Petroleum Group Recommends Changes to Proposed 'Repair' Regs

The American Petroleum Institute (API) is the leading trade association representing almost 500 companies that are among the leaders in the America's oil and natural gas industry: including producers, refiners, suppliers, pipeline operators and marine transporters, as well as service and supply companies that support all segments of the industry. Based on the capital intensive and vital nature of this industry, our members expend a significant amount of money continuously maintaining their facilities to ensure that energy is produced and products are delivered efficiently and within required specifications. Over the years, the issue of whether some of those repair costs should be capitalized for tax purposes has arisen on audit. Therefore, the industry is supportive of clear rules that address this issue to eliminate audit issues and promote efficient use of taxpayer and government resources.

On January 20, 2004, the Internal Revenue Service (IRS) and Treasury Department issued Notice 2004-6 to propose clarifying the tax treatment of expenditures paid to repair, improve or rehabilitate tangible property. The API, on behalf of our members, submitted comments and ideas on those regulations. Subsequently, on August 22, 2006, and March 2, 2008, additional regulations were published that addressed the application of § 263(a) to capitalize amounts paid to acquire, produce, or improve tangible property, for which API submitted comments as well.

Most recently, the IRS issued temporary regulations that provide guidance on the application of §§ 162(a) and 263(a) of the Internal Revenue Code (Code) to amounts paid to acquire, produce, or improve tangible property.

In general, API believes these re-proposed regulations constitute an earnest attempt to clarify and improve upon previous proposals; however, there remain several areas which still appear to be problematic, and we offer the following comments for consideration.

Timing

The preamble to the temporary regulations indicates that they are generally effective for tax years beginning on or after January 1, 2012. However, API recognizes that the IRS is considering various revenue procedures providing further detail on how to implement these regulations when finalized. One potential item for consideration should be a delay in implementation such that it coincides with the beginning of a taxpayer's accounting year or after a reasonable period of time such that the taxpayer is able to make the necessary changes to adopt the regulations. Given the size and scope of the operations of our members, API fully supports procedures that allow for a reasonable period of time to adopt these regulations.

Issues Concerning Regulations Addressing Materials and Supplies

With respect to the temporary regulations addressing the treatment of materials and supplies under § 162, we suggest the removal of two examples used to clarify the timing of the deduction for such costs. Specifically, we request that Examples 7 and 8 within Temp. Treas. Reg. § 1.162-3T(h) be removed from the temporary regulations. These examples appear to require the tracking of a small item that will begin to be used when purchased but may continue to be used into the following year. This results in the capitalization of a portion of costs for one year. We believe that these examples would more likely tie to the deduction of incidental materials and supplies found in Temp. Treas. Reg. § 1.162-3T(a)(2). The present value of the one year timing is clearly immaterial and will be a significant administrative burden for taxpayers and the IRS.

Dispositions of MACRS property

Temp. Treas. Reg. § 1.168(i)-8T(f)(2) states that if a taxpayer accounts for the asset disposed of in multiple asset account or pool and the total dispositions of assets with the same recovery period during the taxable year are readily determined from the taxpayer's records but it is impracticable from the taxpayer's records to determine the particular taxable year in which the asset disposed of was placed in service by the taxpayer, the taxpayer must use a first in, first out method of accounting. This language seems very narrow when applied to very large manufacturing assets. A typical scenario on older manufacturing assets is to improve or replace sections of the asset over a period of time on an as-needed basis. The costs of the improvements/replacements are capitalized in the year the event occurs. Over a period of time, it may no longer be possible to know with certainty the exact vintage of the asset that is being replaced. Instead, the taxpayer may know all the components that make up the asset and the associated basis for each vintage that makes up the entire asset being repaired, but not the specific vintage and basis for the specific section or component of the asset being replaced. Therefore, the temporary regulations should continue to allow a reasonable allocation method to write off the remaining basis over the remaining vintages of the asset being repaired.

Transaction Costs

Temp. Treas. Reg. § 1.263(a)-2T(f)(4), Example 5 details a situation requiring the costs of an interior designer associated with the purchase of a conference table for a legal firm to be construed as facilitative costs. We respectfully request that this section be removed from the temporary regulations as it is overly broad and problematic. Temp. Treas. Reg. § 1.263(a)-2T defines "facilitate" as an amount paid in the process of investigating or otherwise pursuing an acquisition. It is a facts and circumstances test, and the fact that the amount would or would not have been paid but for the acquisition is relevant, but not determinative. Temp. Treas. Reg. § 1.263(a)-2T(f) also provides a "whether and which" rule applicable to real property. Costs incurred for activities conducted in the process of investigating or pursuing real property to determine whether to acquire real property and which property to acquire don't facilitate the acquisition unless an activity is listed as inherently facilitative. This provision is similar to the due diligence provision in Treas. Reg. § 1.263(a)-5. The due diligence provision allows a certain amount of preliminary investigation of a potential acquisition before costs must be capitalized, unless the costs are incurred for something that is inherently facilitative. Based on that, there remains concern surrounding what is considered inherently facilitative. It seems that the regulations between real and personal property should be consistently applied and single property applications to particular properties is requested to be changed to "the property."

De Minimis Rule

Temp. Treas. Reg. § 1.263(a)-2T(g) allows a taxpayer to deduct amounts paid to acquire or produce real or personal property, except land and inventory, under a ceiling as part of a de minimis rule, provided that several requirements are met. To apply a de minimis rule the taxpayer must: (1) have an applicable financial statement ("AFS"); (2) at the beginning of the year, have written accounting procedures treating as an expense, for non-tax purposes, the amounts paid for property costing less than a certain dollar amount; (3) treat the amounts paid during the tax year as an expense on its AFS in accordance with its accounting procedures; (4) the amounts expensed cannot exceed the ceiling described in Temp. Treas. Reg. § 1.263(a)-2T(g)(1)(iv). To fall under the ceiling the aggregate of amounts paid and not capitalized for the tax year must be less than or equal to the greater of 0.1% of the taxpayer's gross receipts for the taxable year or 2% of the taxpayer's total depreciation and amortization expense for the taxable year.

The Preamble states that these requirements need not be met for a taxpayer to apply a de minimis rule if the IRS examining agent and the taxpayer reach an agreement for a different de minimis ceiling. Furthermore, the Preamble states that "a taxpayer that seeks a deduction for amounts in excess of the amount allowed by this rule or by agreement with IRS examining agents will have the burden of showing that such treatment clearly reflects income." Thus, the Preamble allows a taxpayer to exceed the de minimis ceiling described in Temp. Treas. Reg. § 1.263(a)-2T(g)(1)(iv) through an agreement with the IRS examining agent that clearly reflects income or without an agreement in place as long as the taxpayer's treatment clearly reflects income.

To avoid the confusion and administrative burden, for both taxpayers and the IRS, of applying two different de minimis rules, i.e. the de minimis ceiling (Temp. Treas. Reg. § 1.263(a)-2T(g)(1)(iv)) versus clear reflection of income (Temp. Treas. Reg. Preamble), we suggest that the de minimis ceiling be removed in Temp. Treas. Reg. § 1.263(a)-2T(g)(1)(iv) and replaced with the clear reflection of income standard. We suggest stating that if a taxpayer follows GAAP, such taxpayer is considered to have met the clear reflection of income standard since GAAP provides for a clear reflection of income.

Alternatively, if both standards are retained, there would be several additional changes that we would recommend. First, we suggest clarification of the interaction between the two standards. One possible method is to expand the de minimis rule in § 1.263(a)-2T(g)(1) to include clear reflection of income and make the de minimis ceiling a safe harbor. Another method is to expand the paragraph in the Preamble on the de minimis rule to state more clearly that the clear reflection of income standard is an alternative to the de minimis ceiling. Second, it appears that the de minimis ceiling calculation is not computed at the consolidated level but rather at the specific company level. The Preamble states that the IRS and Treasury Department are aware that some taxpayers would prefer the ceiling apply at the consolidated level and that this is still under consideration. We urge that if the de minimis ceiling remain, it be applied at the consolidated level. Third, the de minimis ceiling computation is based on the taxpayer's current year gross receipts or depreciation and amortization expenses, which makes its application very difficult. We recommend that, instead of using figures from the current year in the computation, taxpayers be allowed to use figures from the prior year or a three year rolling average.

In addition, the language in Temp.Treas. Reg. § 1.263(a)-2T(g)(4) suggests that if a taxpayer inadvertently capitalizes costs that would otherwise be de minimis under its book policies, the taxpayer has elected to capitalize de minimis costs which can only be revoked by obtaining permission from Commissioner. We suggest clarification that the capitalization election applies only to the individual unit of property that the taxpayer capitalizes and not the entire category of unit of property as described in the taxpayer's written accounting procedures.

Unit of Property Determination: Plant Exception

We note that the temporary regulations continue to adjust the previous general rule definition of a unit of property ("UOP") for assets other than buildings to include set components that are functionally interdependent -- that in order to place one component into service, another component or components must be placed into service as well. Included in this new definition is a category associated with plant property, which includes functionally interdependent machinery or equipment used to perform an industrial process. However, for plant property, the temporary regulations provide that a UOP is comprised of each component associated with an item of plant property that performs a discrete and major function or operation within the functionally interdependent machinery or equipment.

API and its members continue to have concerns with this definition as it appears that this definition would act as an exception to the general definition and disregard the functional interdependence of different pieces of machinery that would otherwise comprise one unit of property. Instead, the proposed regulation would require taxpayers to consider each major component of an otherwise accepted UOP as a separate unit of property. Apparently, this allows for a smaller UOP to be considered when determining whether or not certain costs should be considered an improvement to the particular asset.

We remain concerned that raising the components of a plant to the level of a UOP in the temporary regulations will conflict with the functional interdependence test and introduce uncertainty as to when cost recovery may begin. Where there are components that operate together to form a single function, the IRS has disregarded the readiness of the components and looked to the readiness of the integrated unit as a whole in determining when depreciation begins under § 167. Having one UOP definition for purposes of starting depreciation under § 167 and a different property definition for purposes of capitalizing improvements is unnecessary.

Safe Harbor for Routine Maintenance on Property Other Than Buildings

Temp. Treas. Reg. § 1.263(a)-3T(g) provides a current deduction associated with amounts paid for routine maintenance activities that the taxpayer expects to perform to keep the property in its ordinarily efficient operating condition. Further, it states that "the activities are routine only if, at the time the UOP is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life of the unit of property." First, it seems that the language should be changed to "one or more" from "more than once." A simple example to illustrate the need for this change in a typical Refinery or Chemical plant manufacturing operation is the replacement of sections of an alloy feed stock or distribution pipelines used in a chemical or refinery plant which normally expected to last a long time, and routine replacement of the pipe is not expected or deemed necessary. However, when used in a corrosive fluid environment it is expected that at some point during the life of the line sections of pipe may become damaged due to the corrosion. The repair does not extend the life of the Unit or even the life of line and therefore they are replaced as a maintenance activity when needed. To simplify the illustration even further, this is similar to the replacement of a muffler in a car. A typical muffler is not expected to be replaced multiple times during the life of the car however if the car is driven in areas of the country where there is a lot of snow and the highways are salted on a regular basis then it is likely that at some point during the life of the car that salt will damage the muffler and will need to be replaced. The replacement is conditional on the amount of time spent in a corrosive environment which cannot pre-determined. The point is that it is generally expected that these types of services may be done once during the life of the asset; therefore, under a strict interpretation of the temporary regulations, these costs would be capital because they do not meet the expectation requirement of "more than once."

Second, with regard to large self-constructed manufacturing assets, it is not always possible to know the exact vintage of the component being serviced. For example, it is common to have to replace small corroded sections of large vessels or drums used in the specific units in a refinery such as the atmospheric columns or vacuum columns in a typical crude unit. Because the columns are very large assets, major sections may have been constructed/replaced and capitalized over multiple years and it is not possible to know the exact vintage of the column where a small section of corroded sheet metal is being replaced. Assuming the small replacements do not extend the life, increase the value, or change or improve the process, they should be deductible as routine maintenance irrespective of the vintage or age of the asset.

Casualty Loss

Temp. Treas. Reg. § 1.263(a)-3T(i)(iii) states a taxpayer must capitalize repairs of a damaged UOP for which the taxpayer has properly taken a basis adjustment as a result of a casualty loss under § 165. This provision seems overly broad and contradicts other tax provisions that are enacted to provide taxpayer relief from natural disasters. The President has authority to grant relief to taxpayers under § 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act for damage caused by severe storms, tornados or flooding. The purpose of the relief is to provide stability and prevent disruption in the economy and financial system. The Emergency Economic Stabilization Act of 2008 states in § 198A(a) that "[a] taxpayer may elect to treat any qualified disaster expenses which are paid or incurred by the taxpayer as an expense which is not chargeable to capital account. Any expense which is so treated shall be allowed as a deduction for the taxable year in which it is paid or incurred." The intent is to give relief to the taxpayer as an inducement to restore the damaged assets to their condition prior to the disaster as quickly as possible. The Temporary Regulations appear to negate that relief by stating that all repairs to damaged property must be capitalized. In addition, the language is very narrow in its interpretation and does not take into account other provisions within § 263(a) such as whether the cost incurred increased the value of the asset, prolonged its useful life, or modified the assets to a new or different use which are the basic requirements for capitalization. Often times a significant portion of the costs incurred to restore the damaged assets are related to flood restoration and clean-up. These costs do not meet the requirement for capitalization. The provisions, as currently drafted, actually can result in detrimental treatment to the taxpayer. For example, a taxpayer that sustains flood damage to a two year old unit in a chemical plant will be required to capitalize all repair costs which will clearly exceed the net remaining basis of the assets damaged (assuming tax class life of 5 years and bonus depreciation) even though there was no increase in value in the asset restored.

Major Component Rule

The temporary regulations provide that the replacement of a major component or substantial structural part of the UOP must be capitalized. The 2008 proposed regulations provided a bright-line test by defining major component or substantial structural part as a part or a combination of parts of the UOP, the cost of which comprises 50% or more of the replacement cost of the UOP or the replacement of which comprises 50% or more of the physical structure of the UOP ("the 50% Rule").

The new regulations eliminated the 50% Rule and instituted facts and circumstances test in determining whether an amount is paid for the replacement of a major component. A major component includes a part (or combination of parts) that comprise a large portion of the physical structure of the UOP or perform a discrete and critical function in the operation of the UOP. To mitigate the administrative burdens associated with a facts and circumstances analysis, and to provide a safe harbor for taxpayers, taxpayers should be able to follow the non-distortive book treatment or GAAP of the replacement costs in determining whether an amount paid for replacing a component to the UOP should be capitalized.

Change in Method of Accounting

We appreciate the two Revenue Procedures' provision of streamlined and expedited processes for requesting change in method of accounting, including automatic consent procedures and use of stat sampling for § 481(a) adjustments. However, the mechanism for § 481 adjustments is still too burdensome. We request the use of same stat sample extrapolation or the use of data from one or two recent years and extrapolate back to determine amount.

Conclusion

API and its member companies appreciate the continued effort associated with this regulation project. We look forward to continuing our engagement with you on this issue and, should you have any follow-up questions regarding our comments, please do not hesitate to contact me.