposed treatment of our clients' situations, part of the cost of the property would be eligible for 100 percent bonus depreciation, and the remainder of the cost of the property would not be eligible for 100 percent bonus depreciation, should not present an obstacle to the approach we are proposing.

In conclusion, we propose that the IRS and the Treasury modify the proposed regulations when they are finalized by including a provision that addresses the type of cancellable contract we have described in the manner we have proposed. It would be useful to have an example that covers this type of fact pattern. A suggested example is as follows.

Example. X Corp. entered into a contract with contractor Y Corp for the construction of a facility to be used in X's trade or business. The contract was entered into on September 1, 2017. Under the terms of the contract, X has the right to cancel the contract at any time by giving notice of cancellation to Y. If the project is canceled, X Corp. is entitled to retain the work-in-progress up to the date of cancellation. Upon the receipt of a notice of cancellation of the contract, Y is required to discontinue any further work on the facility and may bill X for the costs incurred by Y, plus a 15 percent profit margin, up to the point in time when the notice of cancellation from X was received by Y.

Assume that Y incurs $200X of costs constructing the facility prior to September 28, 2017. Assume that Y incurs $800X of costs after September 27, 2017 to complete construction of the facility. Y bills X for the entire $l,000X amount of the costs plus the 15 percent profit margin in 2018. X places the facility in service on August 15, 2018. Under these facts, X may treat $800X of costs plus a 15 percent profit margin as eligible for 100 percent bonus depreciation, but the $200X of costs plus a 15 percent profit margin incurred before September 28, 2017, are not eligible for 100 percent bonus depreciation.

If you have any questions about this comment letter or would like to discuss any of the comments further, please feel free to contact either of the undersigned at (202) 393-7600.

Respectfully submitted,

Leslie J. Schneider

Patrick J. Smith
Ivins Phillips Barker Chartered
Washington, DC

Cc:
John Moriarty, Associate Chief Counsel (IT&A), IRS
Kathleen Reed, Branch Chief, Br. 07, Office of Associate Chief Counsel (IT&A), IRS
Elizabeth R. Binder, Br. 07, Office of Associate Chief Counsel (IT&A), IRS
Ellen Martin, Office of Tax Legislative Counsel, U.S. Treasury Dept.
Wendy Friese, Office of Tax Legislative Counsel, U.S. Treasury Dept.