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March 20, 2013
Retail Industry Group Suggests Changes to Proposed 'Repair' Regs

Full Text Published by Tax Analysts®

This document originally appread in the March 11 edition of Tax Notes Today.


Summary by Tax Analysts®

Kirt Johnson of the Retail Industry Leaders Association, commenting on proposed repair regulations (REG-168745-03), has urged Treasury to treat a building as a single unit of property for all purposes, provide methods to determine the adjusted basis of retired building components, and modify the routine maintenance safe harbor to apply equally to all types of tangible property.


March 11, 2013

Lisa Zarlenga
Tax Legislative Counsel
U.S. Department of the Treasury
Office of Tax Policy
1500 Pennsylvania Avenue, NW
Washington, DC 20220

Andrew Keyso, Jr.
Associate Chief Counsel
Income Tax & Accounting
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Dear Ms. Zarlenga and Mr. Keyso:

On behalf of the Retail Industry Leaders Association ("RILA") and its representatives, I want to thank you again for meeting with us on February 20, 2013, to discuss our concerns with the regulations published on December 27, 2011, regarding the tax treatment of amounts paid or incurred to improve tangible property (the "Temporary Regulations"). We thought the meeting was very productive. The purpose of this letter is to address certain issues that arose during our meeting.

Componentization of Buildings. As we stated during the meeting, RILA believes that a building and its structural components should be treated as a single unit of property for all purposes rather than being componentized into the building structure and eight or more building systems for purposes of applying the betterment and restoration tests. In our view, the uncertainty and overwhelming additional burden inherent in (i) the measurement of the capacity, productivity, efficiency, strength, quality, or output of the building structure and the various building systems (for purposes of the betterment test) and (ii) the determination of what constitutes a major component or substantial structural part of the building structure or the various building systems (for purposes of the restoration test) renders the componentization approach practically unadministrable.

In regard to the betterment test, we believe that the determination of whether an expenditure materially increases capacity, productivity, efficiency, strength, quality, or output is more appropriately measured at the unit of property level rather than the building structure or building system level. As stated in the Preamble to the Temporary Regulations (the "Preamble"), the betterment tests are intended to serve as a proxy for those expenditures that generally would result in a material increase in value. However, because the substantial body of existing precedent generally applied the increase in value standard to a complete asset or unit of property, application of the betterment tests to building components not only will lead to increased controversy, but also will lead to results inconsistent with existing case law. This follows from the fact that a given expenditure may materially increase the strength, productivity, efficiency, output, etc. of the building structure or a building system, but have immaterial effect on the building viewed as a whole. Moreover, componentization of a building places undue pressure on the issue of materiality absent the promulgation of an appropriate bright-line standard, as a substantially higher materiality threshold should be applied to the extent that a unit of property (in this case, a building) is broken up into its component parts. Accordingly, RILA strongly submits that the betterment test should be applied to the unit of property (the entire building) rather than the building structure and building systems.

In regard to the restoration test, as we discussed during our meeting, we believe that, even if buildings are not componentized into the building structure and building systems, the restoration test as presently formulated fully addresses Treasury's and the Service's concern that treatment of a building as a single unit of property would arguably enable taxpayers to claim a deduction for the cost of major work (such as the installation of a new roof or replacement of the entire HVAC system) because the work affected only a small portion of the unit of property (the entire building). Specifically, the Temporary Regulations provide that an expenditure results in a "restoration" if made for the replacement of a part or combination of parts that comprise a major component or a substantial structural part of a unit of property. Thus, read literally, the restoration test is not applied to the unit of property in its entirety, but instead addresses the replacement of major components or substantial structural parts of the unit of property. Because a building's roof and entire HVAC system each constitute a major component or substantial structural part of the building as a whole, capitalization of the cost of their replacement would be required under the Temporary Regulations without applying the restoration test separately to the building structure and building systems. Accordingly, it is unnecessary to componentize a building into the building structure and building systems in order to achieve tax treatment consistent with existing case law.

During our meeting, we were asked how a "major component" or a "substantial structural part" of a building should be defined for purposes of application of the restoration test. We remain of the view that the currently delineated building systems -- the HVAC system, plumbing system, electrical system, escalators, elevators, fire protection and alarm system, security system, and gas distribution system -- fairly describe the "major components" of a building. Furthermore, we would define the substantial structural parts of a building as the foundation, structural framework, exterior closure, and roof. For example, in the case of a high-rise office building, the structural framework is fabricated from steel or cast-in-place concrete, to which a glass exterior curtain wall (the exterior closure) is attached. In the case of a warehouse or so-called big box retail store building, the structural framework and exterior closure consist of concrete blocks or tilt up concrete walls, together with a roof supported by steel roof joists. Finally, the structural framework of an apartment building or motel having three stories or less is stick frame, including wooden roof joists or trusses, and the exterior closure consists of bricks or wooden or laminated siding.

RILA also believes that the entirety of a major component or substantial structural part need not be replaced in order to trigger capitalization of the associated costs. In this regard, the Temporary Regulations state that a major component or substantial structural part includes a part or combination of parts that comprise a large portion of the physical structure of the unit of property or that perform a discrete and critical function in the operation of the unit of property. The 2008 proposed regulations provided that capitalization of amounts paid to replace a major component or substantial structural part of a unit of property was not required unless the amounts were paid after the recovery period for the property and either (i) the replacement cost comprised fifty percent or more of the replacement cost of the entire unit of property or (ii) the replacement parts comprised fifty percent or more of the physical structure of the unit of property. While the Preamble expresses concern that this standard would have led to results contrary to long-standing case law, RILA submits that a similar bright-line rule containing reasonable percentages should be included in the final regulations to provide clarity and avoid controversy. In addition, RILA posits that the definition of a major component or substantial structural part by reference to the performance of a discrete and critical function in the operation of a unit of property is patently unclear and should be deleted.1

Finally, RILA submits that the restoration test, like the betterment test, must be applied in a manner consistent with the holding in Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962). For example, in Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103, 106 (1926), acq. (V-2 CB 2), the taxpayer owned a seven-story building on the bank of the Chicago River. Due to sudden and unexpected lowering of the water level, dry rot of the wooden piles that formed the building's foundation caused a wall of the building to settle so materially that the entire building threatened to collapse. To prevent the total loss of the building, the taxpayer sawed off the rotted piles at a point below the lower water level and inserted concrete supports between the ends of the submerged piles and the floor of the building. The repair also required removal of "a large portion of the ground floor" and work to shore up and raise the partially collapsed wall.

Consistent with the principles of Plainfield-Union (i.e., a comparison of the condition of the property after the repairs with the condition of the property immediately prior to the condition necessitating the repair -- in this case, the sudden and unexpected drop in the water level), the court held that the expenditures were deductible repairs rather than capital improvements. By contrast, the restoration test as presently stated in the Temporary Regulations presumably would reach the opposite conclusion due to the fact that the taxpayer replaced a major component or substantial structural part (i.e., portions of the foundation and a large portion of the ground floor) of the building structure. Accordingly, to remain consistent with current case law, the restoration test should be modified to incorporate the Plainfield-Union test.

Retirement of Building Components. RILA applauds the decision to permit taxpayers to treat the retirement of a building component as a disposition and recognize the resulting loss. There are significant practical challenges, however, that will arise in the application of this new rule, due in large part to the fact that existing fixed asset accounting systems lack the capability to track separately the costs of a building's structural components or the dates on which such components were placed in service As a result, the tracking of the adjusted basis of retired components, even prospectively, under the new rule will require significant system changes and time to implement. Moreover, because real estate transactions involving the purchase of an existing building or the construction of a new building typically do not separately identify the costs of the building's structural components, the new rule will require taxpayers to undertake costly valuation analyses to allocate the cost basis among the various building components. These practical challenges are further compounded in the case of existing buildings, where taxpayers must manually sort through volumes of records (assuming such records remain available) in an attempt to re-create the requisite cost and placement in service information.

The Temporary Regulations permit taxpayers to use "any reasonable method that is consistently applied" to determine the adjusted basis of a retired component. However, the determination as to whether a method is "reasonable" is inherently subjective and will invite controversy. Accordingly, RILA recommends that Treasury and the Service provide additional guidance in the form of specific methods and/or safe harbors that would be considered reasonable. In the absence of such guidance, the treatment of retirement losses afforded by the Temporary Regulations will give rise to significant controversy between taxpayers and the Service.

RILA specifically recommends that Treasury and the Service endorse a method whereby taxpayers could estimate the adjusted basis of a retired component by starting with the cost of the replacement component, and then further adjusting that amount for inflation (calculated using an objective inflation index) and depreciation (based on the method and placement in service date utilized to depreciate the building as a whole for federal income tax purposes). In addition to providing a reasonable estimate of the retired component's adjusted basis, this proposed method would be administrable and verifiable, thereby eliminating much of the potential for controversy that may be inherent in other methods.

Other reasonable methods might include the use of third-party construction indexes or software to estimate the replacement cost of a component, expanded use of statistical sampling to estimate the adjusted basis of retired components, and the use of tables prescribed in the final regulations containing safe-harbor percentages based upon current replacement cost.

Application of the Routine Maintenance Safe Harbor to Buildings. The Temporary Regulations provide a safe harbor from capitalization for amounts paid for "routine maintenance" performed on a unit of property "other than a building or a structural component of a building." For this purpose, "routine maintenance" is defined as recurring activities that a taxpayer reasonably expects to perform more than once during the class life of the unit of property to keep it in an ordinarily efficient operating condition.

The Preamble explains that buildings were excluded from the routine-maintenance safe harbor because the 39.5 year class life of buildings would permit current deduction of the costs of major work (such as the replacement of a roof, HVAC system, or electrical system) if the taxpayer expected to perform the work more than once during the class life. RILA submits that this concern could be solved by modifying the definition of "routine maintenance" to make clear that routine maintenance does not include expenditures resulting in a restoration; i.e., a replacement of a major component or substantial structural part of the building. Alternatively, the final regulations could prescribe, specifically for buildings, a shorter period for purposes of identifying those activities that a taxpayer reasonably expects to perform more than once to keep the building in an ordinarily efficient operating condition.

Summary. For the reasons discussed in our meeting and discussed above, RILA strongly urges Treasury and the Service to (i) treat a building as a single unit of property for all purposes, (ii) provide methods and/or safe harbors by which to determine the adjusted basis of retired building components, and (iii) modify the routine maintenance safe harbor to apply equally to all types of tangible property, including buildings.

                Sincerely yours,

                Kirt Johnson
                Vice President, Tax Policy
                Retail Industry Leaders Association
                Arlington, VA
cc: Internal Revenue Service -- Income Tax & Accounting:

    Scott Dinwiddie
    Robert Casey
    Merrill Feldstein
    Kathleen Reed
    Patrick Clinton
U.S. Department of the Treasury -- Office of Tax Policy:

    Alexa Claybon
    Scott Mackay
FOOTNOTE

1 The uncertainty of the "discrete and critical function" standard is readily demonstrated by Examples (23) and (24) in section 1.263(a)-3T(i)(5) of the Temporary Regulations, which conclude that thirty out of the three hundred exterior windows in a large office building do not perform a discrete and critical function in the operation of the building structure, whereas two hundred out of the three hundred exterior windows in the same office building do perform a discrete and critical function in its operation. Why thirty windows do not perform a discrete and critical function during a torrential rainstorm or major winter storm, but two hundred windows do so, is not readily discernable.

END OF FOOTNOTE


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