Firm Seeks Clarifications in Proposed Depreciation Deduction Regs

October 3, 2018

The Honorable Steven Mnuchin
U.S. Department of the Treasury
1500 Pennsylvania Ave. NW
Washington, D.C. 20220

Elizabeth R. Binder
U.S. Department of the Treasury
1500 Pennsylvania Ave. NW
Washington, D.C. 20220

Re: REG-104397-18 — Notice of proposed rulemaking re: Additional First Year Depreciation Deduction

Dear Secretary Mnuchin and Ms. Binder,

K&L Gates, LLP (“K&L Gates”), submits the following comments in response to the notice of proposed rulemaking issued by the Internal Revenue Service (“IRS”) and the Department of the Treasury (“Treasury”) in the Federal Register on August 8, 2018 regarding the “Additional First Year Depreciation Deduction” (the “Notice”).¹ The Notice sets out proposed regulations to implement Section 168(k) of the Internal Revenue Code (“Code”),² as amended by the Tax Cut and Jobs Act (“TCJA”).³ Section 168(k) allows, in certain circumstances, an immediate first-year 100 percent depreciation deduction (“bonus depreciation”) of the basis of qualified property placed in service after September 27, 2017 and prior to January 1, 2023.

In passing the TCJA, Congress sought to create a level playing field for American businesses and to incentivize capital investment by U.S.-owned corporations. Conscious of this intent and aware of concerns about potential abuse resulting from the expansion of bonus depreciation to used property, K&L Gates requests that Treasury reconsider three policies of the Notice's proposed regulations so that: (1) property used for the first time in the United States is treated as new property; (2) a zero-year look-back safe harbor period applies to used property that has not previously been a U.S. depreciable interest; and (3) used property not previously depreciated under U.S. law, transferred at arm's-length between affiliated entities, and acquired at fair market value based on a certified appraisal qualifies for the TCJA's increased first-year depreciation deduction. These clarifications would be entirely consistent with the principles of the TCJA, continue to stimulate the American economy, avoid unintended abuses of the new Code, and prioritize the interests of U.S. businesses globally.

I. Background

a. TCJA: Statutory Changes to IRC Section 168(k)

Taxpayers generally are permitted to recover the cost of property acquired for use in a trade or business over a number of years through annual depreciation deductions.⁴ Prior to the enactment of the TCJA, a first-year bonus depreciation deduction in the amount of 50 percent of the adjusted basis of qualifying property was allowed, provided that the property was placed in service prior to 2020 (or 2021 in certain cases). Among other requirements, to be qualifying property the original use of the property must have been with the taxpayer.⁵

The TCJA made several changes to the deduction for bonus depreciation. Section 13201(a)⁶ of the TCJA extends the first-year bonus depreciation allowance through 2026 (for certain property, through 2027). The deduction is increased from 50 percent to 100 percent through 2022, followed by a multi-year phase-down of 20% of the adjusted basis each year through 2026. In addition, Section 13201(c)⁷ of the TCJA broadens the scope of property that is eligible for increased expensing to include used property.

b. Proposed Regulations

Definition of used property

The proposed regulations define property to be “used” if at “any time prior to acquisition by the taxpayer
. . . the taxpayer or a predecessor had a depreciable interest in the property . . . whether or not the taxpayer or the predecessor claimed depreciation deductions for the property.”⁸

Suggesting some flexibility with respect to this definition of used property, Treasury specifically has requested comments “on whether a safe harbor should be provided on how many taxable years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor previously had a depreciable interest in the property.”⁹ Comments of this nature should “provide the number of taxable years recommended for the look-back period and the reasoning for such number.”¹⁰

Related party rules

If property is determined to be used, the revised statute and proposed regulations allow bonus depreciation only if certain requirements are met with respect to related parties. Among them is the requirement that “the acquisition of the property meets the related party and carryover basis requirements of section 179(d)(2) . . .”¹¹ Section 179(d)(2) requires that the property at issue “is not acquired from a person whose relationship to the person acquiring it would result in the disallowance of losses under section 267 or 707(b).”¹² Both sections bar deductions for losses resulting from sales or exchanges between two closely related entities.¹³ Further, Section 179(d)(2) requires that the property “is not acquired by one component member of a controlled group from another component member . . .”¹⁴

Paragraph (b)(3)(iii)(C) of the proposed regulations explains that intermediate transfers will not disguise a transaction between related parties: “[t]he property is treated as directly transferred from the original transferor to the ultimate transferee,” and “[t]he relation between the original transferor and the ultimate transferee is tested immediately after the last transaction in the series.”¹⁵

II. Congressional Intent Behind Definition of Used Property and Related Party Rules

Expanding the scope of the bonus depreciation deduction to include used property is consistent with the overarching goals of tax reform to stimulate economic activity, create jobs, and improve the competitive position of U.S. businesses in the global marketplace. In many cases, the acquisition of new property may be impractical, while the acquisition of used property makes good business sense. The economics of a business may make it impossible to afford new equipment. Long lead-times and business exigencies may demand prompt purchases. National security concerns, including the choice of buying used property from a trusted source rather than new property from one that is not, may also drive purchasing decisions.

Anticipating potential gaming, Congress instituted anti-abuse language throughout the TCJA, including the definition of used property and the related party rules of Section 168(k). Congress' concern is clear in the TCJA conference committee report, which reads in relevant part that “[t]o prevent abuses, the additional first-year depreciation deduction applies only to property purchased in an arm's-length transaction.”¹⁶ As discussed later in this letter, while acquisitions from a related party may skirt arm's length standards, they do not necessarily do so. In some cases the acquisition of used property from a related person is completely consistent with the principles of the TCJA and sound business decision-making, and poses no threat of abuse.

III. Request for Consideration: Property Used for the First Time in the United States is New Property. Previous Regulations Provide Precedent for Definition of Original Use.

K&L Gates requests that Treasury reconsider the Notice's definitions of new and used property so that property previously used outside the United States and acquired by a U.S. business to be used in the United States for the first time is treated as new property. Guidance issued pursuant to enterprise zones offers precedent for this treatment as does more recent Opportunity Zone legislation.¹⁷

In 1993, as part of the Omnibus Budget Reconciliation Act,¹⁸ Congress created “enterprise zones” to spur investment in certain U.S. communities. The legislation put in place tax-exempt enterprise zone facility bonds. To qualify, a majority of the bond proceeds had to be used toward the creation of enterprise zone facilities, which were to consist of “qualified zone property.”¹⁹ The law defined “qualified zone property” to include only property “the original use of which . . . commences with the taxpayer.”²⁰ Treasury regulations implementing the program stipulated that “the term original use means the first use to which the property is put within the zone.”²¹ This view was reiterated as recently as 2008 in an IRS private letter ruling, which stated that “for purposes of issuing tax-exempt bonds . . . the original use requirement . . . is defined to mean the first use to which the property is put within the zone.”²²

Applying this rationale to the definitions of new and used property under Section 168(k), property acquired for its original use in the U.S. would be analogous to the first use of property within the enterprise zone. The enterprise zone guidance does not require that the property is new property, only that it is the first use of the property within the zone. Similarly, property with its first use within the U.S. should qualify as new property for purposes of the bonus depreciation rules. This approach is both logical and consistent, since property never before used in the U.S. has not been depreciated for U.S. tax purposes.

Significantly, the Opportunity Zone legislation enacted in December 2017 reinforces that the concept of original use can be situational. In defining qualified opportunity zone business property, Congress borrowed from enterprise zones and looked to “the original use of such property in the qualified opportunity zone . . .”²³ If Congress disagreed with the approach to defining original use in the enterprise zone program, they would not have reprised it 25 years later in the Opportunity Zone program.

IV. Request for Consideration: A Zero-Year “Look Back” Period is Appropriate for Used Property That Has Never Been a U.S. Depreciable Interest

Alternatively, K&L Gates requests that a zero-year safe harbor look back period be instituted for purposes of determining whether there is a preexisting depreciable interest when used property is acquired from a non-U.S. related source to be used in the United States for the first time. The Notice asks for comments on “whether a safe harbor should be provided on how many taxable years a taxpayer or a predecessor should look back to determine if the taxpayer or the predecessor previously had a depreciable interest in the property.”²⁴ Again, the enterprise zone regulations provide precedent for a look-back safe harbor period, providing that “if property is vacant for at least a one-year period including the date of zone designation, use prior to that period is disregarded for purposes of determining original use.”²⁵ This one-year look-back period was reiterated in the 2008 IRS private letter ruling which stated that “[f]or this purpose, use of property prior to a one-year period during which the property was vacant is disregarded.”²⁶

Applying this “reboot” rationale to the bonus depreciation rules and Treasury's request for comments, a zero-year look-back period for used property never before used in the U.S. is practical and reasonable. Such property would never have been a U.S. depreciable interest so would effectively be new for U.S. tax purposes. Particularly in situations where long lead times or national security concerns are involved, imposing a lengthier look-back period would create artificial and unnecessary bottlenecks in business operations and expansion, contrary to the intent of the TCJA.

To avoid the possibility of gaming or other abuses of this zero-year look back period, a certified appraisal could be required to ensure the arm's-length and fair market value acquisition of the property to establish compliance with Congressional intent.

V. Request for Consideration: Full Expensing for Arm's-Length Acquisition of Used Property from a Related Party

Alternatively, K&L Gates requests that used property acquired at fair market value from a non-U.S. related party, to be used in the U.S. for the first time by a domestic affiliate, qualifies for the 100 percent bonus depreciation deduction. Here too, fair market value could be established by a certified appraisal.

As discussed earlier in this letter, the statute and the proposed regulations generally prohibit the bonus depreciation deduction for used property acquired from a related party. This is consistent with concerns that transactions between related parties could result in inflated purchase prices or deflated sale prices in order to increase deductions or reduce income. However, the Notice makes clear that the involvement of a parent does not per se taint eligibility for the deduction in the instance of a step transaction. Instead, the Notice stipulates that the stages of the transaction will be collapsed so that the property is treated as directly transferred from the original transferor to the ultimate transferee. For example, paragraph (b)(3)(iii)(C)²⁷ describes eligibility for bonus depreciation when a parent company acquires property directly from a third party, and then contributes the property itself to a subsidiary entity. This is the case even though the subsidiary entity would normally acquire the property with a carryover basis. This approach relies on the substance of the transaction rather than its form.

This same rationale should apply to a transaction involving used property between a non-U.S. parent and a U.S. affiliate assuming the transaction is established to be at arm's length through a certified appraisal or other substantiation as required by Treasury and the IRS. Eliminating the possibility of abuse through third-party substantiation of an arm's length transaction would put the related party transaction on equal footing as a transaction between unrelated parties. Whether the property is new or used should not be the determinative factor, particularly when there has never before been a U.S. depreciable interest.

VI. Policy Considerations Support these Comments

Each of the three policies discussed in this letter would promote behavioral and economic results consistent with the policies of the TCJA, particularly when coupled with the anti-abuse protections that we have suggested. They will make it easier for smaller businesses to afford the property they need to prosper and create jobs. They will eliminate artificial restrictions created by whether property is considered new or used, or is acquired from a related party. They will eliminate barriers to entry and bottlenecks created by long production lead times. They will foster national security by facilitating the acquisition of used high-quality major equipment from trusted sources rather than from sources and countries that are less reliable and trustworthy and have adverse interests. They will help make U.S. businesses more competitive on a global scale.

As House Ways and Means Committee Chairman Kevin Brady (R-TX) said regarding the TCJA's passage, “it will revitalize our economy so American businesses can once again compete and win. . .”²⁸ Likewise, Senate Finance Committee Chairman Orrin Hatch (R-UT) touted the new law's ability to ensure that “businesses, both small and large, can better compete and bring more jobs and investment back home.”²⁹ We believe the policies proposed herein are consistent with these goals.

VII. Conclusion

Thank you for the opportunity to provide these comments. Please contact Mary Burke Baker at mary.baker@klgates.com with any questions or to discuss any of these comments in more detail.

Very truly yours,

Mary B. Baker
K&L GATES LLP
Washington, DC