Improvements to property are sometimes hard to distinguish from repairs.
The IRS proposed voluminous new regulations in late August in an attempt to draw clearer lines.
The line-drawing is important for companies that spend money to maintain existing power plants, pipelines, electricity grids, roads and other assets. If the spending is classified as a “repair,” then it can be deducted immediately. If it is an improvement, then the spending is considered an additional investment in the facility with the result that the cost must be recovered over time through depreciation. Maintenance costs more to the extent the cost cannot be deducted immediately.
In general, spending is considered an improvement rather than a repair if it materially increases the value of an asset, substantially prolongs its useful life or adapts the asset to a new or different use.
One of the most difficult issues, when trying to decide whether the value of an asset has been materially increased, is how to figure out what is the unit of property. Spending $100,000 in a year on a power plant may be insignificant if the asset is the entire power plant, but it is material if the asset is just a conveyor belt. The IRS said it does not think the appropriate unit of property is an entire power plant. It adopted a three-part test for how to break a project into smaller pieces.
The taxpayer is supposed to make a first cut by treating as a single asset all the property that is functionally and integrally related. This first cut identifies the largest possible single asset.
Then the taxpayer must make a second cut. For companies that are in regulated industries, the second cut is easy. They must break the project into the separate asset categories in the uniform system of accounts used by the Federal Energy Regulatory Commission, the Federal Communications Commission or the Surface Transportation Board.
It does not matter whether the particular company is actually regulated. Thus, for example, tax departments at independent power companies and private equity funds that invest in power projects will have to become familiar with the FERC asset accounts. All electric, gas, water, telecom, cable television and transportation companies will be treated as in regulated industries and will be required to use these accounts.
For companies in other industries, the largest possible asset identified in the first cut must be split as follows. First, treat each building and its structural components, like wiring and floors, as a single asset. Second, divide up any other real property, like land, parking lots and fences, into separate assets using common- sense lines. Finally, use four rules of thumb for breaking down the machinery and equipment into separate assets. One rule of thumb is that pieces of equipment that the taxpayer acquires from separate vendors are probably separate assets. Another rule of thumb is to look at what the company does on its financial reports or books. If it has assigned different useful lives for computing book depreciation to different parts of a project, then these lines are a guide for breaking a project into separate assets for tax purposes. Another rule of thumb is to treat equipment that performs a different function than the rest of the machinery as a separate asset. Finally, rotable spare parts are treated as separate assets. A rotable spare part is a spare part that a company takes out of one machine, repairs, and then reinstalls in a different machine.
A company must then do a third cut. If it has treated a piece of equipment as a separate asset for any other federal income tax purpose, then it is bound by that division. An example is where a power company claims a loss on grounds that it abandoned X asset. It cannot claim later than an asset like X is actually part of a larger unit of property.
The new rules do not apply to “network assets.” Examples of network assets are oil and gas pipelines, electric transmission and distribution lines, gas, water and sewer mains, and telephone and cable lines. The IRS is still struggling to come up with rules for them.
The IRS declined to set a single percentage that in all cases would be considered material. However, it appears that an increase of at least 25% in value will always be material.
The IRS said it would use a “Plainfield-Union test,” named after a court decision that the agency had refused to accept in the past, for testing whether spending has materially increased the value of an asset or substantially prolonged its useful life. By definition, any repair to a piece of equipment that is broken increases its value or extends its life. The IRS said the comparison should be done by looking at the equipment before the event that necessitated the repair.
Spending is an improvement — rather than a repair — if it substantially prolongs the useful life of an asset. Larger companies that assign a useful life to particular kinds of assets on “applicable financial statements” will be required to use that life for purposes of comparison. The agency said the useful life is “substantially” prolonged if it is extended by more than one tax year beyond when it was originally expected to have to be retired.
Finally, the IRS said it would let companies claim an annual repair allowance. An amount of spending each year up to the allowance can be deducted. Any spending above that would have to be “capitalized,” or added to the tax basis of assets. A company would have to file an election if it is willing to agree to this. Once an election is made, then a company will be bound by it for all future years unless it can persuade the IRS to let it revoke the election.
The proposed regulations include the repair allowance percentages. For example, annual spending on all equipment that is classified as 5-year MACRS property for depreciation could not exceed 10% of the original cost of such property. An example of 5-year property is a wind farm, solar power project or a power plant that burns biomass as fuel. The proposed repair allowance for 15-year property is 3.33% a year. It is 2.5% a year for 20-year property. An example of 15-year property is a simple-cycle power plant that burns gas. An example of 20-year property is a coal-fired power plant or combined-cycle power plant that burns gas.
The IRS is collecting comments on the new rules until November 20. They will not take effect until they are republished in final form. Meanwhile, the new business plan the IRS released in mid-August said the agency is working on a separate revenue ruling about when amounts that power companies spend on maintenance can be deducted.