The IRS today released an IRS Large Business & International (LB&I) memorandum providing direction to IRS examiners who are examining a taxpayer eligible to change to the transmission and distribution property safe harbor method of accounting described in Rev. Proc. 2011-43.
LB&I Control No. LB&I-4-1111-019 (dated November 25, 2011).
Rev. Proc. 2011-43 provides a method for taxpayers to determine whether expenditures to maintain, replace, or improve electric transmission and distribution property must be capitalized under section 263(a) or are deductible under section 162.
The use of the safe harbor is only permitted under the terms and conditions contained in the revenue procedure, and must not be considered for purposes of resolving capitalization issues in prior open exam years.
This directive applies to taxpayers who are eligible to use the Rev. Proc. 2011-43 safe harbor, whether or not a change to the safe harbor method of accounting has been filed. The directive provides guidance for addressing prior open exam years.
Taxpayers that transmit and distribute electricity incur significant expenditures to maintain, replace, and improve transmission and distribution property. For those taxpayers eligible to adopt the unit of property definitions and safe harbor provisions provided in Rev. Proc. 2011-43, today’s directive sets forth guidance to the field related to closing current examination activity relating to capital versus repair treatment for expenditures on utility electric transmission and distribution property.
Examination guidance for tax years ending before December 31, 2010
The LB&I directive instructs IRS examiners that for tax years ending before December 31, 2010, examiners are to discontinue current examination activity involving whether costs incurred to maintain, replace, or improve electric transmission and distribution property must be capitalized under section 263(a). Discontinuing this examination activity only applies to positions taken on original returns filed for the years ending before December 31, 2010.
Rev. Proc. 2011-43 waives the scope limitations for a request to change a method of accounting, which normally apply to a taxpayer under examination, for the taxpayer's first and second tax year ending after December 30, 2010. If a taxpayer with applicable asset expenditures has not adopted the safe harbor method under Rev. Proc. 2011-43 for its first or second tax year ending after December 30, 2010, the examiner is to follow the guidance provided for tax years ending on or after December 31, 2010, as provided in the next section.
The LB&I directive states that for an examiner to discontinue the examination of the capital versus repair expense issue, certain steps outlined in the directive are to be followed.
Examination guidance for tax years ending on or after December 31, 2010
The LB&I directive instructs IRS examiners that when examining returns of utility companies for tax years ending on or after December 31, 2010, examiners are to determine if the taxpayer filed a Form 3115, Application for Change in Accounting Method, to adopt the safe harbor method provided in Rev. Proc. 2011-43.
- If the taxpayer adopted the safe harbor method, the examiner is to determine if the adoption is consistent with the Rev. Proc. 2011-43. If the adoption is not consistent, then a determination needs to be made whether the taxpayer correctly adopted the method and the examiner needs to consult with the Deductible and Capital Expenditures Issue Practice Group for further guidance.
- Rev. Proc. 2011-43 section 5.03(3) provides a transition rule for
the first three tax years ending on or after December 31, 2010,
permitting taxpayers to determine the percentage of a unit of linear
property replaced based on average circuit length within a county or
geographic area similar to a county, such as a parish, borough, or other
similar geographic division. Examiners are not to challenge a taxpayer's ability to use the transition rule for tax years ending before January 1, 2014.
The LB&I directive states that when performing the risk assessment, the examiner is to also consider the accuracy of the section 481(a) adjustment. If prior to the issuance of Rev. Proc. 2011-43, the taxpayer filed a Form 3115 to change the treatment of expenditures for transmission or distribution property, then the section 481(a) adjustment resulting from a change to the Rev. Proc. 2011-43 safe harbor method ("new section 481(a) adjustment") will account for any previous section 481(a) adjustment ("old section 481(a) adjustment"). The taxpayer must also affirm that the new section 481(a) adjustment properly accounts for electric transmission and distribution property repair expenses that were computed under the taxpayer's prior method and deducted under section 162 in the interim years between the old and new section 481 adjustments. When changing to the Rev. Proc. 2011-43 safe harbor, a taxpayer must take the entire net section 481(a) adjustment into account (whether positive or negative) in computing taxable income in the year of change.
If the taxpayer did not adopt the safe harbor method, then the agent must perform a risk assessment to determine the materiality of the repair deduction claimed with respect to the electric transmission and distribution property. If the result of the risk assessment is deemed to be material, the examiner must examine the deduction utilizing code section 263(a) and the Treasury Regulations thereunder.
Potential impact on repair regulations
The release of the repair regulations under section 263(a) is expected before the end of the year. LB&I’s issuance of the directives may indicate its position with regard to examinations of repair issues outside of these industries. For example, if the regulations are implemented with a section 481 adjustment, LB&I may wish to minimize the exam activity around repairs and maintenance deductions for tax years that precede the effective date of the regulations. In other words, it is reasonable to expect that LB&I may issue a similar directive for all taxpayers under exam for repairs and maintenance expenditures after the regulations are issued. Thus, taxpayers currently under exam may want to postpone resolution or settlement of cases involving disputed repair expenses until the regulations are issued.
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ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
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