Re-proposed Repair Regulations: Implications for Gas Utilities

Re-proposed Repair Regulations:Implications for Gas UtilitiesTAX

Carol Conjura , KPMG LLP, Washington National TaxSusan Grais, Ernst & Young LLP, Washington National Tax

June 29, 2010

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Presenters

Carol Conjura, KPMG LLP: 202-533-3040

Susan Grais, Ernst & Young LLP: 202-327-8782

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Agenda

RepairsOverview of re-proposed regulationsTechnical UpdateTier 1 Status and ImplicationsRetirementsUnit of Property


Overview of Re-proposed Rules


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 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


What is the Unit of Property?

Buildings and Structural ComponentsGenerally one unit of property, except leasehold improvementsRetail outlets and C stores

General rule for all other propertyFunctional InterdependenceExceptions

Plant propertyGroup of components that performs a discrete and major functionCompare 2006 proposal, which used the Uniform System of Accounts

Network assets [reserved] (pipelines, storage facilities)Additional rule

Separate financial statement livesDifferent and proper MACRS class or method


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 production2. Result in material addition to the unit of property3. Result in material increase in capacity, productivity, efficiency,

strength, or quality to the unit of property or its outputFocus is on qualitative, not quantitative change in fair market valueMateriality not definedUnavailability of replacement partsCompare with status of property prior to last normal repair, or prior to a particular event


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


Repairs 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


Casualty 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


Relocation Costs

Costs of relocating pipelines and other facilitiesDo not result in a betterment or restorationConsistent with Badger Pipeline v. Commissioner, T.C. Memo 1997-457


Removal Costs

Rev. Rul. 2000-7If 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 deductibleIf replacement is an improvement—removal costs are capitalCompare re-proposed regulations which treat replacement of component as capital if gain or loss recognized on removal


Environmental 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 capitalizedCosts of water treatment facility are capitalBut 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)

Pre-existing material condition or defectRemediation of pre-acquisition contamination treated as a bettermentLatent 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 uncertainExtension of section 198

Election to expense otherwise capital remediation

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Spare 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 partsCurrent law: deductible when placed in serviceRe-proposed regulations: deductible when disposed of

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Supplies

Definition of supplyNot a unit of propertyUnit of property with economic useful life of 12 months or lessUnit of property with acquisition or production cost of $100 or lessIdentified 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 taxpayersFERCFCCSTB

Must follow regulatory method of accounting for tax purposesMust use for all tangible property subject to regulatory accounting rules

Optional Regulatory Accounting Method


Routine Maintenance Safe Harbor

Includes recurring activities to keep a unit of property in ordinarily efficient operating conditionActivities are routine if:

Reasonably expected to occur more than once in an asset’s MACRS class life

Gas production—Every 7 years or more frequentlyGas transportation—Every 11 years or more frequently

Not applicable if property restored under tests 1-4i.e., if replacements are componentized or after a casualty, or dysfunctional state

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Minimum Capitalization Rule

Taxpayer may use financial statement minimum capitalization policyRequirements/restrictions

Not applicable to repair and improvement costsApplicable Financial Statement; written accounting procedures; no income distortionSafe 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


Section 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 improvementsPursuant 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


Section 263A Impact (cont’d)

Repairs in connection with inventory production must be capitalized to current productionSection 481 adjustment for repairs change relates to prior production activities

Impact depends on inventory cost flow assumptionMay relate to prior LIFO layer

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Re-proposed Repair Regulations: Implications for Gas Utilities

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