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Energy Company Urges IRS to Revise Business Interest Regs

FEB. 22, 2019

Energy Company Urges IRS to Revise Business Interest Regs

DATED FEB. 22, 2019
DOCUMENT ATTRIBUTES

February 22, 2019

The Honorable David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue, NW
Washington, DC 20220

The Honorable William M. Paul
Acting Chief Counsel and Deputy
Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

The Honorable Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments Submitted Pursuant to Section 163(j) Notice of Proposed Rulemaking

Dear Messrs. Kautter, Rettig, and Paul:

We commend the Treasury Department and the Internal Revenue Service (the "IRS") for the careful thought and consideration that went into the development of the Notice of Proposed Rulemaking regarding section 163(j)1 as amended by the Tax Cuts and Jobs Act (P.L. 115-97) (the "TCJA"), published in the Federal Register on December 28, 2018 (the "Proposed Regulations").2 The Proposed Regulations adequately address many of NextEra Energy's and the utility industry's comments and concerns regarding implementation of section 163(j) as amended by the TCJA.3

Due to the complexity and impact of section 163(j), the Treasury Department and IRS requested comments on various aspects of the Proposed Regulations. We appreciate the opp01iunity to provide comments and this letter makes recommendations with respect to the following specific requests for comments: (1) the methodology for computing adjusted taxable income ("ATI") and items that should be included as additional adjustments to taxable income; and (2) the deemed asset sale rule for taxpayers that are actually or effectively precluded from making an election under section 336, 338, or 754.4 Additionally, this letter requests guidance on certain miscellaneous provisions.

I. Summary of Recommendations

We respectfully make the following recommendations with respect to the Proposed Regulations:

A. Recommendation #1 — Depreciation Capitalized and Taken into Account as COGS Should be Allowed as an Addback in Computing ATI

Prop. Treas. Reg. § 1.163(j)-1(b)(1)(iii) should be revised to provide that depreciation capitalized to inventory and taken into account as cost of goods sold ("COGS") is added back for purposes of determining ATI prior to 2022.

Part II below contains a detailed discussion of the need for this revision and the rationale/basis for making it.

B. Recommendation #2 — Regulated Utilities with a Regulatory Liability for Deferred Taxes Should be Treated as "Effectively Precluded" from Making a Step-Up Election by the Applicable Regulatory Agency

Prop. Treas. Reg. § 1.163(j)-10(c)(5)(iv) should be revised to clarify that a taxpayer will qualify for deemed asset sale treatment where (a) the taxpayer meets the requirements under section 336, 338, or 754 to make an election with respect to an interest acquired in a corporation or partnership, as applicable, and (b) such corporation or partnership had (at the time of the acquisition) a regulatory liability for deferred taxes on its books with respect to public utility property (as defined in section 168(i)(10)).

Part III below contains a detailed discussion of the need for this revision and the rationale/basis for making it.

C. Recommendation #3 — Request for Additional Guidance on Miscellaneous Provisions

Part IV below contains a summary of additional guidance requested and a discussion of the rationale/basis for such requests.

II. Depreciation Capitalized and Taken Into Account as COGS Should Be Added Back for Purposes of Determining ATI Prior to 2022

A. The Proposed Regulations Undermine Statutory Intent and Disproportionately Harm Manufacturers by Providing Depreciation Included in COGS is Not Added Back in Computing ATI

The TCJA replaced section 1630) with a broader limitation on interest deductibility.5 Under new section 1630), the taxpayer's deduction for net business interest in any taxable year cannot exceed 30 percent of the taxpayer's ATI for that year.6 For taxable years beginning before January 1, 2022, ATI is defined as taxable income of the taxpayer determined without regard to, inter alia, any deduction allowable for depreciation, amortization, or depletion (collectively, "depreciation").7

Depreciation may be recovered in one of two ways depending on the type of activities engaged in by the taxpayer. Non-manufacturers (including service providers) are generally allowed a deduction for depreciation pursuant to section 167(a), as determined under section 168. Conversely, manufacturers are generally required to capitalize depreciation pursuant to section 263A and recover it through COGS as an offset to gross receipts in computing gross income.8 Although an amount recovered through COGS reduces taxable income to the same extent as an equivalent amount of allowed "deductions," case law has distinguished deductions from COGS.9 Specifically, COGS reduces the selling price of goods that is used to calculate gross income, and is technically not a deduction that is applied against gross income in determining taxable income.10

The IRS has taken the position that the cost of producing electricity, including depreciation related to a facility that generates electricity, should be capitalized to the electricity as inventory and taken into account as COGS.11 As a practical matter, the recognition of COGS related to the sale of electricity occurs in the same taxable year that the depreciation is allowable because electricity generally is not stored and thus does not result in ending inventory.

Significantly, neither the TCJA nor the accompanying legislative history makes a distinction between the two methods of recovering depreciation or express an intent to treat manufacturers differently than non-manufacturers. In spite of this absence, the Proposed Regulations provide that an amount incurred as depreciation that is capitalized to inventory under section 263A is not a deduction for depreciation for purposes of determining ATI under section 163U).12

The Proposed Regulations adopt an unnecessarily strict interpretation that would, in effect, limit the addback for depreciation to service providers and other non-manufacturers that are not required to capitalize amounts to inventory, thus treating similarly situated taxpayers differently. Such interpretation is inconsistent with Congressional intent to apply an EBITDA test for taxable years prior to 2022 and would undermine the broader goal of the TCJA to incentivize domestic capital investment because such investment is largely driven by manufacturers. Moreover, this result would be unintended as it was not provided for in the statute or contemplated by the legislative history. Finally, the result would be especially harsh and unjustified for energy producers because they generally have no beginning or ending inventory. If Congress had intended to limit the depreciation addback to non-manufacturers, it would have stated so explicitly.

Accordingly, in order to eliminate the arbitrary distinction between non-manufacturers and manufacturers, we believe that depreciation capitalized to inventory and taken into account as COGS should be added back for purposes of determining A TI prior to 2022 under section 163(j)(8). Treasury clearly has the authority to provide for this add back, under the theories set forth in Parts IT.B and II.C, infra. The example set forth below illustrates the disparate treatment that would result from the Proposed Regulations, and how the proposed revision would correct this disparate treatment.

Example. In a taxable year beginning before 2022, (1) Taxpayer A (a service provider) has taxable income of $500, depreciation expense of $500 that is deducted under section 167, and business interest expense of $400; and (2) Taxpayer B (a manufacturer) has taxable income of $500, depreciation expense of $500 that is capitalized to inventory, and business interest expense of $400. Taxpayer B has no ending inventory (i.e., all depreciation capitalized during the taxable year is taken into account as COGS in such year). As illustrated in the table below, Taxpayer B is substantially worse off than Taxpayer A under the Proposed Regulations, even though there is no substantive economic difference between Taxpayer A and Taxpayer B. Specifically, both taxpayers have the same amount of taxable income and take into account an equivalent amount of depreciation to reduce taxable income. The table also illustrates how the proposed revision would eliminate the uneconomic disparity.

 

Proposed Regulations

Proposed Revision

 

Taxpayer A

Taxpayer B

Taxpayer A

Taxpayer B

Taxable Income

$500

$500

$500

$500

Interest Expense

$400

$400

$400

$400

Depreciation Allowance

$500

$500

$500

ATI

$1,400

$900

$1,400

$1,400

30% Limitation

$420

$270

$420

$420

Disallowed Interest Expense

$0

$130

$0

$0

B. COGS Should Be Treated as a "Deduction" in Order to Interpret and Apply Section 163(j) Consistent With Congressional Intent

i. The Supreme Court has Held that Statutes Should Not Be Read Literally if Such Reading Would Frustrate Legislative Intent

Treasury has clear authority to interpret section 163(j) (and amend the Proposed Regulations) to allow depreciation capitalized to inventory and taken into account as COGS to be added back for purposes of calculating ATI prior to 2022. The Supreme Court has acknowledged that it is often necessary to look beyond the literal words of a statute where a literal reading produces an unreasonable result "plainly at variance with the policy of the legislation."13 The Supreme Court has stated that "[i]t is a well-established canon of statutory construction that a court should go beyond the literal language of a statute if reliance on that language would defeat the plain purpose of the statute,"14 but "the plain meaning of legislation should be conclusive, except in the rare cases [in which] the literal application of a statute will produce a result demonstrably at odds with the intentions of its drafters."15

Reading section 163(j)(8)(A)(v) literally to disallow the addback of depreciation capitalized to inventory and taken into account as COGS would clearly be at odds with the intent of the drafters. There is no view suggested by the legislative history that manufacturers should be treated differently than non-manufacturers. Furthermore, there is no policy justification for treating these two industries differently.16 In enacting section 163(j)(8), Congress contemplated providing taxpayers with additional relief against interest disallowance for taxable years prior to 2022. Punishing manufacturers by strictly applying the literal language of section 163(j)(8)(A)(v) would defeat the purpose of this statutory provision. Certainly, if Congress had intended this result, it would have specifically expressed this intent.

For example, for purposes of the base erosion and anti-abuse tax ("BEAT"), COGS is not treated as a base erosion payment unless such payment is made to a related foreign corporation that recently inverted.17 In the context of the BEAT, Congress was very clear that it intended to treat the two groups of taxpayers (i.e., inverters and non-inverters) differently. Congress expressed no such intent in the context of section 163(j).

Section 1016 provides another example where a literal reading of the statute would frustrate legislative intent. Specifically, section 1016(a)(2) provides that tax basis shall be adjusted "for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent of the amount (A) allowed as deductions in computing taxable income . . ., and (B) resulting (by reason of the deductions so allowed) in a reduction for any taxable year of the taxpayer's taxes . . ." (emphasis added). If read literally, depreciation that is capitalized to inventory would not result in a reduction to tax basis because such depreciation is not a "deduction" in computing taxable income; rather, it is a reduction to gross receipts in computing gross income. Such result would clearly be at odds with the Congressional intent of the provision and is not a generally accepted reading of section 1016.18

ii. The IRS has Consistently Interpreted "Deduction" to Include COGS Where Necessary to Effectuate Congressional Intent

Previous IRS administrative guidance interpreted "deduction" broadly to include COGS in order to effectuate Congress's intent in enacting the relevant statute. In Action on Decision ("AOD") 1977-77,19 the IRS expressed disagreement with the Tax Court decision in B.C. Cook & Sons,20 wherein the court rejected the government's argument that the amount included in COGS was a "deduction" for purposes of applying the mitigation provisions of sections 1311-1315. The IRS noted that it had previously followed certain cited cases that "embody the view that the mitigation provisions ought to be interpreted to effectuate the underlying Congressional purpose of preventing inequitable taxation or tax avoidance caused by the adoption of a position inconsistent with those taken in years barred by the statute of limitations or other rule of law."21 The IRS then concluded that the court applied an "overly-literal interpretation" of the word "deduction" that was inconsistent with Congressional intent, and that such word should be interpreted to refer to items which reduce gross income whether included in COGS or deducted from gross income in a technical sense. The IRS has consistently followed the logic in AOD 1977-77 to conclude that the term "allowable as a deduction" should be read broadly to encompass amounts included in COGS where Congress clearly did not mean to distinguish between items that reduce taxable income through COGS or a deduction.22

In Associate Chief Counsel Legal Advice ("CCLA") 2008-012,23 the IRS concluded that environmental remediation costs and workers' compensation costs that are allocated to inventory under section 263A and recovered through COGS constitute amounts "allowable as a deduction," satisfying the definition of specified liability losses under section 172(f).24 The IRS reasoned that "Congress used the phrase 'allowable as a deduction' in [section] 172(f)(1)(B)(i) to mean amounts that may be taken into account in computing taxable income. Congress did not mean to distinguish 'deductions' from 'cost of goods sold.'" In the IRS's view, Congress intended that an amount be "allowable as a deduction" for purposes of section 172(f) if it is taken into account in computing taxable income, either as a reduction to, or deduction from, gross income.25

Furthermore, an interpretation of section 172(f) that prohibits capitalized costs from qualifying as specified liability losses would effectively limit application of that provision to service providers and others not subject to section 263A. According to the IRS, such a reading would produce an unintended limitation and, "[i]f Congress had intended to limit [section] 172(f) so, it would have stated it explicitly. " The IRS determined that there was nothing in the legislative history of section 172(f) indicating that Congress intended to exclude manufactures from obtaining specified liability loss treatment. Accordingly, the CCLA concludes that Congress did not intend the phrase "allowable as a deduction" to disqualify expenditures merely because those expenditures are allocated to inventories under section 263A and recovered through COGS.

Similarly, in Chief Counsel Advice ("CCA") 200931007,26 the IRS concluded that nuclear decommissioning costs that must be recovered through COGS, though not deductible by the producer of electricity under section 162(a), are " allowable" deductions that can be taken into account in computing taxable income under the Code. As " allowable" deductions, such nuclear decommissioning costs qualified as specified liability losses under section 172(f). Similar to CCLA 2008-012, the IRS reasoned that Congress used the phrase "allowable as a deduction" to mean an amount that may be taken into account in computing taxable income and did not intend to distinguish "deductions" from "cost of goods sold."

Another example of the IRS' s willingness to interpret terms in a manner consistent with Congressional intent is the claim of right doctrine under section 1341. Section 1341(a) permits a taxpayer to adjust its tax for a taxable year if (1) an item was included in "gross income" for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item, (2) a "deduction is allowable" for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or portion of such item, and (3) the amount of such "deduction" exceeds $3,000. In CCAs 20080502127 and 20032705 3,28 the IRS concluded that section 1341 should not apply to the payment of an amount in a taxable year that, if paid in a prior taxable year, would have increased COGS and reduced gross income in that prior year.29 One of the grounds on which the IRS based its conclusion was that Congress intended "gross income" to mean gross receipts (unreduced by COGS) for purposes of section 1341 even though Treas. Reg. § 1.61-3(a) explicitly defines " gross income" as total sales less COGS.30 Although unnecessary and redundant to the conclusion, the IRS applied a strict technical reading of " deduction" to conclude that COGS was not a deduction and that the taxpayer thus did not meet the requirement for claim of right in section 1341(a)(2).

The interpretations of "gross income" and COGS by the IRS in these CCAs were clearly results-driven as the IRS meant to apply section 1341 in a manner consistent with the intent of the statute, which is to recompute tax liability when a taxpayer returns or restores an item of income received under a claim of right in a previous year.31 Amounts that impact COGS do not restore proceeds received in earlier taxable years, and accordingly, it was clear that the IRS did not view this as an appropriate circumstance in which section 1341 should be applied.32 This view is consistent with the Congressional intent of section 1341.

In support of its position in CCA 200805021, the IRS cited B.C. Cook & Sons, Inc. However, as discussed above, the IRS has expressed disagreement with the Tax Court decision and reasoning in B.C. Cook & Sons, Inc. on multiple occasions.33 These seemingly contradictory views can only be reconciled by the unavoidable conclusion that the IRS has consistently chosen to eschew a strict technical reading in favor of a more flexible interpretation of COGS as a "deduction" where such interpretation is clearly consistent with Congress's intent in enacting the statute under consideration. This conclusion is further supported by the fact that the IRS issued the mitigation and specified liability loss authorities treating COGS as a "deduction" both before and after the claim of right CCAs.

In adopting an EBITDA test for taxable years prior to 2022, Congress did not mean to distinguish "deductions" from COGS. In addition, neither the statute nor legislative history provides any support for treating manufacturers differently than non-manufacturers. Quite the opposite, the TCJA was intended to incentivize capital investment, and the COGS rule is completely contradictory to that intent. Accordingly, the Treasury Department and IRS should amend the Proposed Regulations to interpret "deduction" for purposes of section 163(j)(8)(A)(v) in a manner consistent with its interpretation of this word for purposes of the mitigation and specified liability loss provisions. Specifically, "deduction" for these purposes should be defined broadly to include items that reduce taxable income, whether the items are capitalized and taken into account as COGS or deducted from gross income.34

C. Even if Treasury Decides COGS is Not a "Deduction," it Can Achieve the Same Result as it Has Explicit Authority to Make "Other Adjustments"

Even in the event the Treasury Department determines that it is prevented by the literal language of section 163(j) to treat COGS as a "deduction" for purposes of calculating ATI, the Treasury Secretary has authority to make "other adjustments" deemed appropriate to effectuate Congressional intent. Specifically, section 163(j)(8)(B) provides that ATI is "computed with such other adjustments as provided by the Secretary." For all the reasons outlined above, providing an adjustment to the calculation of ATI to include depreciation capitalized to inventory, and taken into account as COGS, would be consistent with Congressional intent to adopt an EBITDA test for taxable years prior to 2022 and ensure that similarly situated taxpayers are treated consistently. Accordingly, the Secretary should exercise the authority granted to it by Congress in section 163(j)(8)(B) to provide for this result.

III. Regulated Utilities with a Regulatory Liability for Deferred Taxes Should be Treated as "Effectively Precluded" from Malting a Step-Up Election

The Proposed Regulations provide that, solely for purposes of determining the amount of basis allocable to excepted and non-excepted trades or businesses, an election under section 336, 338, or 754, as applicable, is deemed to have been made for any acquisition of corporate stock or partnership interests where the taxpayer "demonstrates to the satisfaction of the Commissioner that the taxpayer was eligible to make an election but was actually or effectively precluded from doing so by a regulatory agency with respect to an excepted regulated utility trade or business."35 The deemed asset sale election rule was necessary to eliminate potential distortions in the allocation of debt after the acquisition of an interest in an entity engaged in a regulated utility business, as there is generally no practical ability to make an actual basis step-up election if the acquired entity has a regulatory liability for deferred taxes on its books because (as explained below) such election would cause customer bills to increase. As a result, a taxpayer that acquires an interest in such an entity typically finds it imprudent to raise the prospect of a basis step-up election with the applicable regulatory agency, and thus should be treated as effectively precluded by that agency from making such election.

A utility is entitled to collect from its customers its cost of service (which is its operating costs, including tax expense) plus an allowable return on its rate base (which is the depreciated cost of its investments). The utility must reduce its rate base by the amount of its regulatory liabilities. Thus, the regulatory liability created by accelerated tax depreciation lowers rate base and customer bills. A step-up in tax basis would reduce or even eliminate this regulatory liability and would therefore increase the rate base and raise customer bills. The example set forth below illustrates the effect of a regulatory liability on rate base and customer bills, and how a step-up in the tax basis of the assets would impact these items.

Example. A regulated utility has a rate base of $1 million before taking into account a regulatory liability of $300,000 for deferred taxes that was created by accelerated tax depreciation. The regulatory agency that has jurisdiction over the regulated utility permits the utility to earn a 10 percent return on its adjusted rate base of $700,000. A purchaser acquires all of the interests in the regulated utility in a transaction that is eligible for a basis step-up election. As illustrated in the table below, a step-up in the basis of the assets of the regulated utility would cause the regulatory liability for deferred taxes to be eliminated and result in an increase in rate base and customer bills vis-à-vis a no basis step-up scenario.

 

No Tax Basis Step-Up

Tax Basis Step-Up

Benefit/(Detriment) to customers

Rate Base (Pre-DTL)

$1,000,000

$1,000,000

 

Deferred Tax Liability

($300,000)

$0

 

Rate Base (Post-DTL)

$700,000

$1,000,000

($300,000)

Allowable Return

10%

10%

 

Return on Rate Base

$70,000

$100,000

($30,000)

Because of the adverse impact on customer bills, as a practical matter, a taxpayer that acquires an interest in a regulated utility business that has a regulatory liability for deferred taxes on its books generally must do so in a manner that does not result in a step-up in the tax basis of the utility's assets. In fact, it is usually imprudent for the taxpayer in this case to raise the possibility of a step-up to the regulatory agency that has jurisdiction over the utility business and the proposed acquisition. Because the step-up in such an instance would be viewed as harmful to customers, raising the possibility of one could unnecessarily create concerns for the regulatory agency and ultimately lead the agency to deny approval of the proposed transaction.

Accordingly, we believe a taxpayer that acquired or acquires an interest in a regulated entity should be deemed to have made an election to step-up the tax basis of the assets of the acquired entity where (a) the acquisition qualified for an election under section 336, 338, or 754, and (b) the acquired entity had (at the time of the acquisition) a regulatory liability for deferred taxes on its books with respect to public utility property.36 Requiring the involvement of the applicable regulatory agency in this case would be unnecessary and impractical. Such a rule would also alleviate the need to locate and provide documentation for historic transactions, which may not exist due to the practical considerations mentioned above or due to the passage of time.

IV. Request for Additional Guidance on Miscellaneous Provisions

A. Regulated Utility Definition

Prop. Treas. Reg. § 1.163(j)-1(b)(13) requires that to qualify as an excepted regulated utility trade or business, the rates for the furnishing or sale of the items identified therein must be determined on a "cost of service or rate of return basis" (emphasis added). The preamble to the Proposed Regulations indicates that Treasury intended to define "excepted regulated utility trade or business" consistent with the definition of public utility property under section 168(i)(10). Historically, public utility property has included only property where the rates are set on a cost of service and rate of return basis. Accordingly, we recommend that Prop. Treas. Reg. § 1.163(j)-1(b)(13) be revised to require that the rates be determined on a "cost of service and rate of return basis" (emphasis added), consistent with the definition of public utility property as interpreted by the IRS.

B. Quarterly Asset Testing

Under Prop. Treas. Reg. § 1.163(j)-10(c)(6), a taxpayer would be required to determine the adjusted basis in its assets on a quarterly basis and average those amounts to determine the relative asset basis for its excepted and non-excepted trades or businesses for a taxable year. The Treasury Department and IRS requested comments on the frequency of asset basis determinations.37 We recommend revising the quarterly asset testing in Prop. Treas. Reg. § 1.163(j)-10(c)(6) to a simple average based on the first and last day of the taxpayer's taxable year with adjustments for material transactions, because quarterly testing is likely to result in a significant tax compliance burden for taxpayers with minimal benefit to the IRS. Proposed regulations issued under section 861 provide a useful model for utilizing a simple average of beginning and end of year values.38 The section 861 proposed regulations appropriately balance the administrative burden on taxpayers of performing multiple asset calculations against the IRS's potential concern for significant business changes that could impact the average asset values.

C. Basis Adjustments Upon Disposition of Partnership Interests

Section 163(j)(4)(B)(iii)(II) provides that if a partner disposes of a partnership interest, the adjusted basis of the partner in the partnership interest is increased immediately before the disposition by the deferred interest expense allocated to such partner that has not previously been taken into account as business interest paid or accrued by the partner. Prop. Treas. Reg. §1.163(j)-6(h)(3) provides that the basis increase only applies "[i]f a partner disposes of all or substantially all of a partnership interest." We request that the Treasury Department consider whether a "substantially all" requirement is appropriate given that the statute requires only that "a partner disposes of a partnership interest" without additional restriction. If the Treasury Department retains the "substantially all" requirement, then we request that the Proposed Regulations be amended to define "substantially all" for this purpose.

D. Real Property Trade or Business Election

Section 163(j)(7)(A)(ii) provides that any electing real property trade or business, as defined in section 469(c)(7)(C), is treated as an excepted trade or business for purposes of section 163(j). The Proposed Regulations would amend Treas. Reg. § 1.469-9(b) to provide rules relating to the definition of real property trade or business under section 469(c)(7)(C). Specifically, the Proposed Regulations would provide guidance on the meaning of real property and types of trades or businesses that qualify as a "real property trade or business" for purposes of section 469(c)(7). Furthermore, Prop. Treas. Reg. § 1.469-9(b)(2)(iii) includes examples illustrating the operation of these provisions. We recommend that the Treasury Department consider including an example illustrating that operating pipeline and transmission assets not otherwise treated as an excepted trade or business under Prop. Treas. Reg.§ 1.163(j)-1(b)(13)(i)(A) qualify as a "real property trade or business."

* * * * * * * *

Thank you for considering these comments. Please do not hesitate to contact me at (561) 691-2437 or bruce.goldstein@nee.com if you have any questions or need further clarifications.

Sincerely,

Bruce Goldstein
Vice President and Chief Tax Officer, NextEra Energy
Juno Beach, FL

cc:
Krishna Vallabhaneni, Deputy Legislative Counsel, Office of Tax Policy
Christopher Call, Esq., Attorney-Advisor
Brett York, Esq., Attorney-Advisor

FOOTNOTES

1Unless otherwise noted, all references to "section" are to the Internal Revenue Code of 1986, as amended (the "Code"), and a ll references to "Treas. Reg. §" or " Prop. Treas. Reg. §" are to the final or proposed Income Tax Regulations promulgated under the Code by the Treasury Department and IRS.

2See Limitation on Deduction for Business Interest Expense, REG-1-10106089-18, 83 fed. Reg. 67,610 (Dec. 28, 2018).

3See NextEra Energy, Inc., Letter to Treasury Department and IRS Re: Section 1630) Comments Submitted Pursuant to Notice 2018-28 (May 30, 2018); Edison Electric Institute & American Gas Association, Letter to Treasury Department and IRS Re: Request for Guidance with Respect to interest Deduction Under Section 163(j) (May 25, 2018).

4See Proposed Regulations, supra note 2, 83 Fed. Reg. at 67,493, 67,521.

5Prior to the TCJA, section 163(j) applied only to certain indebtedness between (or guaranteed by) related persons.

8See Treas. Reg. §§ 1.61-3(a) and 1.263A-1(e)(3)(ii)(I).

9See B. C. Cook & Sons, Inc. v. Comm'r, 65 T.C. 422 (1975), nonacq., 1977-2 C.B.1, aff'd per curiam, 584 F.2d 53 (5th Cir. 1978) (court rejected government's argument that an amount included in COGS was a deduction for purposes of applying the mitigation provisions); Max Sobel Wholesale Liquors v. Comm'r, 630 F.2d 670 (9th Cir. 1980) (court rejected government's argument that section 162(c)(2), which prohibits a deduction for illegal payments, precludes a taxpayer from recovering the payments through COGS).

10See Treas. Reg. § 1.61-3(a); see also Huzella v. Comm'r, T.C. Memo. 20 17-210 ("[t]echnically speaking, cost of goods sold is not a 'deduction'"); Velinski v. Comm'r, T.C. Memo. 1996-180, acq., 1996-2 C.B. 1 (holding that petitioner was entitled to partial innocent spouse relief where overstatement of COGS resulted in an understatement of gross income; "cost of goods sold is taken into account in computing gross income and is not an item of deduction").

11See, e.g., Technical Advice Memorandum ("TAM") 200916004 (Apr. 17, 2009) (taxpayer's nuclear decommissioning liability will be capitalized to the cost of electricity produced and will be recoverable through COGS); TAM 200811021 (Mar. 14, 2008) (costs to maintain customer service were "allocated to the production, transmission, and/or distribution of electricity, and consequently, become recoverable through cost of goods sold"); TAM 200626004 (July 28, 2006) ("capitalizable mixed service costs allocated to the electricity were included immediately in cost of goods sold"); General Counsel Memorandum 37199 (July 25, 1977) (concluding that costs incurred in the production of electricity are in fact COGS).

12Prop. Treas. Reg. § 1.163(j)-1(b)(1)(iii).

13See U.S. v. American Trucking Ass'ns, 310 U.S. 534, 543 (1940).

14Bob Jones Univ. v. U.S., 461 U.S.574, 586 (1983).

15U.S. v. Ron Pair Enters., Inc., 489 U.S. 235, 242 (1989).

16See Ron Pair, at 243.

17See Section 59A(d)(4); H. Rept. 115-466, at 653, 657 (Dec. 15, 2017) ("Conference Report").

18See IRS Publ. 551 "Basis of Assets" (Rev. Dec. 10, 2018) (concluding that basis reductions required by section 1016(a)(2) apply to "any depreciation capitalized under the uniform capitalization rules").

19Apr. 4, 1977.

2065 T.C. 422 (1975).

21Specifically, the IRS cited Rev. Rul. 58-327, 1958-1 C.B. 316, and Rev. Rul. 68-1 52, 1968-1 C.B. 369, in which it agreed to follow Gooch Miffing & Elevator Co. v. U.S., 312 F.2d 376 (5th Cir. 1962) and Lin Matheson Chem. Corp. v. U.S., 265 F.2d 293 (7th Cir. 1959).

22See, e.g., Non-Docketed Significant Advice Review ("NDSAR") 020407 (May 31, 2002) (applying the rationale of AOD 1977-77, concluding that an insurance company's reduction of unpaid loss reserves constitutes the denial of a "deduction" for purposes of the mitigation provisions even though the unpaid losses were accounted for in the calculation of gross income, rather than claimed as a deduction); Field Service Advice ("FSA") 199932014 (May 5, 1999) (applying the rationale of AOD 1977-77, concluding that an adjustment to COGS as a result of royalty payments constitutes the denial of a "deduction" for purposes of the mitigation provisions).

23Dec. 19, 2008.

24See also Industry Director's Directive #2 on Specified Liability Losses IRC 172(t), LMSB-4-0309-011 (June 19, 2009) (providing field direction for the examination of section 172(f) specified liability loss claims and citing CCLA 2008-012 to specify that workers' compensation costs allocated to inventory under section 263A are taken into account in determining specified liability loss to the extent included in COGS for that year).

25Environmental remediation costs and workers' compensation payments, "though not deductible by a manufacturer under [section] 162(a), are 'allowable' deductions that can be taken into account in computing taxable income under the Code." The IRS concluded that "[a]s 'allowable' deductions, environmental remediation costs and workers compensation payments are both (I) eligible to be allocated to inventory to the extent required by [section] 263A, and (2) eligible for treatment as a specified liability loss. . . ." See also Chief Counsel Advice 200931007 (July 31, 2009).

26July 31, 2009.

27Feb. 1, 2008.

28May 30, 2003.

29See also TAM 200310001 (Oct. 15, 2002) (patent infringement damages capitalized to inventory do not qualify for section 1341 claim of right treatment; capitalized costs "are not 'deducted' but ' recovered' through cost of goods sold").

30In CCA 200805021, the IRS appears to conflate "gross income" with "net taxable income." The IRS stated that "[a] business realizes income on its gain: gross receipts [or sales] less the costs of producing that income [or COGS], i.e., net taxable income." Furthermore, after citing Treas. Reg. § 1.61-3(a) (defining gross income for manufacturing, merchandising, and mining businesses), the IRS concluded "[t]hat definition means net taxable income. . . ."

31See S. Rep. No. 1622, 83d Cong. 2d Sess. 118 (1954) ("Under present law if a taxpayer is obliged to repay amounts which he had received in a prior year and included in income because it appeared that he had an unrestricted right to such amount, he may take a deduction in the year of restitution."); H.R. Rep. No. 1337, 83d Cong. 2d Sess. 86 (1954) (same).

32See also Rev. Rul. 72-28, 1972-1 C.B. 269 (concluding that COGS is ignored in determining whether an item has been included in gross income within the meaning of section 1341).

33See, e.g., AOD 1977-77; NDSAR 020407; FSA 199932014.

34We believe it is appropriate to take depreciation and other items capitalized to inventory into account only to the extent it is included in COGS for the taxable year. For producers of electricity, the taxable year of depreciation and inclusion in COGS will generally be the same because electricity cannot be stored long-term. To the extent depreciation is included in ending inventory, it would not be added back in determining ATI until such depreciation is included in COGS.

35Prop. Treas. Reg. § 1.163(j)-10(c)(5)(iv).

36For this purpose, public utility property should be defined by reference to section 168(i)(10). Under section 168(i)(10), public utility property is defined as property that is predominantly used in one of the enumerated trades or businesses, which includes the furnishing or sale of certain regulated items listed in section 163(j)(7)(A)(iv), and where the rates for such furnishing or sale are established or approved on a cost of service and rate of return basis.

37Proposed Regulations, supra note 2, 83 Fed. Reg. at 67,519.

38See Prop. Treas. Reg. § 1.861-9(g)(2)(i)(A). For purposes of determining interest expense apportionment under section 864(e)(2), the proposed regulations would determine asset values taking an average of the values at the beginning and end of the taxable year. Where a substantial distortion of asset values would result from the beginning and end of year averaging (i.e., major corporate acquisition or disposition), "the taxpayer must use a different method of asset valuation that more clearly reflects the average value of assets weighted to reflect the time such assets are held by the taxpayer during the taxable year." Id.

END FOOTNOTES

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