On July 6, the Internal Revenue Service (IRS) Large Business and International Division issued a Directive1 to IRS agents regarding how to determine when a major component pertaining to steam or electric generation property has been replaced for purposes of the tangible property regulations. Agents are directed not to challenge a taxpayer’s determination of when “substantially all” of a major component has been replaced as defined by Rev. Proc. 2013-242 if the taxpayer uses one of the methods described below.
The Directive provides that “substantially all” of a component is considered to have been replaced if at least 80% of a major component has been replaced. If a replacement fails to reach the 80% threshold, the IRS may nonetheless challenge the treatment if the appropriate IRS counsel and director of field operations have been consulted and agree with the challenge. More importantly, the Directive’s 80% threshold represents the government’s view of when replacements rise to the level of an improvement; taxpayers that incur costs to maintain, repair or improve steam or electric generation property may find that a different standard should be applied to their replacements.
Generally, a taxpayer must capitalize amounts paid to improve a unit of property owned by the taxpayer. A unit of property is improved if there has been a betterment, the property has been adapted to a new or different use, or the property has been restored. A restoration may be considered an improvement if “it is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of a unit of property.”3 To determine whether an amount is paid or incurred for the restoration of a unit of property, the regulations require factual analysis and fail to provide any objective measurement.4
To determine whether a component has been 80% replaced, the Directive gives taxpayers two measurement methods that field agents should not challenge. Taxpayers may either (1) compare the actual replacement cost with the underappreciated financial statement cost of the major component, or (2) compare the actual replacement cost with the estimated replacement cost of the entire major component. While these two methodologies seem reasonable, the IRS did not include broader language, such as “any reasonable method” that would have allowed for alternative methods to be used based on common usage or practice. That, perhaps, may stem from a desire by the IRS to provide more rigid rules regarding measurement methods, as it did in establishing an 80% threshold in the Directive.
In addition to providing two measurement methods, the Directive also states that neither measurement method constitutes a method of accounting. This clarification saves taxpayers from the time-consuming task of obtaining advance IRS consent merely to test whether they have replaced 80% of a major component.
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Sutherland Commentary
Because of the scope and impact of the tangible property regulations (T.D. 9636), taxpayers are currently finalizing numerous accounting method changes to fulfill implementation requirements for the 2014 effective date. This Directive provides power generating companies with an objective test to assist in their analysis of whether “substantially all” of a major component has been replaced. It is helpful that the IRS has provided an objective measurement, which may simplify determinations for certain companies. The objective test provided in the Directive may give taxpayers some comfort in their implementation of the final tangible property regulations and accompanying accounting method changes.
The Directive may signal that the IRS is seeking to reduce controversy involving the tangible property regulations. It is hoped that the IRS is considering additional directives so that other taxpayers have enhanced clarification on how to apply the tangible property regulations.
It is important to note, however, that an IRS Directive indicates the IRS view on a particular issue. Although IRS agents are obligated to follow the Directive as guidelines in an examination, taxpayers may independently review the issue and follow the facts and circumstances approach set forth in the regulations taking a different position than the 80% standard suggested in the IRS Directive.
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1 LB&I Directive 04-0315-002.
2 2013-22 I.R.B. 1142 (providing guidance for power generating taxpayers regarding the unit of property and major component definitions).
3 Treas. Reg. § 1.263(a)-3(k)(1)(vi).
4 Treas. Reg. § 1.263(a)-3(k)(6)(i).
