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Transport Co. Seeks ‘Component Election’ in Bonus Depreciation Regs

OCT. 2, 2018

Transport Co. Seeks ‘Component Election’ in Bonus Depreciation Regs

DATED OCT. 2, 2018
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October 2, 2018

Elizabeth Binder
CC:PA:LPD:PR (REG-104397-18), Room 5203
Courier's Desk
Internal Revenue Service,
1111 Constitution Avenue NW
Washington, DC 20224

Re: Bonus Depreciation for Components of Self-constructed Property

Dear Ms. Binder:

Saltchuk Resources, Inc. (Saltchuk) is a privately held U.S. corporation organized under the laws of the state of Washington, and treated as a small business corporation within the meaning of section 1361(b) (an "S Corp”) for federal income tax purposes. Saltchuk, through its subsidiaries, provides: (i) air cargo services; (ii) domestic and international shipping and logistic services; (iii) marine services; (iv) nationwide trucking and logistics services; and (v) petroleum distribution throughout North America. The Company has aggregate annual revenue of nearly $2.75 billion and employs approximately 5,500 people. It is one of the largest privately held businesses in the state of Washington.

I am writing to you in my capacity as Vice President of Tax at Saltchuk to offer our observations and recommendations that may be useful to the IRS and Treasury in finalizing guidance under Section 168(k). In particular, many taxpayers and tax advisers have questions regarding the application of the bonus depreciation rules to self-constructed property and longer production period property (LPPP) and whether separately acquired components of self-constructed property will qualify for increased 100% bonus depreciation if they are determined to be acquired after September 27, 2017.

History of Bonus Depreciation

100-percent Bonus Depreciation

The 2017 Tax Cuts and Jobs Act (the 2017 Act) enacted December 22, 2017, made substantial changes to the US federal income tax rules for depreciation under section 168(k) as part of Congress's plan for a "pro-growth tax reform"1. One of the most substantial changes now permits taxpayers to expense too percent of the cost of qualified property acquired after September 27, 2017, and placed in service by December 31, 2022 (December 31, 2023, for LPPP). Under section 168(k) as in effect prior to the 2017 Act, taxpayers were limited to 50-percent bonus depreciation for qualified property placed in service through 2017 (2018 for LPPP), with phase downs to 40 percent and 30 percent for qualified property placed in service in 2018 (2019) and 2019 (2020), respectively.

The 2017 Act amended Section 168(k)(1)(A) by striking "50 percent” and inserting "the applicable percentage”. For qualified property acquired after September 27, 2017, and placed in service before January 1, 2023 (January 1, 2024, for LPPP), the applicable percentage is 100 percent. In contrast, for property acquired before September 27, 2017, and placed in service in after 2017, the applicable percentage is phased-down until it is fully phased out in 2020 (2021 and thereafter for LPPP).

For purposes of determining when property is acquired, Section 13201(h)(1) of the 2017 Act provides that property shall not be treated as acquired after the date on which a written binding contract is entered into for such acquisition. While the 2017 Act does not set forth a definition of "binding contract,” proposed regulations under section 168(k) issued by the IRS and Treasury provide a definition.

Bonus Depreciation Legislative and Regulatory Background

Bonus depreciation under section 168(k) was originally added to the Code following the terrorist attacks of September 11, 2001, by section 101 of the Job Creation and Worker Assistance Act of 2002 (the "2002 Act”). The original version provided 30-percent bonus depreciation for qualified property acquired and placed in service after September 10, 2001. The Jobs and Growth Tax Relief Act of 2003 (the "2003 Act”) raised the applicable bonus depreciation percentage to 50-percent, Bonus depreciation expired at the end of 2004, but this economic stimulus tool was revived by the Economic Stimulus Act of 2008 (the "2008 Act”), and further extended, enhanced and modified in the following years.2

As originally enacted, section 168(k) specified property that qualified for bonus depreciation, as long as each the following four requirements under section 168(k)(2) were met:

  • Property of a Specified Type

  • Original Use3

  • Acquisition of Property

  • Placed-in-Service Date

The IRS and Treasury issued temporary regulations (T.D. 9091) in 2003, providing guidance regarding bonus depreciation. Final regulations (T.D. 9283) were issued in 2006 ("regulations” or "final regulations"). The regulations provide rules for the original 2001/2003 version of bonus depreciation. However, the IRS and taxpayers alike have applied the regulations and their definitions, where applicable, to subsequent iterations and extensions of bonus depreciation4. See, e.g., Rev. Proc. 2011-26, as discussed later.

The IRS and Treasury released proposed regulations (F.R. Vol. 83, No, 153) in August 2018, providing guidance regarding the amendments to bonus depreciation from the 2017 Act. The proposed regulations provide roles for property acquired and placed in service after September 27, 2017.

Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iii)

Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iii) provides guidance on whether property meets the acquisition requirement for bonus depreciation for property acquired and placed in service after September 27, 2017. For property that is not self-constructed property, a critical factor is whether a written binding contract was in existence for the acquisition of the property prior to the relevant bonus depreciation window. (For property self-constructed by a taxpayer, discussed below, the critical factor is when the manufacture, construction, or production of the property began.)

The proposed regulations generally retained the definition in the Treas. Reg. § 1.168(k)-1(b)(4)(ii). The proposed regulations define a contract as binding only if it is enforceable under state law against the taxpayer or a predecessor, and does not limit damages to a specified amount (for example, by use of a liquidated damages provision). For this purpose, a contractual provision that limits damages to an amount equal to at least 5 percent of the total contract price will not be treated as limiting damages to a specified amount. In determining whether a contract limits damages, the fact that there may be little or no damages because the contract price does not significantly differ from fair market value will not be taken into account. If the contract provided for a full refund of the purchase price in lieu of any damages allowable by law in the event of breach or cancellation, the contract is not considered binding.

The proposed regulations further provided that a contract is binding even if subject to a condition, as long as the condition is not within the control of either party or a predecessor. A contract will continue to be binding if the parties make insubstantial changes in its terms and conditions or because any term is to be determined by a standard beyond the control of either party. A contract that imposes significant obligations on the taxpayer or a predecessor will be treated as binding notwithstanding the fact that certain terms remain to be negotiated by the parties to the contract.

The proposed regulations added that a letter of intent for an acquisition is not a binding contract.

Under the proposed regulations, an option to either acquire or sell property is not a binding contract, nor is a supply or similar agreement if the amount and design specifications of the property to be purchased have not been specified. The contract will not be a binding contract for the property to be purchased until both the amount and the design specifications are specified. Finally, under the proposed regulations, a binding contract to acquire one or more components of a larger property will not be treated as a binding contract to acquire the larger property.

Prop. Treas. Reg. § 1.168(k)-2(b)(5)(iv)

As referenced above, Prop. Treas. Reg. section 1.168(k)-2(b)(5)(iv) provides guidance for the application of the acquisition rule to self-constructed property. Generally, if a taxpayer manufactures, constructs, or produces property for use by the taxpayer in its trade or business (or for its production of income), tire acquisition rules in Prop, Treas. Reg, section 1.168(i)-2(b)(5)(i) are treated as met for qualified property if the taxpayer begins manufacturing, constructing, or producing the property after the beginning of the relevant bonus depreciation window, and before the close of the relevant bonus depreciation window.

Property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract (as defined in paragraph Prop. Treas. Reg. section 1.168(k)-2(b)(5)(iii)) that is entered into prior to the manufacture, construction, or production of the property for use by the taxpayer in its trade or business (or for its production of income) is not considered to be manufactured, constructed, or produced by the taxpayer, i.e., self-constructed property. The proposed regulations differ from the Treas. Reg. § 1.168((k)-1(b)(iii), which provided that property that was manufactured, constructed, or produced for the taxpayer by another person under a written binding contract entered into before manufacture, construction, or production of property begins was considered self-constructed property.

If a taxpayer enters into a written binding contract after the beginning of the relevant bonus depreciation window with another person to manufacture, construct, or produce property described in section 168(k)(2)(B) (longer production period property) or section 168(k)(2)(C) (certain aircraft) and the manufacture, construction, or production of this property begins after September 27, 2017, then the acquisition rule in paragraph (b)(5)(i) or (b)(5)(ii) of Prop, Treas. Reg. §1.168(k)-2 or paragraph (b)(4)(i)(A)(2) or (b)(4)(i)(B)(2) of Treas. Reg. § 1.168(k)-1 are met.

Under this section of the proposed regulations, manufacture, construction, or production of property begins when physical work of a significant nature begins. Physical work does not include preliminary activities such as planning or designing, securing financing, exploring, or researching. The determination of when physical work of a significant nature begins depends on the facts and circumstances. However, preliminary work, such as clearing a site, test drilling to determine soil condition, or excavation to change the contour of the land (as distinguished from excavation for footings) does not constitute the beginning of construction. If a facility is to be assembled on-site from modular units manufactured off-site and delivered to the site where the outlet will be used, then manufacturing begins when physical work of a significant nature commences at the off-site location.

10-percent Safe Harbor

In lieu of the aforementioned "physical work of a significant nature” test to determine when the manufacture, construction or production of property begins, the proposed regulations provide a safe harbor under which physical work of a significant nature will not be considered to begin before the taxpayer incurs (in the case of an accrual basis taxpayer) or pays (in the case of a cash cash taxpayer) more than 10 percent of the total cost of the property (excluding the cost of any land and preliminary activities such as planning or designing, securing financing, exploring, or researching) ("10-percent Safe Harbor"). A taxpayer chooses to apply this safe harbor by filing a federal income tax return for the placed-in-service year of the property that determines when physical work of a significant nature begins consistent with this section.

The 10-percent Safe Harbor provided in the proposed regulations does not define the term "incurred" for purposes of this section. The common definition of the term "paid or incurred" under Section 7701(a)(25) provides that it shall he construed according to the method of accounting upon the basis of which the taxpayer's taxable income is computed. Over the years, taxpayers and the IRS5 have applied the rules under section 461 to determine when costs are incurred for purposes of satisfying the 10-percent Safe Harbor. Under section 461, an amount is incurred for an accrual basis taxpayer when all events have occurred to fix the liability, the amount can be determined with reasonable accuracy, and economic performance has occurred, If the liability of a taxpayer arises out of the providing of services or property to the taxpayer by another person, then economic performance occurs as the services or property are provided. See Treas. Reg, section 1.461-4(d)(2)(i).

Acquired components of self-constructed property

This section of the proposed regulations also provides rules pertaining to qualifying acquired components of larger self-constructed property for bonus depreciation.6 Specifically, if a binding contract to acquire a component does not satisfy the acquisition requirement, then the component does not qualify for bonus depreciation. A binding contract to acquire one or more components of a larger self-constructed property will not preclude the larger self-constructed property from satisfying the acquisition requirements. Accordingly, the unadjusted depreciable basis of the larger self-constructed property that is eligible for bonus depreciation must not include the unadjusted depreciable basis of any component that does not satisfy the acquisition requirement. If the manufacture, construction, or production of the larger self-constructed property begins before the relevant bonus depreciation window, then the larger self-constructed property and any acquired components related to the larger self-constructed property do not qualify for bonus depreciation. If a binding contract to acquire the component is entered into during the relevant bonus depreciation window, but the manufacture, construction, or production of the larger self-constructed property does not begin before the end of the relevant bonus depreciation window, then the component qualifies for the additional first year depreciation deduction (assuming all other requirements are met) but the larger self-constructed property does not.

Further, if the manufacture, construction, or production of a self-constructed component does not satisfy the self-constructed property acquisition rules, then the component does not qualify for bonus depreciation. However, if the manufacture, construction, or production of a self-constructed component does not satisfy the self-constructed property acquisition rules, but the manufacture, construction, or production of the larger self-constructed property satisfies the self-constructed property acquisition rules, then the larger self-constructed property qualifies bonus depreciation (assuming all other requirements are met) even though the component does not qualify for bonus depreciation. Accordingly, the unadjusted depreciable basis of the larger self-constructed property that is eligible for the bonus depreciation must not include the unadjusted depreciable basis of any component that does not qualify for the bonus depreciation. If the manufacture, construction, or production of the larger self-constructed property began before the relevant bonus depreciation window period, then the larger self-constructed property and any self-constructed components related to the larger self-constructed property do not qualify for bonus depreciation. Finally, if the manufacture, construction, or production of a component begins during the relevant bonus depreciation window period, but the manufacture, construction, or production of the larger self-constructed property does not begin before the expiration of the bonus depreciation window period, then the component qualifies for the additional first year depreciation deduction (assuming all other requirements are met) but the larger self-constructed property does not.

Rev. Proc. 2011-26

Rev. Proc. 2011-26 provides guidance under the SBJA of 2010 and the TRUIRJCA of 2010. Sections 2022(a) of the SBJA and 401(a) of the TRUIRJCA amended section 168(k)(2) of the Internal Revenue Code by extending the placed in-service dale for property to qualify for the 50-percent additional first year depreciation deduction. Section 401(b) of the TRUIRJCA amended section 168(k) by adding former section 168(k)(5), which temporarily allowed a 100-percent additional first year depreciation deduction for certain new property.

Section 2.04 of Rev. Proc. 2011-26 states that sections 1.168(k)-1(b)(4)(iii)(C)(1) and (2) of the Income Tax Regulations provide that if the manufacture, construction, or production of the larger self-constructed property begins before December 31, 2007 (as modified by the dates in section 168(k)(2)(E)(i)), for qualified property, the larger self-constructed property and any acquired or self-constructed components related to the larger self-constructed property do not qualify for the 50-percent additional first year depreciation deduction. This section further notes that because of the policies underlying the enactment of an unprecedented 100-percent additional first year depreciation provision, rules similar to, but not necessarily the same as, the acquisition rules under section 16S(k)(2)(A)(iii) for qualified property are warranted solely for purposes of former section 168(k)(5). Accordingly, the Treasury Department and the IRS allowed, solely for purposes of section 168(k)(5), a limited exception to this rule in Treas. Reg. sections 1.168(k)-1(b)(4)(iii)(C)(i) and (2) for certain components.

Section 3.02(2)(b) of Rev. Proc. 2011-26 provided the limited exception for components acquired or self-constructed after September 8, 2010 (the date that 100-percent bonus depreciation became effective in 2010, and the equivalent date to September 27, 2017, under the 2017 Act), and before January 1, 2012, when the manufacture, construction, or production of larger self-constructed property began before September 9, 2010 ("Component Election”). The Component Election is described in Rev. Proc. 2011-26 as follows:

Solely for purposes of § 168(k)(5) and section 3.02(1)(a) of this revenue procedure, the Treasury Department and the Service will allow a limited exception to the rule described in section 2.04 of this revenue procedure for the components described in this section 3.02(2)(b). If before September 9, 2010, a taxpayer begins the manufacture, construction, or production of the larger self-constructed, property that is qualified property for use in its trade or business or for its production of income, but this larger self-constructed property meets the requirements of sections 3.02(1)(b) [placed in service requirement] and (c) [original use requirement] of this revenue procedure, the taxpayer may elect to treat any acquired or self-constructed component of that larger self-constructed property as being eligible for the 100-percent additional first year depreciation deduction if the component is qualified property and is acquired or self-constructed by the taxpayer after September 8, 2010, and before January 1, 2012 (before January 1, 2013, in the case of qualified property described in § 168(k)(2)(B) or (C)). The taxpayer may make this election for one or more components that are described in this section 3.02(2)(b), The taxpayer must make the election in this section 3.02(2)(b) by the due date (including extensions) of the federal tax return for the taxpayer's taxable year in which the larger self-constructed property is placed in service by the taxpayer, and by attaching a statement to that return indicating that the taxpayer is making the election provided in section 3.02(2)(b) of Rev. Proc. 2011-26 and whether the taxpayer is making the election for all or some of the components described in section 3.02(2)(b) of Rev. Proc. 2011-26. If a taxpayer has timely filed its federal tax return for the taxpayer's taxable year in which the larger self-constructed property is placed in service by the taxpayer on or before April 18, 2011, see § 301.9100-2(b) of the Procedure and Administration Regulations for an automatic extension of 6 months from the due date of that federal return (excluding extensions) to make the election specified in this section 3.02(2)(b)."

Rev. Proc. 2011-26, provides, in the following Example 3 of when a component election is made:

X, a calendar-year taxpayer, began constructing a ship for its own use in March 2010. Between March 2010 and June 2012, X incurred $25 million to complete the construction of the ship. This $25 million includes $15 million for acquired components that were acquired by X after September 8, 2010, and before January 1, 2013, and for self-constructed components, the construction, manufacturing, or production of which began after September 8, 2010, and before January 1, 2013 (the ship is property described in § 168(k)(2)(B)). All acquired components of the ship were acquired by X pursuant to written binding contracts entered into after March 2010. The original use of all components of the ship commences with X. X completed construction of the ship in June 2012, and placed it in service in August 2012. On its 2012 federal tax return, X makes the election provided under section 3.02(2)(b) of this revenue procedure. The ship is included in asset class 00.28 of Rev, Proc. 87-56, and has a recovery period of 10 years under § 168(c). First, X must determine if the ship is qualified property and if its components are qualified property. X began construction of the ship after December 31, 2007, and all of its components were self-constructed beginning, or acquired pursuant to written binding contracts entered into, after December 31, 2007. Also, the original use of the ship began with X after December 31, 2007, and X placed the ship in service before January 1, 2014 (the ship is property described in § 168(k)(2)(B)). Thus, the ship and its components are qualified property. X must next determine if the ship and any of its components are eligible for the 100-percent additional first year depreciation deduction. Although the original use of the ship began with X after September 8, 2010, and X placed the ship in service after September 8, 2010, and before January 1, 2013 (the ship is property described in § 168(k)(2)(B)), not all of X's total expenditures of $25 million qualify for the 100-percent additional first year depreciation deduction. X began construction of the ship before September 9, 2010, but made the election provided under section 3.02(2)(b) of this revenue procedure. As a result, the $15 million portion (of the total $25 million unadjusted depreciable basis for the ship) incurred for the components that were acquired or self-constructed by X after September 8, 2010, and before January 1, 2013, qualifies for the 100-percent additional first year depreciation deduction. The remaining $10 million portion of the total $25 million unadjusted depreciable basis qualifies only for the 50-percent additional first year depreciation deduction.

Request To Follow Historical Guidance

Historically, the impact of a written binding contract on self-constructed property was generally to determine if property was treated as acquired property or self-constructed property. Specifically, as noted above, if a taxpayer manufactured, constructed, or produced property for use by the taxpayer in its trade or business (or for its production of income) then the acquisition rules were treated as met for qualified property if the taxpayer began manufacturing, constructing, or producing the properly after the beginning of the relevant bonus depreciation window, and before the close of the relevant bonus depreciation window. In addition, property that was manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that was entered into prior to the manufacture, construction, or production of the property for use by the taxpayer in its trade or business (or for its production of income) was considered to be manufactured, constructed, or produced by the taxpayer, i.e., self-constructed property. Once the determination had been made that the property was self-constructed, then the taxpayer applied either the physical work of a significant nature test or the 10-percent safe harbor and, for applicable years if so elected, the Component Election of Rev. Proc. 2011-26.

However, for purposes of determining when property is acquired for the current iteration of bonus depreciation, section 13201(h)(1) of the 2017 Act provides that property shall not be treated as acquired after the date on which a written binding contract is entered into for such acquisition. As a result of this provision, the proposed regulations depart from the historical rules regarding self-constructed property by looking to the written binding contract date as the determining factor for when construction begins.

If the written binding contract rule is to be interpreted as an over-arching rule for all property for bonus depreciation under the 2017 Act, then that treatment would obsolete the historical rules applicable to self-constructed property. As a result, this position would be contrary to the legislative intent of the 2017 Act's bonus depreciation provision to stimulate the economy and encourage investment in capital assets. Moreover, such an interpretation would result in the entire depreciable basis of self-constructed property not being eligible for 100-percent bonus depreciation if the written binding contract date for the property was prior to September 28, 2017.7

As described above, the 2017 Act's increase in the applicable bonus depreciation rate from 50-percent to 100-percent is not unprecedented, as Congress enacted legislation in 2010 that did just that. The Trump Administration and Congressional Republican leaders released the "Unified Framework for Fixing Our Broken Tax Code" ("Framework") on September 27 2017, as a blueprint to Tax Reform. The Framework "represents an unprecedented level of expensing with respect to the duration and scope of eligible assets” that would be allowed to be immediately expensed, explicitly referring to depreciable assets "made” after September 27, 2017.8

Additionally, the OECD reports that "recent tax reforms that cut corporate income tax rates and temporarily include full expensing of capital outlays will likely give a substantial boost to investment activity."9 Thus, immediate expensing is an integral part of driving continued growth in the economy. In contrast to the final Trees. Reg. §1.168(k)-1, under the Prop, Treas. Reg. §1.168(k)-2 property with a written binding contract entered into before September 27, 2017, is not permitted for immediate expensing.

Accordingly, in order to reflect Congressional intent in once again enacting 100-percent bonus depreciation, we respectfully request that the final regulations under Treas. Reg. §1.168(k)-2 for bonus deprecation under the 2017 Act include an election similar to the Component Election, which would allow taxpayers to take the bonus depreciation on assets that are placed in service and acquired within the specified dates even if such assets are components of a larger property that is not otherwise eligible for bonus depreciation. Such an election would also provide well-established rules that are familiar to both the IRS and taxpayers, thereby likely resulting in limited IRS examination disagreements and increased certainty for taxpayers.

I appreciate the time you have given to this matter. On behalf of Saltchuk, I respectfully request that you issue guidance addressing the issues raised above.

Very truly yours,

J. Michelle Brown
Vice President, Tax
Saltchuk Resources, Inc.
Seattle, WA

cc:
Tom West, Tax Legislative Counsel, Office of Tax Policy, Department of the Treasury
Ellen Martin, Tax Policy Advisor, Office of Tax Policy, Department of the Treasury

Scott Dinwiddie, Associate Chief Counsel, Internal Revenue Service Office of Chief Counsel
Kathy Reed, Branch Chief, CC:ITA;B07, Internal Revenue Service Office of Chief Counsel

FOOTNOTES

1House Ways and Means Committee Chairman Kevin Brady (R-TX) refers to 2017 tax reform as "pro-growth tax reform that will create jobs, increase paychecks, and strengthen our nation's economy." (https://waysandmeans.house.gov/chairman-brady-opening-statement-hearing-tax-reform-will-grow-economy-create-jobs/)

2See American Recovery and Reinvestment Tax Act of 2009; Small Business Jobs Act of 2010 (the "SBJA of 2010"); Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (the "TRUIRJCA of 2010"); American Taxpayer Relief Act of 2012; Tax Increase Prevention Act of 2014; and the Protecting Americans from Tax Hikes Act of 2015 (the "2015 Act”).

3Note that the original use requirement has generally been removed under the 2017 Act, thus now generally permitting bonus depreciation for used property, except with respect to property acquired in certain related-party transactions.

4Note that with respect to the 2015 Act, the IRS did not extend the application of rules related to acquisitions of property. The acquisition requirement was dropped from bonus depreciation by the 2015 Act. At that point, an acquisition requirement as a limiter on qualifying property for bonus depreciation was generally irrelevant, given the continuous bonus depreciation window extending from 2008-2017.

5See Private Letter Rulings ("PLRs") 201210004, 201214002, and 201313012.

6Prop. Treas. Reg. section 1.168(k)-1(b)(5)(iv)(C).

7As noted in the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 111th Congress, Part Two: Revenue Provisions of the American Recovery and Reinvestment Act of 2009 (Public Law 111-5), the policy reason of allowing additional first-year depreciation was to accelerate purchases of equipment and other assets, and promote capital investment, modernization, and growth. Similarly, in 2010, the reason to increase the applicable percentage from 50 to 100-percent was to promote capital investment and growth. Presumably the same policy intent existed in the 2017 Act to once again increase the applicable percentage from 50 to 100-percent.

8Treasury, "Unified Framework for Fixing Our Broken Tax Code", September 27, 2017. (https://www.treasury.gov/press-center/press-releases/Documents/Tax-Framework.pdf)

9"Tax Foundation, The OECD Highlights the Economic Growth Benefits of Full Expensing, June 12, 2018. (https://taxfoundation.org/oecd-highlights-economic-growth-benefits-full-expensing/)

END FOOTNOTES

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