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Re-proposed Repair Regulations:
Implications for Gas Utilities
TAX
Carol Conjura , KPMG LLP, Washington National Tax
Susan Grais, Ernst & Young LLP, Washington National Tax
June 29, 2010
Carol Conjura , KPMG LLP, Washington National Tax
Susan Grais, Ernst & Young LLP, Washington National Tax
June 29, 2010
©2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved. 2
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 general in nature and based on authorities that are
subject to change. Applicability to specific situations is to be determined through consultation with your tax adviser.
You (and your employees, representatives, or agents) may disclose to any and all persons, without limitation, the tax treatment or tax structure, or both, of any transaction described
in the associated materials we provide to you, including, but not limited to, any tax opinions, memoranda, or other tax analyses contained in those materials.
©2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved.
PresentersPresenters
Carol Conjura, KPMG LLP: 202-533-3040
Susan Grais, Ernst & Young LLP: 202-327-8782
3
©2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved.
AgendaAgenda
Repairs
Overview of re-proposed regulations
Technical Update
Tier 1 Status and Implications
Retirements
Unit of Property
©2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved.
Overview of Re-proposed RulesOverview of Re-proposed Rules
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Is the expenditure for new construction, acquisition,
expansion, or replacement of entire unit of property?
Capitalize
Restoration?
RoutineMaintenance
Expense
New or Different Use?
Betterment?
Capital vs. Repair AnalysisCapital vs. Repair Analysis
Is the expenditure for new construction, acquisition,
expansion, or replacement of entire unit of property?
Capitalize
Restoration?
RoutineMaintenance?
Expense
New or Different Use?
Betterment?
NO
NO
NO
YES
YES
YES
YES
NO
YES
NO
©2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved.
What is the Unit of Property?What is the Unit of Property?
Buildings and Structural Components
Generally one unit of property, except leasehold improvements
Retail outlets and C stores
General rule for all other property
Functional Interdependence
ExceptionsPlant property
Group of components that performs a discrete and major function
Compare 2006 proposal, which used the Uniform System of Accounts
Network assets [reserved] (pipelines, storage facilities)
Additional ruleSeparate financial statement lives
Different and proper MACRS class or method
©2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved.
What is a Betterment?What is a Betterment?
Amounts paid result in a betterment to the unit of property only if they:
1. Correct a material condition or defect that existed prior to taxpayer’s acquisition or arose during production
2. Result in material addition to the unit of property
3. Result in material increase in capacity, productivity, efficiency, strength, or quality to the unit of property or its output
Focus is on qualitative, not quantitative change in fair market value
Materiality not defined
Unavailability of replacement parts
Compare with status of property prior to last normal repair, or prior to a particular event
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What is a Restoration?What is a Restoration?
1. Replace a component deducted as loss2. Replace a component and basis adjusted for sale or exchange3. Repair after a casualty if basis adjusted4. Return the property to operating condition if in a state of
disrepair and no longer functional for its intended use5. Rebuild the property to like-new condition after the end of
economic life6. Replace a major component or substantial structural part after
the end of the property’s MACRS recovery periodReplace a combination of parts that comprise 50% or more of property’s replacement cost Replace a combination of parts that comprise 50% or more of property’s physical structure
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Repairs after a CasualtyRepairs after a Casualty
Chief Counsel Memo AM 2006-006Taxpayer cannot take both a casualty loss and repair deduction as a result of a single casualtyApplies proposed regulations, even though prospectiveInconsistent with CCM 199903030, permitting deduction for both casualty loss and restoration expenses
Designated as Tier II LMSB exam issueImpact of TAM 200902011
Unit of property for casualty loss purposes (SIP)Electric transmission unit of property is each transmission line, substation. Electric distribution unit of property is each circuit and substation
©2010 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ("KPMG International"), a Swiss entity. All rights reserved. 11
Casualty Loss ExampleCasualty Loss Example
1 2 3
SIP Adjusted Basis $10,000 $ -0- $5,000
FMV Decline 5,000 5,000 10,000
Repair Cost 5,000 5,000 10,000
Deduction 5,000 5,000 5,000
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Relocation CostsRelocation Costs
Costs of relocating pipelines and other facilities
Do not result in a betterment or restoration
Consistent with Badger Pipeline v. Commissioner, T.C. Memo 1997-457
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Removal CostsRemoval Costs
Rev. Rul. 2000-7
If retirement and removal of an asset occurs in connection with the installation or production of a replacement asset, removal costs are deductible
Applies to single asset or mass asset accounts
Not applicable to removal of a component of a depreciable asset
If replacement is a repair--removal costs are deductible
If replacement is an improvement—removal costs are capital
Compare re-proposed regulations which treat replacement of component as capital if gain or loss recognized on removal
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Environmental RemediationEnvironmental Remediation
Re-proposed regulations are consistent with Rev. Rul. 94-38
Soil and groundwater cleanup associated with existing business operations are not required to be capitalized
Costs of water treatment facility are capital
But see Rev. Rul. 2005-42: Otherwise deductible environmental remediation costs must be capitalized under section 263A if incident to production of property
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Environmental Remediation (cont’d)Environmental Remediation (cont’d)
Pre-existing material condition or defect
Remediation of pre-acquisition contamination treated as a betterment
Latent hazardous conditions not treated as a pre-existing material condition or defect
Compare Kerr-McGee v. US, 77 Fed. Cl. (2007)
Application to otherwise periodic maintenance following an acquisition is uncertain
Extension of section 198Election to expense otherwise capital remediation
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Spare PartsSpare Parts
Under current law, may be classified as supplies or fixed assets, depending on facts
Expendable parts are generally treated as suppliesDeferred expense, deductible when consumed
Emergency standby parts and repairable parts are generally treated as fixed assets
Depreciation begins when acquired and ready for use
Rotable spare parts
Current law: deductible when placed in service
Re-proposed regulations: deductible when disposed of
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SuppliesSupplies
Definition of supply
Not a unit of property
Unit of property with economic useful life of 12 months or less
Unit of property with acquisition or production cost of $100 or less
Identified in published guidance
Election to capitalize and depreciate if supply is a unit of property or a component of a unit of property that is not a supply
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Simplified method for regulated taxpayers
FERC
FCC
STB
Must follow regulatory method of accounting for tax purposes
Must use for all tangible property subject to regulatory accounting rules
Optional Regulatory Accounting MethodOptional Regulatory Accounting Method
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Routine Maintenance Safe HarborRoutine Maintenance Safe Harbor
Includes recurring activities to keep a unit of property in ordinarily efficient operating condition
Activities are routine if:
Reasonably expected to occur more than once in an asset’s MACRS class life
Gas production—Every 7 years or more frequently
Gas transportation—Every 11 years or more frequently
Not applicable if property restored under tests 1-4
i.e., if replacements are componentized or after a casualty, or dysfunctional state
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Minimum Capitalization RuleMinimum Capitalization Rule
Taxpayer may use financial statement minimum capitalization policy
Requirements/restrictions
Not applicable to repair and improvement costs
Applicable Financial Statement; written accounting procedures; no income distortion
Safe harbor for no distortion--total aggregate amount of expenses does not exceed the lesser of
0.1% of gross receipts2.0% of total depreciation and amortization expense
Annual, unit-by-unit, election to capitalize and depreciate
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Section 263A ImpactSection 263A Impact
Re-proposed regulations obsolete the general plan of rehabilitation doctrine
See situation 3 of Rev. Rul. 2001-4, requiring otherwise deductible repairs to be capitalized if incurred at same time as capital improvements
Pursuant to section 263A, only repairs that directly benefit or are incurred by reason of an improvement are required to be capitalized
For example, if a utility incurred costs to expand the capacity of a processing plant, contemporaneous repairs to the existing structure would remain deductible
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Section 263A Impact (cont’d)Section 263A Impact (cont’d)
Repairs in connection with inventory production must be capitalized to current production
Section 481 adjustment for repairs change relates to prior production activities
Impact depends on inventory cost flow assumption
May relate to prior LIFO layer
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