Editor: Michael Dell, CPA
The final and reproposed tangible property regulations (T.D. 9636 and REG-110732-13), will significantly affect the oil and gas industry. Specifically, the unit-of-property determination has different implications for oil and gas companies, depending on which segment the companies operate in, as summarized in Exhibit 1.
The final and reproposed regulations are effective for tax years beginning on or after Jan. 1, 2014. There are special rules, however, for amounts paid or incurred in tax years beginning in 2014. Taxpayers may rely on the rules and are permitted to apply them to tax years beginning in 2012 and 2013 for amounts paid or incurred in those years. The final provisions and the reproposed regulations include rules to facilitate implementing the new rules. Forthcoming transition rules will require filing Form(s) 3115, Application for Change in Accounting Method, for accounting method changes to comply with the regulations and require Sec. 481(a) adjustments for some, but not all, of those changes. Certain provisions in the regulations must be implemented by making elections on tax returns.
Final Regulations: De Minimis Safe Harbor
The final regulations set forth an annual, elective safe harbor with a per-invoice or per-item expensing limit determined based on the financial policies in place at the beginning of the tax year beginning on or after Jan. 1, 2014. Under the new rule, a taxpayer that meets certain prerequisites can deduct amounts paid for property costing less than a specified dollar amount, or amounts paid for property with an economic useful life of 12 months or less, as long as the amount paid for the property does not exceed $5,000 per invoice or per item as substantiated by the invoice.
Implications: The de minimis safe-harbor election makes it easier for some companies in the oil and gas industry to continue to follow their existing methods of accounting for de minimis items, which include materials and supplies. Companies should review their book accounting procedures to verify they have written policies in place prior to the beginning of their tax year starting on or after Jan. 1, 2014, to be eligible to use the election. While the de minimis safe harbor covers only items costing $5,000 or less, it does not prevent taxpayers with a book capitalization threshold higher than $5,000 to follow book expensing for tax purposes; however, taxpayers have the burden of showing that deducting amounts in excess of the threshold clearly reflects income. For those taxpayers, documentation will be important.
Also, the preamble to the final regulations states that the de minimis safe harbor is not intended to disrupt an existing agreement or prevent a taxpayer from reaching a new agreement with an IRS examining agent relating to deducting amounts over the de minimis safe harbor. Importantly, to be eligible to use the safe harbor, taxpayers must file an annual election statement with their original timely filed income tax return, which, because it cannot be made on an amended return, could be a trap for the unwary if taxpayers inadvertently fail to include the statement.
Materials and Supplies
The final rules expand the definition of materials and supplies to include standby emergency spare parts and also limit the election to capitalize and depreciate material and supplies to rotable, temporary, or standby emergency spare parts. Notably, taxpayers that elect to use the de minimis safe harbor must deduct all materials and supplies that meet the de minimis safe harbor requirements under the final regulations.
Implications: Oil and gas companies should consider the accounting methods and elections available for rotable/temporary spare parts and emergency standby parts. To the extent rotable parts are used for extended periods, it may be beneficial to elect to capitalize and depreciate these parts for tax purposes. Alternatively, if the period of use is short, it may be beneficial to write off parts as they are disposed of or, perhaps, adopt the optional method for rotable and temporary spare parts. The election to capitalize and depreciate rotable, temporary, and emergency spare parts may be made on a per-part basis by capitalizing and depreciating the part on the tax return in the year the part is acquired.
Routine Maintenance Safe Harbor
As anticipated, the final regulations retain the safe harbor for routine maintenance for personal property (except network assets such as utility transmission and distribution lines) and now include a new safe harbor for routine maintenance for buildings. To qualify for the safe harbor for personal property, the taxpayer must reasonably expect to perform the relevant activities more than once during the alternative depreciation system (ADS) tax life of the unit of property (see class life table in Exhibit 2).
Routine maintenance activities for buildings are activities that taxpayers expect to perform more than once during the 10-year period after the property is placed in service and may include inspecting, cleaning, and testing of the property and replacing damaged or worn parts with comparable and commercially available replacement parts. Factors in determining whether there is a reasonable expectation that the activities will be performed more than once at the time the property is placed in service include, but are not limited to, the recurring nature of the activity, industry practice, manufacturer’s recommendations, and the taxpayer’s experience with similar property. Amounts paid for routine maintenance are generally deemed not to improve property.
Implications: The routine maintenance safe harbor may provide a simplification for many oil and gas companies. Although it is still necessary to apply many of the improvement rules, the safe harbor eliminates the need to analyze whether a replaced component is a major component or substantial structural part of the unit of property. The major component rule is a facts-and-circumstances test that will likely continue to be a source of controversy; thus, the ability to avoid it by meeting the safe harbor will provide valuable administrative relief.
Upstream companies should consider whether the routine maintenance safe harbor applies for workovers, down-hole service operations, well maintenance, and well intervention costs. Oil field service companies should determine whether it applies to repairs of hydraulic fracturing equipment. Downstream companies should consider whether the safe harbor applies to turnaround costs.
As mentioned above, the routine maintenance analysis hinges on the class life of the underlying unit of property, and it will be important for companies to contemporaneously consider and document what major maintenance activities are expected to be conducted more than once over the class life. The class life for many oil and gas activities falls into the categories shown in Exhibit 2. Notable for oil and gas companies, Example 6 in Regs. Sec. 1.263(a)-3(i)(6) clarifies when amounts incurred may qualify under the safe harbor for routine maintenance.
Election to Capitalize Repair and Maintenance Costs
Under the final rules, taxpayers may elect to treat all repair and maintenance expenditures that are capital expenditures for book purposes as amounts paid to improve property for tax purposes, and as assets subject to the allowance for depreciation.
Implications: The election to capitalize repair and maintenance costs covers only expenditures capitalized for book purposes; expenditures treated as repairs for book purposes are subject to the general rules for determining when a unit of property is improved. As with the de minimis safe harbor, to be eligible to make this election, companies must file an annual election statement, and the election will apply to all repair and maintenance costs capitalized for book purposes.
Amounts Paid to Acquire or Produce Tangible Property
The final regulations retain the general requirements to capitalize amounts paid to acquire or produce property and the list of inherently facilitative costs that must be capitalized as transaction costs. The rules also retain the option to deduct employee compensation costs, overhead costs, and certain investigatory costs related to real property acquisitions.
Implications: Notable for oil and gas companies, Example 4 in Regs. Sec. 1.263(a)-2(f)(4) indicates that amounts paid for geological and geophysical (G&G) services are “inherently facilitative” to the acquisition of real property and thus are capitalizable and amortizable. Specifically, taxpayers must capitalize the G&G costs separately (and not together with the basis of the real property acquired) and amortize those costs as required under Sec. 167(h) (24-month amortization of G&G expenditures).
Amounts Paid to Improve Tangible Property
Definition of “unit of property”: Under the final regulations, for plant property, network assets, leased property, and improvements to property (except buildings), the unit-of-property determination is based upon the functional interdependence standard. Components are functionally interdependent if the taxpayer’s placing one component into service depends on the taxpayer’s placing the other component into service. For plant property, the unit of property is further broken down into each component (or group of components) that performs a discrete and major function or operation in an industrial process, within the functionally interdependent machinery or equipment. Companies should review Examples 5, 6, and 7 in Regs. Sec. 1.263(a)-3(e)(6), which illustrate units of property for plant property.
Implications: To determine the unit of property, oil and gas companies should analyze their operations and tangible property to identify components of functionally interdependent systems that perform discrete and major functions within their respective oil and gas operations. Notably, for network assets (which include oil and gas pipelines), the IRS and Treasury expect to issue guidance on the unit of property for gas transmission and distribution in the next few months.
The final regulations retain the general construct of prior iterations of the regulations—that amounts paid to better, restore, or adapt property to a new or different use must be capitalized as improvements. For betterments, the final rules generally provide that a betterment occurs if the expenditure ameliorates a material condition or defect that existed before the asset was acquired, materially adds to property, or is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.
Implications: The final regulations contain several examples that further clarify when amounts paid result in a betterment to a unit of property, including:
- Betterment Example 1: Amounts paid by a taxpayer to remediate land contaminated by a previous owner’s underground storage tanks result in a betterment to land that must be capitalized, even though the taxpayer was not aware of the contamination at the time of purchase.
- Betterment Example 15: Amounts paid to increase the depth of a channel from 10 feet to 20 feet to allow for ingress, egress, and unloading of larger barges (through a material increase in capacity of the channel) must be capitalized.
The final regulations generally retain the rules for restorations—that a taxpayer must capitalize amounts paid to replace property for which a loss (or basis adjustment) was taken, to restore damaged property for which a basis adjustment is required as a result of a casualty loss, to replace a major component or substantial structural part, and to make other specified restorations of property. Notably, the final regulations provide additional clarity about what constitutes the replacement of a major component or substantial structural part of a unit of property.
They also provide favorable rules for replacements of property related to a casualty to allow a deduction when otherwise permitted for amounts spent in excess of the adjusted basis of the property damaged in a casualty. Oil and gas companies must still capitalize amounts paid to restore damaged property for which the taxpayers have properly recorded a basis adjustment. However, amounts paid to restore the property above the basis recorded may potentially be deducted.
Under the final rules for removal costs, if a taxpayer disposes of or partially disposes of a depreciable asset and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, the costs of removing the asset or component do not have to be capitalized under Sec. 263(a). If a taxpayer disposes of a component of a unit of property and the disposal is not a disposition for federal tax purposes, the taxpayer must deduct or capitalize the costs of removing the component, based on whether the removal costs directly benefit or are incurred by reason of a repair to the unit of property or an improvement to the unit of property.
Reproposed Disposition and Depreciation Regulations
Dispositions: Under the proposed regulations, a building (including its structural components) would be the asset for disposition purposes. Nevertheless, the proposed regulations would allow the disposition rules to apply to a partial disposition of an asset and would allow taxpayers to claim a loss on the disposition of a structural component of a building or a component of any other asset without identifying the component as an asset before the disposition event. This partial disposition election would be made in the year the component is disposed of.
Specific rules for general asset accounts: Under the proposed regulations, a taxpayer may elect to terminate general asset account treatment when the taxpayer disposes of all the assets, or the last asset, in the account, or disposes of an asset in a qualifying disposition. A taxpayer may also elect to terminate general asset account treatment for some, but not all, assets within the account in the case of a qualifying disposition, as defined in the regulations. In certain other cases, a portion of an asset in a general asset account may be required to be disposed of, as described in the proposed regulations.
Oil and gas companies should evaluate the impact these rules have on their state tax returns. Recasting previously capitalized fixed assets as deductible repairs may affect state investment-based tax credits or result in different Sec. 481 adjustments due to differing state tax basis in assets. Consideration should also be given to any sales and use tax or property tax implications of changes in the treatment of tangible property.
The IRS has indicated that forthcoming revenue procedures will provide guidance on how to request changes in accounting methods to adopt and implement the regulations and should provide greater insight into the implications of making the elections permitted in the regulations.
Editor: Michael Dell, CPA
Michael Dell is a partner at Ernst & Young LLP in Washington, D.C.
For additional information about these items, contact Mr. Dell at 202-327-8788 or email@example.com.
Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.