In recently issued Rev. Proc. 2023-15, the IRS provides a safe harbor method of accounting under which taxpayers may classify costs to repair, maintain, replace, or improve natural gas transmission and distribution property as either capital or deductible expenditures (the NGSH Method). While the NGSH Method may lessen the burden of compliance to taxpayers by providing clear bright-line rules on which taxpayers may rely in lieu of making these complex factual determinations, taxpayers choosing not to use the NGSH Method may face greater IRS scrutiny. This long-awaited guidance also provides the procedures by which taxpayers may receive automatic consent to change to the NGSH Method, with the option to make a change to the NGSH Method on a cut-off basis for the first three taxable years ending after May 1, 2023.

Overview:

Natural gas transmission and distribution companies generally incur significant expense to maintain, repair, replace, and improve their transmission and distribution property. As a general rule, expenditures that result in a betterment or restoration of the property, or that adapt the property to new or different use, must be capitalized,¹ whereas taxpayers may generally deduct repair and maintenance expenditures that do not result in a betterment, restoration, or adaptation in use of the property.² Furthermore, expenditures properly allocable to property produced by the taxpayer are generally required to be capitalized under section 263A. When considering large networks of interconnected assets, such as natural gas transmission and distribution property, the fact-intensive determination of whether expenditures are required to be capitalized is particularly complex and has been the subject of considerable uncertainty and disputes between taxpayers and the IRS. As a result of these disputes, the IRS selected the issue for its Industry Issue Resolution (“IIR”) program, which aims to resolve frequently disputed or burdensome business tax issues affecting many taxpayers.

The IIR Process

As noted, the IIR program typically addresses significant, complicated tax issues that impact many taxpayers. The goal of any project selected for the IIR program is to provide clear guidance that business taxpayers can use in order to reduce the time and expense of resolving these frequent issues on a case-by-case basis in the IRS Exam process. Under the IIR program, business taxpayers, industry associations, and other interested parties submit issues for resolution. Then, the applicable IRS and Treasury parties screen, evaluate, and select issues for an IIR project. The project is then announced publicly and an IIR team of representatives from the IRS, Chief Counsel, Appeals, and Treasury is formed to perform fact-finding, evaluate input, and recommend guidance to resolve the issue. Once an IIR team is formed, submitters and other interested parties may meet with the team and provide additional information to assist in the development of the issue. An issue selected for an IIR project is generally resolved through IRS-published guidance, such as a revenue ruling or revenue procedure.

Rev. Proc. 2023-15 and the NGSH Method

Revenue Procedure 2023-15 provides a safe harbor method of accounting for taxpayers to determine whether certain maintenance, repair, replacement, or improvement costs related to natural gas transmission and distribution property are required to be capitalized under either section 263(a) or section 263A or whether they are deductible under section 162. Rev. Proc. 2023-15 also contains procedures under which taxpayers may receive automatic consent to change to the safe harbor method of accounting and is effective for taxable years ending after May 1, 2023.

The NGSH Method

The NGSH Method may be used to determine whether certain direct and indirect costs to maintain, repair, replace, and improve natural gas transmission and distribution property are required to be capitalized under either section 263(a) or section 263A, or whether the costs are deductible business expenses under section 162. Under the NGSH Method, a taxpayer first classifies its natural gas transmission and distribution property as either linear (e.g., pipes, fittings, valves) or non-linear (e.g., compressors, regulators, meters). The NGSH Method includes a required safe harbor applicable to linear property (the Linear Safe Harbor) and an optional safe harbor for non-linear property (the Non-Linear Safe Harbor). The NGSH Method refers to all rules set forth in the revenue procedure, including the Linear Safe Harbor, the Non-Linear Safe Harbor, and other applicable rules.

The NGSH Method is available to taxpayers with a depreciable interest in natural gas transmission or distribution property and that pay or incur costs to maintain, repair, replace, or improve natural gas transmission or distribution property. Section 3.03 of Rev. Proc. 2023-15 identifies costs that do not qualify as costs “to maintain, repair, replace, or improve” natural gas transmission or distribution property. Transmission property includes real and personal property used to transport, control, and store natural gas between a gas processing plant or custody transfer point and a city gate station or other delivery point, but does not include gas production wells, gathering lines, and processing plants. Distribution property includes real and personal property used to transport, control, and store natural gas between and including a city gate or other custody transfer point and the customer gas meter or other delivery point to the customer. The IRS will respect a taxpayer’s reasonable and consistently applied designation of property as transmission or distribution property used for federal or state regulatory purposes or, in the case of an unregulated taxpayer, used for books and records.

Linear Safe Harbor

A taxpayer using the NGSH Method must apply the Linear Safe Harbor to all of its transmission and distribution linear property. Any natural gas transmission and distribution property that is not included in the definition of non-linear property is linear property. For transmission property, the Linear Safe Harbor defines the appropriate units of transmission property and provides a simplified rule under which replacement costs of transmission property generally must only be capitalized if more than ten percent of the length of the transmission property unit is being replaced. For distribution property, the Linear Safe Harbor divides distribution property into “distribution mains” and “distribution service lines” and provides separate simplified rules for determining whether (1) distribution main replacement costs and (2) repair, maintenance, replacement, or improvement costs for distribution service lines must be capitalized.

Non-Linear Safe Harbor

A taxpayer using the NGSH Method may choose to apply the optional Non-Linear Safe Harbor to all of its non-linear property. Non-linear property is all natural gas transmission and distribution property that is compressor station property, gas storage facility property, measuring and regulating station property, or meters or regulators. The Non-Linear Safe Harbor defines units of property and major components of non-linear transmission and distribution property and provides that the cost of replacing a unit or major component of non-linear property must be capitalized, along with the cost of any repairs, maintenance, or replacements that directly benefit or are incurred by reason of the replacement of the non-linear property.

Other Rules

Section 5.05 of Rev. Proc. 2023-15 identifies certain direct and indirect costs as per se capital expenditures for any taxpayer using the NGSH Method. To the extent a taxpayer can identify with reasonable accuracy the distribution service line costs associated with distribution main per se capital expenditures, such costs are also treated as per se capital expenditures under section 5.05.

Section 5.06 of Rev. Proc. 2023-15 provides aggregation rules, whereby a taxpayer aggregates multiple replacements if certain requirements are satisfied to determine whether the applicable thresholds for capitalization of property under the Linear Safe Harbor and the Non-Linear Safe Harbor are met.

Section 5.08 requires taxpayers using the NGSH Method to make an election under section 168(i)(4) and Treas. Reg. section 1.168(i)-1(l) to include certain natural gas transmission and distribution property that is MACRS property in general asset accounts. Because natural gas companies often dispose of old items when replacing natural gas transmission and distribution property, use of general asset accounts will help to avoid triggering the per se capitalization rules for losses on disposition. Section 5.08 also provides procedures for making the general asset account elections and transition rules for taxpayers changing to the NGSH Method in certain years.

Under section 5.10, amounts to which a taxpayer applies the NGSH Method are not separately capitalized under section 263A as the direct or indirect costs of producing gas transmission and distribution property. However, a producer or reseller of natural gas must still capitalize the direct and indirect costs of producing or acquiring natural gas under section 263A.

Distribution Service Line Costs

Under the NGSH Method, a taxpayer determines the amount of capitalizable distribution service line costs in accordance with Rev. Proc. 2023-15, section 5.07(2) and (3). Under section 5.07(2), to the extent a taxpayer can identify distribution service line costs with reasonable accuracy, the taxpayer must capitalize such identified distribution service line costs that are per se capital expenditures or that are associated with distribution main replacements of more than four miles. All other identified distribution service line costs are not required to be capitalized. To the extent a taxpayer cannot identify distribution service line costs with reasonable accuracy, section 5.07(3) provides steps by which a taxpayer can determine its total amount of unidentified distribution line costs, an applicable capitalization ratio, and, using the ratio and total unidentified costs, its capitalizable unidentified distribution service line costs.

Methods of Accounting

The revenue procedure provides that the Linear Safe Harbor and the Non-Linear Safe Harbor are methods of accounting within the meaning of section 446, and thus taxpayers must obtain the Commissioner’s consent to change to either or both methods. Section 6.05 of Rev. Proc. 2023-15 provides procedures by which a taxpayer may obtain the Commissioner’s automatic consent to change to either safe harbor method.

A change to the NGSH Method is generally made with a section 481(a) adjustment. This adjustment may be computed using statistical sampling in accordance with Rev. Proc. 2011-42. Further, Appendix B of Rev. Proc. 2023-15 provides an extrapolation methodology certain taxpayers may use to determine their section 481(a) adjustment. For the first three taxable years ending after May 1, 2023, taxpayers may change to the NGSH Method on a cut-off basis. A taxpayer making the change on a cut-off basis does not receive audit protection.

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