Contractors Seek Changes to Manufacturing Deduction Rules

We respectfully submit the following comments for your consideration on behalf of the Association of General Contractors of America (AGC). AGC is the leading association in the construction industry, representing nearly 30,000 leading firms. AGC members are engaged in all forms of nonresidential construction and consist primarily of small businesses with the vast majority of our members (typically more than 70 percent) organized as pass-through entities.

Our comments regard a Notice of Proposed Rulemaking [REG-136459-09] dated August 27, 2015, in which the Department of Treasury ("Treasury") and Internal Revenue Service ("IRS") issued proposed regulations under Section 199 impacting taxpayers engaged in engineering and construction ("E&C") activities.

Specifically, the following comments address the definition of "substantial renovation" in Prop. Treas. Reg. § 1.199-3(m)(5), which indicates that activities constitute substantial renovation where they would be a capitalizable improvement under Section 263(a).

We believe the proposed definition does not comport with the broad test for qualification of construction activities under Treas. Reg. § 1.199-3(m) and would not be administrable. Therefore, we recommend Treasury and the IRS retain the current definition of substantial renovation or implement our suggested changes to the proposed definition of substantial renovation as described herein.

We believe these modifications are necessary to allow taxpayers to evidence construction activities reasonably and prevent a significant increase in future controversies between taxpayers and the IRS.

We appreciate your attention to these comments, and welcome the opportunity to meet with you. If, after reviewing this letter, you have any questions or require additional information before the hearing, please do not hesitate to contact me at 571-214-8071.

The proposed regulations under Section 199¹ uniquely affect members of the AGC, as they engage in significant E&C activities including the construction of real property. The proposed regulations² specifically revise the meaning of "substantial renovation" in Treas. Reg. § 1.199-3(m)(5) to align with the final tangible property regulations ("TPR"), which generally require taxpayers to capitalize amounts paid to improve a unit of property ("UOP") owned by a taxpayer.³ As proposed, the definition of "substantial renovation" would be:

Definition of substantial renovation. The term substantial renovation means activities the costs of which would be required to be capitalized by the taxpayer as an improvement under § 1.263(a)-3, other than an amount described in § 1.263(a)-3(k)(1)(i) through (iii). If not otherwise defined under § 1.263(a)-3, the unit of property for purposes of § 1.263(a)-3 is the real property, as defined in paragraph (m)(3) of this section.⁴

Therefore, in order to determine if activities meet the definition of "substantial renovation" of real property under the proposed Section 199 regulations, taxpayers must determine if the costs incurred would constitute capitalizable improvements to property owners under Section 263(a) with respect to 1) a UOP as defined in the TPR, or 2) real property in the absence of a definition of UOP in the TPR.

II. Executive Summary

The requirement to apply a narrow test under Section 263(a) to determine the qualification of activities under Section 199 does not comport with the broad test for qualification of construction activities in Treas. Reg. § 1.199-3, which, as described below, is whether such activities are 'related to' or performed 'in connection with' the construction or erection of real property.⁵ This is a broad test based on concepts of reasonableness and information reasonably available to the taxpayer.

Moreover, the proposed definition of substantial renovation is not administrable since it requires taxpayers in a highly fragmented industry to have access to information with respect to the construction project that the E&C taxpayer lacks in a typical construction contract.

We believe that if finalized as proposed, the definition of substantial renovation will lead to significant controversies where few have existed under the current, well-settled definition.⁶

Therefore, we respectfully recommend that Treasury and the IRS retain the current definition of substantial renovation. In the alternative, we recommend that Treasury and the IRS strike from the proposed definition of substantial renovation, the phrase -- "by the taxpayer". This phrase can be read to require E&C taxpayers to step in the shoes of property owners to determine if activities are capitalizable improvements based on data unavailable to E&C taxpayers. We also recommend Treasury and the IRS modify the proposed definition of substantial renovation as described herein to clarify that a taxpayer determines whether the taxpayer substantially renovates real property based on information reasonably available to the taxpayer. Also, we recommend that Treasury and the IRS add an example demonstrating these principles. Finally, for administrative ease and to eliminate controversies, we propose that Treasury and the IRS include in the final regulations an elective safe harbor allowing taxpayers to determine whether they substantially renovate real property based on a dollar limit of costs paid or incurred.

We discuss these comments further below.

III. Discussion

The term construction means activities and services relating to the construction or erection of real property (as defined in paragraph (m)(3) of this section) in the United States by a taxpayer that, at the time the taxpayer constructs the real property, is engaged in a trade or business (but not necessarily its primary, or only, trade or business) that is considered construction for purposes of the North American Industry Classification System (NAICS) on a regular basis.

The regulations include broad language in defining a construction "project" to which the construction activities relate. Activities constitute construction where they are part of the overall construction project, as Treas. Reg. § 1.199-3(m)(2)(i) demonstrates: "Activities constituting construction are activities performed in connection with a project to erect or substantially renovate real property, including activities performed by a general contractor or that constitute activities typically performed by a general contractor. . . ."

Further, the taxpayer may use any reasonable method to define the item for determining whether activities constitute construction of real property. For example, Treas. Reg. § 1.199-3(d)(2)(iii) provides: "In the case of construction activities and services or engineering and architectural services, a taxpayer may use any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances to determine what construction activities and services or engineering or architectural services constitute an item."

As these provisions indicate, the taxpayer must only make a reasonable inquiry in determining if the activities are related to or performed in connection with real property construction, and the taxpayer must only use a reasonable method to define the project.

Thus, it is clear that the relation between the activities and the construction activities including erection or substantial renovation of real property is a proximate connection. This is further demonstrated by Treas. Reg. § 1.199-3(m)(2)(iii), which provides a catchall provision listing other activities that will be included in DPGR as follows:

Improvements to land that are not capitalizable to the land (for example, landscaping) and painting are activities constituting construction only if these activities are performed 'in connection with' other activities '(whether or not by the same taxpayer)' that constitute the erection or substantial renovation of real property and provided the taxpayer meets the requirements under . . . [Treas. Reg. 1.199-3(m)(1)]. Services such as grading, demolition (including demolition of structures under section 280B, clearing, excavating, and any other activities that physically transform the land are activities constituting construction only if these services are performed 'in connection with' other activities '(whether or not by the same taxpayer)' that constitute the erection or substantial renovation of real property and provided the taxpayer meets the requirements under . . . [Treas. Reg. 1.199-3(m)(1)].⁸ (Emphasis Added).

Under this provision, a taxpayer's activities constitute qualified construction activities as long as they are broadly connected with the substantial renovation of property, whether or not performed by the taxpayer and whether or not the real property construction occurs subsequent to the taxpayer's engineering and design work.

Moreover, Treas. Reg. § 1.199-3(m)(2)(iv) provides a rule of inclusion for administrative support services that would otherwise not qualify as DPGR except for the fact that they are performed in connection with real property construction activities. It provides: "If the taxpayer performing construction activities also provides, 'in connection with' the construction project, administrative support services (for example, billing and secretarial services) incidental and necessary to such construction project, then these administrative support services are considered construction activities."⁹

5. Determination of Construction Activities is Broader than Test for Determining if a Disposition is a Qualified Transfer of Qualified Property

Treasury and the IRS differentiated the standard for qualifying receipts from activities as construction from the more direct, narrow standard for qualifying receipts from the transfer of qualified property in Treas. Reg. § 1.199-3(a)(1)(i). The latter test requires the taxpayer to qualify receipts from the qualified transfer of qualified property at an item level.¹⁰ This is an objective, direct test. If the taxpayer has a qualified transfer (e.g., a lease, rental, license, sale, exchange, or other disposition)¹¹ of qualified property (e.g., qualified production property,¹² qualified film, or electricity, natural gas, or water), then the taxpayer's receipts from the transfer qualify as DPGR.

However, the test for determining whether receipts from construction activities constitute DPGR under Treas. Reg. § 1.199-3(m)(1)(i) is based on concepts of reasonableness and information readily available to the E&C taxpayer. This is evidenced by the fact that taxpayers must only make a reasonable inquiry as to whether the construction activities relate to the construction of real property,¹³ and must only use a reasonable method to define the item for determining whether activities constitute construction of real property.¹⁴

6. Gibson v. Associates¹⁵ Supports Determining Substantial Renovation Based on a Reasonableness Standard

The Tax Court holding in Gibson & Associates, Inc. v. Commissioner ("Gibson & Associates"),¹⁶ the seminal case for determining whether activities constitute substantial renovation, supports that taxpayers must only make a reasonable inquiry when determining whether activities constitute substantial renovation.

In the case, the Government contended that the taxpayer failed to establish that its construction activities constituted capitalizable improvements under Section 263(a) and thus substantial renovation of real property.¹⁷ The Tax Court disagreed, stating as follows:

Respondent argues that petitioner cannot prevail because it has not established with any specificity that its work materially increased the value or substantially prolonged the useful life of the disputed property. We disagree. Although the record may not allow us to pinpoint the exact increases in value or useful life on account of petitioner's work, suffice it to say that the record supports petitioner's conclusion that the applicable standards were met for each disputed project. The bid sheets show the scope of petitioner's work and the dollar amounts of its projects, and petitioner's use of the 3-year and 5-percent benchmarks is reasonable in the setting at hand to establish that petitioner's work substantially increased the value, capacity, efficiency, strength, and/or quality of each of the items of real property underlying the disputed projects.¹⁸

In determining whether the taxpayer met its burden of establishing that it substantially renovated real property, it is clear that the Tax Court required the taxpayer only to make a reasonable inquiry as to whether its activities constituted substantial renovation.

7. Summary

In sum, E&C taxpayers should not be required to step in the shoes of the property owner and implement a strict, direct test in Section 263(a) where the construction rules are intended to apply broadly. Finalizing the definition of substantial renovation as proposed is contrary to the broad rules for determining construction activities under Section 199 and the holding in Gibson v. Associates.

B. The Proposed Definition of Substantial Renovation Is Not Administrable

The E&C industry is highly fragmented, comprising both large E&C firms that undertake annually tens of thousands of projects and subprojects, and small single employee contractors. E&C taxpayers engage in a wide variety of engineering, architectural and construction services, including services provided in numerous sectors such as commercial buildings, residential buildings, public construction works, and other sectors. Most construction projects are broken down into many task and subtasks, involving numerous contractors and subcontractors performing discrete components of an entire project. These facts are consistent throughout the E&C industry.

For the vast majority of E&C projects, typically, each contractor or subcontractor possesses only the information related to the costs incurred with respect to the contractor or subcontractor's specific activities undertaken for the construction of the real property or component of real property. A contractor or subcontractor does not have visibility into an entire project effort including costs incurred with respect to construction activities performed by other contractors or subcontractors related to the real property or components of real property. Rather, typically only the ultimate project owner has the information available with respect to costs incurred for all aspects of the real property construction including components of real property. This fundamental concept was demonstrated by the following example in comment letters with respect to the previously proposed Section 199 regulations that were issued prior to the final TPR:

Roofer Inc. is hired to come in and replace a major portion of the roof of a building following a hurricane. Another contractor has been hired to install solar panels and special insulation. Another contractor has been hired to do wiring. Roofer Inc. does not know the amounts incurred for the other projects as they relate to other portions of the roof. Further, Roofer Inc. did not participate in the roof design process and the roof design installed by Roofer Inc. is a different design than that of the original roof. Roofer Inc. has hired an asphalt subcontractor to do a significant portion of the asphalt process in the roof construction process. In this example, it is clear that neither Roofer Inc., nor the other contractors in the project, have the information to determine how the owner of the roof will classify this project for tax purposes.¹⁹

Notably, even Treasury and the IRS recognize the highly fragmented nature of the E&C industry and information limitations that E&C taxpayers have. For example, Treasury and the IRS issued Notice 2005-14 on January 19, 2005 which provided interim guidance addressing a number of key issues relating to the application of the Section 199 manufacturing deduction. The notice included an example that demonstrated that a typical construction project has multiple contractors performing various functions, as follows:

(ii) Taxpayers deriving gross receipts from construction. The Service and Treasury Department believe that it is appropriate, in certain situations, for more than one taxpayer to be regarded as deriving gross receipts from construction with respect to the same activity and the same construction project. For example, if X (who is not in the trade or business of construction and is the owner, under federal income tax principles, of a building within the United States) retains Y (a general contractor) to oversee a "substantial renovation" of the building, and Y retains Z (a subcontractor) to install a new electrical system in the building as part of that substantial renovation, the amounts that Y receives from X, and amounts that Z receives from Y, qualify as DPGR.²⁰

Also notable, Treasury and the IRS recognized the information limitations of E&C taxpayers by excluding from the proposed definition of substantial renovation costs that would constitute capitalizable restorations under Treas. Reg. § 1.263(a)-3(k)(1)(i)-(iii) which include amounts for a replacement to a component of a UOP where the taxpayer computed a loss or took a basis adjustment with respect to the property that was replaced.²¹ By excluding these categories of restorations from the proposed definition of substantial renovation, it is clear that Treasury and the IRS acknowledge that contractors and subcontractors lack the information to determine whether such costs are capitalizable restorations, since only owners of property have the information required to make such a determination with respect to these costs.

In sum, to apply the proposed definition of substantial renovation, E&C taxpayers are required to step into the shoes of property owners and determine whether costs related to constructing certain project components constitute capitalizable improvements, based on information typically only available to the owners of the property. This requirement is not administrable for the vast majority of taxpayers in the E&C industry.

C. Recommendations

We believe that if finalized as proposed, the new definition of substantial renovation will lead to significant controversies over the definition where it is currently well-settled. Therefore, we respectfully recommend that Treasury and the IRS retain the current definition of substantial renovation.

Alternatively, we believe that the definition as to what construction activities constitute substantial renovation for purposes of Treas. Reg. § 1.199-3(m)(5) should be crafted to focus on the information reasonably available to the E&C taxpayer.

To that end, we recommend that Treasury and the IRS strike from the proposed definition of substantial renovation, the phrase -- "by the taxpayer", which can be read to require E&C taxpayers to step into the shoes of property owners to determine if activities are capitalizable improvements based on data unavailable to E&C taxpayers.

Additionally, we propose Treasury and the IRS modify the proposed definition of substantial renovation to allow application of a standard of reasonableness where information is unavailable to the taxpayer necessary to determine if costs are capitalizable improvements under Section 263(a), as follows:

Definition of substantial renovation. The term substantial renovation includes activities to renovate a major component or substantial structural part of real property that would generally be characterized as an improvement under § 1.263(a)-3, other than an amount described in § 1.263(a)-3(k)(1)(i) through (iii). . . . In making this determination, the taxpayer performing the construction activities must only make a reasonable inquiry or a reasonable determination as to whether the activity relates to the substantial renovation of real property. The taxpayer must base this determination only on information reasonably available to the taxpayer. (Emphasis Added).

We also recommend that Treasury and the IRS add an example to Prop. Treas. Reg. § 1.199-3(m)(5) demonstrating these principles, as follows:

Example 1.A

A prime contractor has been engaged to replace various components and structures of a facility that has been severely damaged due to a major storm event. The prime contractor hired two different subcontractors to perform different aspects of the project in order to allow the facility to resume occupancy and use. Contractor A is responsible for construction of major roof structural supports and re-surfacing of the facility roof. The amount of the roof destroyed through cave in was 25 percent of the roof surface area with water damage sustained in tangential areas. Contractor A had to replace many of the vertical and lateral structural support beams in the roof and in the structure, as well as re-surface the entire roof structure. Contractor B is responsible for rebuilding the entire foyer/front entrance of the facility, which is approximately 20 percent of the total square footage of the facility.

In order to conclude whether the activities of the subcontractors constitute substantial renovation of real property, Contractors A and B must decide if their construction activities improve the facility under § 1.263(a)-3(j) - § 1.263(a)-3(l) and determine the appropriate unit of property under § 1.263(a)-3(e)(ii).

Based on discussions with the prime contractor, Contractors A and B determined that their portions of the project constituted the replacement of a substantial structural component of the building structure, and thus was a capitalizable restoration under Reg. § 1.263(a)-3(k)(1)(vi).

Therefore, the activities of Contractors A and B qualify as domestic production gross receipts for the substantial renovation of real property, as both contractors concluded, under a reasonable inquiry, that their activities constitute an improvement under § 1.263(a)-3.

Example 1.B

After the same major storm event, Contractor C was responsible for re-building an entry road including the replacement of a substantial structural part of a bridge that suffered severe structural damage. As part of the project, Contractor C was required to rehabilitate and resurface the road as well.

In order to conclude whether Contractor C's activities constitute substantial renovation of real property, Contractor C must decide if its construction activities related to the roadway project constitute a capitalizable improvement under § 1.263(a)-3(j) - § 1.263(a)-3(l) and determine the appropriate unit of property under § 1.263(a)-3(e)(ii).

With information reasonably available, Contractor C determined that its activities constituted the replacement of a substantial structural component of the unit of property (i.e., the bridge), and thus was a capitalizable restoration under Reg. § 1.263(a) 3(k)(1)(vi). Therefore, Contractor C's activities constituted the substantial renovation of a unit of property, which is considered real property. Thus, all of Contractor C's activities with respect to the roadway project are related to real property construction and qualify as domestic production gross receipts.

Finally, for administrative ease and to prevent controversies, we propose that Treasury and the IRS include in the final regulations an elective safe harbor allowing taxpayers to determine whether they substantially renovate real property based on a dollar limit of costs paid or incurred, rather than basing the determination on a reasonably inquiry. We propose a safe harbor similar to that previously proposed with respect to the prior regulations, but with an increased dollar threshold of $5,000.²² For example, under the safe harbor, for any project where the greater of (1) actual project costs (direct and indirect) or (2) customer billings or recognized revenue equal or exceed $ 5,000 for the project, the project is presumed to be for the substantial renovation of property. The safe harbor would still require the taxpayer to show that the project was for real property, for a project in the United States, was construction, etc. However, the dollar amount safe harbor would allow taxpayers to use objective data to satisfy this test, make more administrable the determination of whether a taxpayer's activities constitute substantial renovation of real property, and prevent controversies between taxpayers and the IRS.

IV. Conclusion

In conclusion, we believe the proposed definition of substantial renovation, if finalized as proposed, would lead to significant controversies between taxpayers and the IRS since it does not comport with the broad rules in Treas. Reg. § 1.199-3(m) for determining construction activities. Also, we believe the proposed definition of substantial renovation is not administrable, since it would require E&C taxpayers to step into the shoes of property owners and determine whether costs are capitalizable under Section 263(a) where the E&C taxpayers lack the information to make such determinations. Therefore, we propose Treasury and the IRS retain the current definition, which has generated little controversy, or alternatively, modify the proposed definition of substantial renovation as described above.

We believe these refinements will allow taxpayers to evidence construction activities reasonably, and prevent future controversies between taxpayers and the IRS.

Thank you for your consideration of these comments.

² Prop. Treas. Reg. § 1.199-3(m)(5).

³ Treas. Reg. § 1.263(a)-3.

⁴ REG-136459-09.

⁵ Treas. Reg. § 1.199-3(m)(1)(i).

⁶ See, e.g., Gibson & Associates, Inc. v. Commissioner, 136 TC 195 (2011), citing Notice 2005-14, sec. 3.04(11)(d), 2005-1 C.B. at 511 ("The Service and Treasury Department believe that the standard to be applied in determining whether there has been a substantial renovation of real property is the standard applied under § 263(a) to determine whether a taxpayer's activities result in permanent improvements or betterments of property, such that the cost of the activities must be capitalized * * * [and that the definition of the term substantial renovation as set forth in the notice is] consistent with the rules under § 263(a) * * *").

⁷ Treas. Reg. § 1.199-3(m)(2)(i).

⁸ Treas. Reg. § 1.199-3(m)(2)(iii).

⁹ Treas. Reg. § 1.199-3(m)(2)(iv).

¹⁰ Treas. Reg. § 1.199-3(a)(1)(i).

¹¹ Treas. Reg. § 1.199-3(a)(1).

¹² Treas. Reg. § 1.199-3(j)(1) defines qualified property as tangible personal property, computer software, and sound recordings.

¹³ Treas. Reg. § 1.199-3(m)(2)(iii).

¹⁴ Treas. Reg. § 1.199-3(d)(2)(iii).

¹⁵Gibson & Associates, Inc. v. Commissioner, 136 TC 195 (2011).

¹⁶Id.

¹⁷Id. at 242.

¹⁸Id. at 241.

¹⁹See Associated General Contractors of America letter commenting on Notice 2005-14 (September 7, 2005); see also Associated General Contractors of America letter commenting on Proposed Regulations Under Section 199 (REG-105847-05) (January 13, 2006).

²⁰ IRS Notice 2005-14, section 3.04(11)(e)(ii).

²¹ See, e.g., Treas. Reg. § 1.263(a)-3(k)(1)(i) (other than a casualty loss under Treas. Reg. § 1.165-7); See id. at (ii); See id. at (iii) (subject to the limitation in Treas. Reg. § 1.263(a)-3(k)(4)).

²²See Associated General Contractors of America letter commenting on Notice 2005-14 (September 7, 2005); see also Associated General Contractors of America letter commenting on Proposed Regulations Under Section 199 (REG-105847-05) (January 13, 2006).