The business of extracting natural resources is very capital-intensive, regardless if it relates to mining coal or other aggregates or drilling for oil and gas. Many repairs that are made to keep equipment safe and in good operational condition do not extend the useful life of the equipment in the owners’ mind. However, the Internal Revenue Service (IRS) may take a different view, depending on the facts and circumstances involved.
The IRS has issued guidance on how to deal with the final Tangible Property Regulations (Regulations) recently issued, commonly referred to as the “Repair Regulations.” Considering that the final regulations are more than 200 pages, it is taking some time to determine how these Regulations will impact our clients.
The reference to the Regulations as the “Repair Regulations” is a misnomer, as the Regulations relate to costs incurred from the point of acquiring tangible property through the property’s operational life until its disposition. The Regulations address three phases from acquisition, maintenance and improvement through disposition.
The Regulations provide a de minimis safe harbor that allows companies to adopt on an annual basis, via an election attached to their tax return, a capitalization policy that distinguishes capital expenditures from currently deductible business expenses. For natural resource companies (Companies) that issue applicable financial statements (AFS), the safe harbor is favorable in that it permits an elective $5,000 per-invoice or per-item book conformity deduction.
In other words, if you issue an AFS and have a capitalization policy that provides for book purposes that you will expense items in accordance with that policy, you are permitted to deduct the same amount for tax purposes, up to $5,000. The written book policy must be in place as of the first day of the tax year and is effective for years beginning on or after January 1, 2014.
To illustrate the above de minimis safe harbor, if you purchase 10 computers for $40,000, you will be able to expense the cost regardless if they were invoiced individually or in the aggregate, provided they have been expensed for book purposes and the cost per item is $5,000 or less.
For companies that do not issue an AFS, the de minimis safe harbor is reduced to $500. In most cases an AFS will be an audited financial statement since reviewed and compiled financial statements do not meet the threshold for an AFS as defined in the Regulations.
Companies that do not have an AFS will be able to expense up to $500 per item under the safe harbor method.
Repairs and Maintenance
As a practical matter, relatively few repair and maintenance(R&M) costs expensed for books are likely to be treated as capital improvements. Under the capitalization safe harbor, a taxpayer may elect to treat as capital expenditures for tax purposes those R&M costs that it treats as capital improvements on its books and records. If elected, the safe harbor applies to all R&M costs that the taxpayer incurs during the year that are treated as capital improvements on its books and records other than rotable, temporary or standby emergency spare parts.
The capitalization safe harbor by its terms applies only to amounts paid for R&M. Amounts for which a deduction is already provided by another Internal Revenue Code Section will remain deductible. Therefore, items such as intangible drilling costs or mine development expenses would remain subject to the specific cost recovery rules governing those specific expenditures for tax purposes, regardless of the manner in which they are accounted for relative to nontax purposes.
Materials and Supplies
The IRS defines materials and supplies as tangible property that (1) is used or consumed in the taxpayer’s business operations; (2) is not inventory; and (3) falls into one of the following categories:
- A unit of property with an acquisition or production cost of less than $200;
- A component that is acquired to maintain, repair or improve a unit of tangible property owned, leased or serviced by the taxpayer, and that is not acquired as part of any single unit of tangible property;
- Fuel, lubricants, water and similar items that are reasonably expected to be consumed in 12 months or less, beginning when used in a taxpayer’s operations;
- A unit of property that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations; or
- Any other tangible property identified in IRS guidance as a material or supply [Reg. § 1.1.62-3(c)(1)].
If elected, the de minimis safe harbor also applies to materials and supplies purchased during the year that cost no more than $5,000/$500, depending upon the applicable financial statement requirement, that are expensed for book purposes. As a result, the cost of many materials and supplies will now be deductible under the de minimis safe harbor when the items are purchased, rather than when they are consumed. Only if you defer deducting those items until used or consumed for book purposes will the de minimis safe harbor not apply and the deduction deferred for tax purposes.
Components of Unit of Property
The Regulations further distinguish the cost of repair and maintenance from expenditures for “major components” and “substantial structural” parts. The Regulations provide that a building is its structure and includes up to eight separate building systems. These include: HVAC systems, plumbing systems, electrical systems, all escalators, all elevators, fire protection and alarm systems, security systems for the protection of the building and its occupants, and gas distribution systems.
The Regulations use a “BAR” test to determine whether the building system needs to be capitalized. For this purpose, “B” stands for betterment, “A” stands for adaptation and “R” stands for restoration. The Regulations provide a series of examples that should be reviewed to determine whether costs should be capitalized or can be expensed. As with the de minims safe harbor, the Regulations may be applied retroactively. This may require a study so that the changes in treatment of “major components” and “significant structural” parts can be substantiated and the IRC Section 481(a) adjustment can be computed.
As you can see, these rules require careful tracking of expenses and evaluation based on the facts and circumstances to determine the proper tax treatment. As discussed, the safe harbor methods provided should be used when possible to simplify tax reporting and take advantage of potentially accelerating the deduction for tax purposes as long as the expense treatment is in conformity with the book capitalization policy. Keep in mind that a change in your current method for accounting for repairs or acquisitions may result in a change in accounting method under IRS rules and would require the filing of Form 3115, Application for Change in Accounting Method. In other situations where taxpayers are applying other reasonable methods that are not in accordance with the de minimis elections, the IRS may challenge whether the method clearly reflects income, and the burden of proof in these situations will be on the taxpayer.
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