These new proposed regulations include many of the provisions contained in the 2006 proposed regulations, including the proposed format changes in which §1.263(a)-1 provides general rules for capital expenditures, §1.263(a)-2 provides rules for amounts paid for the acquisition or production of tangible property, and §1.263(a)-3 provides rules for amounts paid for the improvement of tangible property. However, these new proposed regulations provide many additional rules that were not included in the 2006 proposed regulations. For example, these new proposed regulations provide a definition of materials and supplies under §1.162-3 (including a special 12-month rule and a $100 de minimis rule), a book conformity de minimis rule for acquisitions of units of property under §1.263(a)-2, a safe harbor for routine maintenance under §1.263(a)-3, and an optional simplified method for regulated taxpayers under §1.263(a)-3. Additionally, these new proposed regulations provide significant changes to the rules relating to unit of property and restorations, and allow for industry-specific repair allowance methods in future Internal Revenue Bulletin guidance. These new proposed regulations generally will apply to taxable years beginning on or after the date that final regulations are published in the Federal Register.

In addition to providing specific comments, many commentators suggested that, given the broad scope and effect of the regulations and the numerous comments received on the 2006 proposed regulations, consideration should be given to re-proposing the regulations in their entirety. This suggestion has been adopted and the 2006 proposed regulations are withdrawn and replaced with these new proposed regulations.

Various commentators thought that the 2006 proposed regulations failed to fully address the relationship between the rules for capitalization of tangible property under section 263(a) and the materials and supplies rules provided in §1.162-3 of the current regulations because the 2006 proposed regulations did not provide special rules for the interaction between the two provisions. Specifically, commentators noted that under the 2006 proposed regulations, tangible property with a useful life of 12 months or less was not treated as a material and supply, which treatment was inconsistent with existing authorities, particularly with regard to the timing of when to deduct amounts paid to acquire the property with a useful life of 12 months or less. Commentators pointed out that the 2006 proposed regulations were inconsistent with §1.162-3 and would create uncertainty with regard to which provision should be applied to which property. In response, the IRS and Treasury Department decided to revise §§1.162-3 and 1.263(a)-2 to provide clear and consistent treatment for those items that traditionally have been considered to be materials and supplies and to provide distinct, but coordinated, treatment for those items that should be addressed under section 263(a).

The new proposed regulations provide additional guidance under §1.162-3 with respect to the definition of materials and supplies. Specifically, the proposed rules define a material and supply as tangible property that (a) is not a unit of property, (b) is a unit of property with an economic useful life of 12 months or less, (c) is a unit of property that costs $100 or less, or (d) is identified as a material and supply in future guidance.

Under the existing regulations, the costs of non-incidental materials and supplies are deducted as the materials and supplies are used or consumed, and the costs of incidental materials and supplies are deducted as the costs are incurred. These new proposed regulations retain this treatment of materials and supplies, except with respect to rotable and temporary spare parts. These new proposed regulations provide that rotable or temporary spare parts treated as materials and supplies will be considered used or consumed in the taxable year in which the taxpayer disposes of the parts. This rule prevents taxpayers from prematurely deducting the cost of a unit of property by systematically replacing components with rotable spare parts. The IRS and Treasury Department anticipate that taxpayers with rotable or temporary spare parts that are not discarded after their original use generally will prefer to capitalize their costs and treat those parts as depreciable assets. These new proposed regulations provide for an election to capitalize these costs.

Taxpayers should recognize that the used or consumed standard for non-incidental materials and supplies generally is met later than the placed in service standard used for depreciation. In addition, taxpayers are reminded that after a material or supply is used or consumed, capitalization of the material or supply cost to another property may be required. For example, amounts paid for materials and supplies used in the production of inventory or a self-constructed asset generally are required to be capitalized under section 263A. Similarly, amounts paid to produce materials and supplies generally are required to be capitalized as part of the production costs of the materials and supplies. Nothing in these new proposed regulations is intended to change this treatment.

First, these new proposed regulations provide that property that is not a unit of property as defined in §1.263(a)-3 will be considered a material and supply. In general, this definition is intended to describe spare and replacement parts and is consistent with the current characterization of these items.

Second, these new proposed regulations provide that property that has an economic useful life of 12 months or less will be considered a material and supply. Commentators requested clarification concerning the application of the 12-month rule provided in the 2006 proposed regulations. For purposes of applying the 12-month rule, these new proposed regulations generally adopt the economic useful life definition in §1.167(a)-1(b) and provide that, for purposes of these new proposed materials and supplies regulations, the measurement period for economic useful life begins when the item is first used or consumed in the taxpayer’s trade or business. Therefore, the time prior to when an item is used or consumed is not taken into consideration in determining the economic useful life of the asset for purposes of these new proposed regulations, notwithstanding the fact that the item may have been placed in service (ready and available for its intended use) for depreciation.

In addition, these new proposed regulations provide a special economic useful life test under the 12-month rule for taxpayers with applicable financial statements (AFS). Under this rule, taxpayers with AFS are required to determine the economic useful life in a manner consistent with the economic useful life used for purposes of determining depreciation in the books and records supporting their AFS. An exception is provided if a taxpayer does not assign a useful life to certain property in its AFS (for example, the item is currently expensed in the taxpayer’s AFS because it is considered de minimis).

The 2006 proposed regulations did not provide a de minimis rule for the acquisition or production of property but requested comments on whether a de minimis rule should be adopted. Commentators generally agreed that the regulations should include a de minimis rule but varied on how that rule should be structured.

Third, these new proposed regulations provide a $100 de minimis rule within the definition of materials and supplies. Materials and supplies include a unit of property that has a production or acquisition cost of $100 or less, without regard to the treatment of the item in the taxpayer’s financial statements. Allowing small items to be treated as materials and supplies resolves uncertainty with respect to whether those items represent a depreciable asset or a material and supply, and $100 is a low enough threshold to alleviate concerns about the potential distortion of income. However, treating a small unit of property as a material and supply may affect the timing of the deduction for the material and supply cost because expensing an amount paid for a non-incidental material and supply will only occur in the period in which the item is used or consumed.

Various commentators pointed out that taxpayer burden may be reduced by allowing taxpayers to capitalize amounts paid for items that otherwise would qualify as materials and supplies and treat the items as depreciable assets. For example, many taxpayers currently treat rotable spare parts as capital expenditures depreciable over the life of the unit of property in which the rotables are used. See Rev. Rul. 69-200, 1969-1 C.B. 60. See §601.601(d)(2)(ii)(b).

Under these new proposed regulations, taxpayers may elect to treat an amount paid for a material and supply as a capital expenditure. In general, the election is made separately for each material and supply and is revocable only with the consent of the Commissioner. The election is made by capitalizing the cost of the material and supply in the year the cost is incurred and beginning depreciation of the item in the year it is placed in service.

The 2006 proposed regulations revised §1.162-4 (the repair rules), to provide rules consistent with the improvement rules under §1.263(a)-3 of the 2006 proposed regulations. Commentators expressed concern that the proposed changes would result in challenges to the deductibility of costs that the IRS has long agreed with taxpayers are deductible. The IRS and Treasury Department do not think that the proposed change to §1.162-4 creates a burden of proof higher than that which exists under current law or requires capitalization of costs that are not required to be capitalized under current law. Therefore, these new proposed regulations do not propose any specific changes to the rules proposed in the 2006 proposed regulations. However, a routine maintenance safe harbor is provided in these new proposed regulations in §1.263(a)-3.

The existing regulations under §1.162-6 provide rules for professional expenses. These new proposed regulations propose to remove §1.162-6. In general, the treatment of the items listed in §1.162-6 is adequately addressed in these new proposed regulations and other existing regulations. The proposed removal of §1.162-6 is not intended to result in any substantive changes in the treatment of professional expenses.

The 2006 proposed regulations provided rules for the capitalization of selling expenses, except in the case of dealers, under §1.263(a)-1. The 2006 proposed regulations included an example that required the capitalization of advertising costs as a selling expense that must be offset against the sale proceeds. Various commentators questioned this treatment of advertising costs. In general, advertising costs are not capital expenditures. Therefore, these new proposed regulations retain the general rule but remove the references to advertising costs provided in the 2006 proposed regulations and update the examples accordingly.

The 2006 proposed regulations did not provide a specific capitalization rule for amounts paid to acquire or create intangible interests in land. The 2006 proposed regulations specifically requested comments on this issue, but no comments were received. These new proposed regulations provide that amounts paid to acquire or create interests in land, such as easements, life estates, mineral interests, timber rights, zoning variances, or other interests in land, are examples of capital expenditures. Comments are specifically requested on this proposed rule.

The 2006 proposed regulations provided rules for the capitalization of amounts paid to acquire or produce tangible property under §1.263(a)-2. These new proposed regulations generally retain the same format, but make some modifications to the 2006 proposed regulations. For example, modifications have been made to clarify the interaction of §1.263(a)-2 of these new proposed regulations with the materials and supplies rules under §1.162-3. Significant modifications and clarifications are discussed further in this preamble.

Commentators asked whether the term “produce” as used in the 2006 proposed regulations had the same meaning as the term “produce” under section 263A. These new proposed regulations clarify that the definition of the term produce for purposes of §1.162-3 and §1.263(a)-2 generally is the same as the definition of the term produce for section 263A purposes. The sole difference is that the term “improve” is not included in §1.162-3 and §1.263(a)-2 because “improve” under section 263A is specifically defined in §1.263(a)-3 of these new proposed regulations, relating to the improvement of tangible property.

The 2006 proposed regulations generally required a taxpayer to capitalize amounts paid to facilitate the acquisition of real or personal property, and included a list of typical transaction costs. Commentators suggested that with respect to the rules requiring the capitalization of facilitative transaction costs, an exception should be provided for transaction costs for pre-decisional investigatory costs, similar to the exception provided with respect to certain intangibles in §1.263(a)-4(e)(1)(iii) (creation of certain contract rights) and §1.263(a)-5(e) (acquisition of a trade or business). These new proposed regulations provide a general rule similar to the rules in the intangibles regulations requiring that taxpayers capitalize all costs that facilitate an acquisition of tangible property, including the costs of investigating the acquisition, but adopt the commentators’ suggestion in part by providing an exception for certain costs incurred in the investigation of real property acquisitions. The IRS and Treasury Department think it is appropriate to provide an exception for real property acquisitions because these types of transactions most often raise the issue of whether the investigatory costs are deductible business expansion costs rather than capital expenditures to acquire a specific asset. The exception provides that costs relating to activities performed in the process of determining whether to acquire real property and which real property to acquire generally are deductible pre-decisional costs. Under this exception, capitalization will not be required for certain pre-decisional investigative activities, such as marketing studies, that are not specifically identified in these regulations as being inherently facilitative. These new proposed regulations provide that inherently facilitative costs must be capitalized and list the costs, such as transportation and shipping costs, that are inherently facilitative.

A commentator pointed out that section 263A does not apply to acquisitions of property that are not intended for resale, and thus, taxpayers should not be required to capitalize overhead costs to this type of property. These new proposed regulations address this comment by providing a simplifying convention for employee compensation and overhead costs similar to the rules provided for intangible property. However, the new proposed regulations reiterate that section 263A does apply to the production of real or personal property. Section 263A contains rules for certain costs incurred prior to production.

Under current law, if a taxpayer engages in multiple separate and distinct transactions, the taxpayer may allocate transaction costs to the separate transactions and recover the allocable transaction costs as each distinct transaction is abandoned. Sibley, Lindsay & Curr Co. v. Commissioner, 15 T.C. 106, 110 (1950), acq., 1951-1 C.B. 3. See §601.601(d)(2)(ii)(b). However, if the transactions are viewed as alternatives, only one of which the taxpayer can complete, the courts have held that the taxpayer must capitalize all the transaction costs to the one transaction ultimately completed. United Dairy Farmers, Inc. v. United States, 267 F.3d 510 (6th Cir. 2001); Nicolazzi v. Commissioner, 79 T.C. 109 (1982), aff’d, 722 F.2d 324 (6th Cir. 1983). To avoid the difficulty inherent in administering this rule, including ascertaining the intent of the taxpayer, the new proposed regulations provide a more objective rule. This rule allows taxpayers to allocate inherently facilitative costs among the separate and distinct properties considered, regardless of the taxpayer’s ultimate intent or plan. The taxpayer capitalizes the allocable transaction costs to each property, including properties not acquired, and recovers the costs as appropriate under the applicable provision of the Code (for example, section 165, 167, or 168). Examples are provided to demonstrate the application of these rules.

In addition, a commentator noted that the rule contained in the 2006 proposed regulations with respect to costs incurred prior to placing property in service is really a rule for acquisition costs, not improvement costs. The IRS and Treasury Department agree that activities occurring prior to placing the property in service are conceptually more related to the acquisition of the property than to the improvement of property. Therefore, these new proposed regulations move to the acquisition cost section of these regulations the requirement to capitalize amounts paid for work performed prior to placing property in service.

The 2006 proposed regulations did not provide a specific de minimis rule for the acquisition or production of property, but the preamble provided a detailed proposal of what might be an appropriate de minimis rule and requested comments from taxpayers on this issue. Numerous comments supported the adoption of a de minimis rule to the extent such a proposal would not alter the current understandings between taxpayers and examining agents with respect to what type of transactions are considered de minimis on examination for purposes of evaluating risk. Therefore, to reduce burden and provide simplification, these new proposed regulations provide a de minimis rule. With respect to the concerns raised by commentators as to the adoption of a de minimis rule, the IRS and Treasury Department want to make clear that the adoption of such a rule is not intended to alter the general risk analysis currently employed by examining agents. Therefore, the de minimis rule proposed in these regulations should not affect any current understandings between examining agents and taxpayers with respect to the size and character of transactions that will be the focus of examinations.

The proposed de minimis rule is based primarily on a qualifying taxpayer’s financial statement standards. A qualifying taxpayer is a taxpayer that: (a) has an AFS, (b) has written accounting procedures for the expensing of de minimis items, and (c) recognizes de minimis costs as expenses on its AFS. Under the rule provided in these new proposed regulations, a qualifying taxpayer can use the de minimis standard adopted in its AFS to the extent the AFS de minimis standard does not result in a distortion of income. Although commentators varied regarding whether it is appropriate to require conformity with AFS to qualify for a de minimis rule, the IRS and Treasury Department think that it provides simplification and reduces burden only to allow deductions for de minimis amounts paid for property (other than the $100 rule for materials and supplies) that are already being deducted for AFS purposes.

The primary concern with the adoption of a de minimis rule is that expensing items under a de minimis rule may not clearly reflect income under section 446, particularly for aggregate or bulk purchases of de minimis items. In general, the IRS and Treasury Department recognize that accounting for an item using generally accepted accounting principles will not result in a distortion of income. Nonetheless, a distortion of income standard has been adopted in an effort to avoid intentional manipulations of the de minimis rule. These new proposed regulations provide a safe harbor in which the use of an AFS de minimis standard will be deemed not to distort income. Specifically, the safe harbor provides that an amount deducted under the AFS de minimis rule for the taxable year will be deemed not to distort income if that amount, added to the amounts deducted in the taxable year as materials and supplies for units of property costing $100 or less, is less than or equal to the lesser of (i) 0.1 percent of the taxpayer’s gross receipts for the taxable year, or (ii) 2 percent of the taxpayer’s total depreciation and amortization for the taxable year as determined in its AFS. The safe harbor provided in these new proposed regulations is based upon percentages and comparisons provided in case law. See Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo. 2001-149; Cincinnati, New Orleans & Tex. Pac. Ry. Co. v. United States, 424 F.2d 563 (Ct. Cl. 1970). This safe harbor is not intended to be used in other contexts as a bright-line rule of an amount that distorts income. Whether amounts above the safe harbor result in a distortion of income depends upon the taxpayer’s facts and circumstances.

These new proposed regulations also provide that gain on the sale or disposition of property accounted for under the de minimis rule is not treated as gain resulting from the sale or disposition of a capital asset under section 1221 or as property used in the trade or business under section 1231. These new proposed regulations also clarify that property accounted for under the de minimis rule is not a material or supply under §1.162-3.

Moreover, these new proposed regulations provide that taxpayers may elect to capitalize items that might otherwise be within the scope of the de minimis rule. In general, this election to capitalize is made separately for each asset by treating the amount paid as a capital expenditure on the tax return.

These new proposed regulations also make a conforming change to the regulations under section 263A to ensure that amounts paid for property produced by the taxpayer also qualify under the de minimis rule, because there is no basis for distinguishing between acquired and produced property for this purpose. This change is provided in §1.263A-1(b)(14) of these new proposed regulations. The rule provides that the cost of property to which a taxpayer properly applies the de minimis rule contained in §1.263(a)-2(d)(4) of these new proposed regulations (including the requirement that it not distort income) is not required to be capitalized under section 263A as a separate unit of property, but may be required to be capitalized as a cost incurred by reason of the production of other property. This change is necessary because without a conforming change to section 263A, property produced by the taxpayer that qualified under the de minimis rule would be capitalized under section 263A despite the de minimis rule under section 263(a).

These new proposed regulations do not impose any specific record keeping requirements for the use of the de minimis rule. However, under section 6001, taxpayers are required to keep books and records sufficient to establish their eligibility to use the de minimis rule. Specifically, taxpayers must maintain books and records reasonably sufficient to determine (1) the total amounts paid and deducted as materials and supplies pursuant to §1.162-3(d)(1)(iii) of these new proposed regulations; (2) the total amounts paid and not capitalized pursuant to §1.263(a)-2(d)(4)(i) of these new proposed regulations; (3) the computation of the safe harbor amount provided by §1.263(a)-2(d)(4)(iii) of these new proposed regulations; (4) that income has not been distorted by the aggregate of the deductions under §§1.162-3(d)(1)(iii) and 1.263(a)-2(d)(4)(i) of these new proposed regulations if the aggregate amount exceeds the safe harbor amount determined pursuant to §1.263(a)-2(d)(4)(iii) of these new proposed regulations; and (5) that the requirements of §1.263(a)-2(d)(4)(i)(A)-(C) of these new proposed regulations have been met.

In general, these proposed regulations are intended to reduce controversy and provide clarity on how to determine whether an amount paid must be capitalized under section 263(a) as an improvement cost. Consistent with that intent, the 2006 proposed regulations contained rules with respect to improvements, including rules to determine whether an amount paid results in a material increase in value or prolonged useful life. As described below, these regulations modify the rules set forth in the 2006 proposed regulations to reflect comments received. While these proposed regulations attempt to provide more certainty in an area of law that currently requires a subjective analysis, the IRS and Treasury Department request comments on whether the improvement rules in these regulations are consistent with the overriding goal of providing clarity and certainty in this area.

The IRS and Treasury Department received numerous comments regarding the improvement rules provided in the 2006 proposed regulations. Many of the comments received included a general request that consideration be given to providing more bright-line rules and clarifying definitions as well as providing greater consistency with other provisions of the Code. The rules contained in these new proposed regulations attempt to address these concerns.

Section 1.263(a)-3 of the 2006 proposed regulations provided that taxpayers are required to capitalize amounts paid to improve a unit of property. Under the general rule in the 2006 proposed regulations, a unit of property is improved if the amounts paid (i) materially increase the value of the unit of property; or (ii) restore the unit of property. Under the 2006 proposed regulations, amounts paid to adapt a unit of property to a new or different use were considered to materially increase the value of a unit of property. The 2006 proposed regulations also contained rules for determining the appropriate unit of property.

These new proposed regulations remove the new or different use standard from the material increase in value rules and provide a separate category for new or different use. Additionally, the material increase in value standard has been renamed the “betterment” standard because the betterment standard more closely reflects the manner in which section 263(a) has been interpreted and applied under current law. Therefore, these new proposed regulations identify three categories of costs that result in an improvement to property. Taxpayers under the new proposed regulations must capitalize amounts paid that:

(i) Result in a betterment to a unit of property;

(ii) Restore a unit of property; or

(iii) Adapt a unit of property to a new or different use.

These new proposed regulations continue to include rules for defining the unit of property to be used in making these determinations.

The 2006 proposed regulations did not prescribe a plan of rehabilitation doctrine as traditionally described in the case law. That judicially-created doctrine provides that a taxpayer must capitalize otherwise deductible repair costs if they are incurred as part of a general plan of rehabilitation to the property. See Norwest Corp. v. Commissioner, 108 T.C. 265 (1997); Moss v. Commissioner, 831 F.2d 833 (9^th Cir. 1987); United States v. Wehrli, 400 F.2d 686 (10^th Cir. 1968). Commentators requested that the regulations specifically state that the plan of rehabilitation doctrine either is eradicated or is limited to clearly defined circumstances.

Section 263A requires that all direct costs of an improvement and all indirect costs that directly benefit or are incurred by reason of the improvement must be capitalized. See section 263A(b)(1), which states that section 263A applies to real or tangible property produced by the taxpayer, and section 263A(g)(1), which states that the definition of “produce” includes improve. See also §1.263A-1(e), which requires the capitalization of direct costs and of all indirect costs that directly benefit or are incurred by reason of the performance of production activities. Section 263A, therefore, requires a taxpayer to capitalize otherwise deductible repair costs as part of an improvement if the taxpayer improves a unit of property and the otherwise deductible repair costs directly benefit or are incurred by reason of the improvement to the property. Thus, section 263A has eliminated the need for a plan of rehabilitation doctrine to determine the allocable costs that must be capitalized as part of an improvement. Although some commentators requested that the circumstances in which otherwise deductible repair costs must be capitalized as part of an improvement be limited, for example, to property that is totally dysfunctional and unsuitable for its intended purpose, there is no authority for doing so because section 263A specifically applies to improvements. The legislative history to the Tax Reform Act of 1986, P.L. 99-514 (100 Stat. 2085) also indicates that Congress intended section 263A to apply to improvements to property. See, for example, S. Rep. No. 99-313, 99^th Cong., 2d Sess. 133-152 (1986), which states that the uniform capitalization rules will apply to assets or improvements to assets constructed by a taxpayer for its own use in a trade or business or in an activity engaged in for profit, and that the rules are not intended to apply to expenditures properly treated as repair costs under present law that do not relate to the manufacture, remanufacture, or production of property.

Section 263A does not require otherwise deductible repair costs to be capitalized if the repairs do not directly benefit or are not incurred by reason of a production activity (for example, an improvement). The judicially-created plan of rehabilitation doctrine, however, has been cited to require capitalization of otherwise deductible repair costs solely because the taxpayer has a plan (written or otherwise) to perform periodic repairs or maintenance, or solely because the taxpayer performs several repairs to the same property at one time even though the property is not improved. As stated in the preamble to the 2006 proposed regulations, the IRS and Treasury Department do not think this characterization is appropriate. These new proposed regulations specifically provide that repairs that are made at the same time as an improvement, but that do not directly benefit or are not incurred by reason of the improvement, are not required to be capitalized under section 263(a). These new proposed regulations do not prescribe a plan of rehabilitation doctrine. Therefore, when these new proposed regulations are finalized, the judicially-created plan of rehabilitation doctrine will be obsolete, particularly with regard to the assertion that the doctrine transforms otherwise deductible repair costs into capital improvement costs solely because the repairs are performed at the same time as an improvement, or are pursuant to a maintenance plan, even though the repairs do not improve the property under §1.263(a)-3. However, section 263A continues to require a taxpayer to capitalize otherwise deductible repair costs if the taxpayer improves a unit of property and the otherwise deductible repair costs directly benefit or are incurred by reason of the improvement to the property.

The 2006 proposed regulations began with an initial unit of property determination of all components that are functionally interdependent to define the largest unit of property as a starting point for the analysis. Special rules applied to buildings and their structural components and to property used in certain regulated industries. Network assets were excluded from the definition of unit of property. The unit of property determination for other personal property employed a facts and circumstances test based on the application of four exclusive factors—(1) marketplace treatment; (2) industry practice and financial accounting; (3) treatment as a rotable spare part; and (4) functional use. An overriding rule required taxpayers to treat property as a unit of property for purposes of section 263 if the taxpayer did so for any other Federal income tax purpose.

The IRS and Treasury Department received multiple comments on the definition of a unit of property provided in the 2006 proposed regulations. The commentators generally expressed dissatisfaction with the unit of property rules provided in the 2006 proposed regulations, particularly with respect to the regulated industry rules and the rule for rotable spare parts. Commentators generally agreed with the unit of property rules for a building, but raised objections that the remaining rules provided in the 2006 proposed regulations were overly complex and ambiguous. Many commentators recommended that the determination of a unit of property be based primarily on the functional interdependence test, similar to that used for depreciation and section 263A purposes, with no further factors, while other commentators recommended that the determination be based on the factors used in FedEx Corp. v. United States, 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6th Cir. 2005).

The IRS and Treasury Department think that most of the factors listed in the 2006 proposed regulations were the same as the factors used in FedEx. However, commentators generally criticized the manner in which the 2006 proposed regulations applied these factors. Nonetheless, the IRS and Treasury Department agree that some factors, such as the rotable spare parts factor, may be overly burdensome, particularly for taxpayers that use small components in their businesses. Additionally, although some taxpayers in regulated industries favored the ability to conform to regulatory reporting, many that are not subject to regulatory accounting for all assets objected to the conformity rule as inappropriate and a potential source for uncertainty and controversy. Therefore, these new proposed regulations substantially modify the unit of property definition contained in the 2006 proposed regulations.

These new proposed regulations provide unit of property rules that generally are based on the functional interdependence standard, and include special rules for buildings, plant property, and network assets. Additional rules are provided that may require a smaller unit of property characterization in certain circumstances. Generally, improvements to a unit of property are not considered separate units of property even though the improvements are treated as separate assets for depreciation purposes.

These new proposed regulations generally provide the same rule for buildings as the 2006 proposed regulations. A building and its structural components are treated as a single unit of property. However, a special rule for condominiums and cooperatives is provided. Additionally, a leasehold improvement that is section 1250 property and is made by a lessee is a separate unit of property.

For property other than a building, these new proposed regulations provide that, in general, a single unit of property includes all components that are functionally interdependent. However, a number of special rules are provided that may require a smaller unit of property to be considered. The IRS and Treasury Department do not think that applying solely a functional interdependence test results in the appropriate unit for all types of property. For some types of property, such as machinery and equipment in a manufacturing plant, the functional interdependence test often results in a very expansive unit of property. The IRS and Treasury Department think it is inappropriate to use such a large unit of property for making a determination regarding improvements.

These new proposed regulations provide a special rule for plant property, which is defined as “functionally interdependent machinery or equipment . . . used to perform an industrial process . . . .” This definition is not intended to include all types of property used in a taxpayer’s trade or business, but is intended only to capture the functionally interdependent machinery and equipment used in industrial processes like manufacturing, electric generation, distribution, warehousing, as well as equipment used in providing industrial services such as automated materials handling equipment. This special rule requires that the functionally interdependent machinery and equipment be separated into a component or a group of components that performs a discrete and major function or operation. These new proposed regulations provide various examples to illustrate activities that will constitute a discrete and major function.

These new proposed regulations provide the same definition of network assets as the 2006 proposed regulations and continue to reserve on providing a special rule for networks assets. The IRS and Treasury Department think that in many situations, the unit of property for network assets should be smaller than the unit of property determined under the functional interdependence test. The IRS and Treasury Department generally think that the unit of property rules for network assets should be addressed on an industry by industry basis in Internal Revenue Bulletin guidance. Industries are invited to submit requests for guidance under the Industry Issue Resolution (IIR) program after these regulations are finalized.

These new proposed regulations also provide two additional rules that may require a smaller unit of property determination than that provided under the general rule. The first rule is triggered if the taxpayer has assigned different economic useful lives for financial statement or regulatory purposes to components of a single unit of property at the time the unit of property is placed in service by the taxpayer. Simply accounting for components separately (for example, recording the property separately in depreciation or other asset-tracking books and records) does not trigger this rule. However, assigning a different economic useful life to components will require that the unit of property determination be limited to those components that have been assigned the same useful life for financial statement purposes. The second rule applies when components of a single unit of property are depreciated by the taxpayer under different MACRS classes (including a different MACRS class that results from a change in method of accounting). This second rule also applies if components of a single unit of property are depreciated by the taxpayer using different recovery methods (for example, double-declining balance versus unit-of-production). Again, simply recording various components separately in the taxpayer’s depreciation books and records will not trigger the rule.

These rules are intended to prevent overly broad unit of property determinations that are inconsistent with the taxpayer’s characterization of the unit of property for depreciation purposes. In general, the IRS and Treasury Department anticipate that these limiting rules will apply only in unique circumstances. The IRS and Treasury Department encourage taxpayers to provide comments on the application of these limiting rules and to identify situations (if any) in which the limiting rules may not operate as intended.

The 2006 proposed regulations did not contain a routine maintenance safe harbor. Various commentators requested that the regulations provide guidance to clarify when the cost of a routine maintenance activity will be considered a deductible expense. In addition, commentators expressed concern that under the rules provided in the 2006 proposed regulations, routine maintenance activities are required to be capitalized if performed near the end of the economic useful life of the property, regardless that identical activities were considered deductible if performed earlier in the useful life.

To address this concern, these new proposed regulations provide a routine maintenance safe harbor under which qualifying activities will be deemed to not improve the unit of property. Under this safe harbor, routine maintenance activities include recurring activities that a taxpayer expects to perform more than once over the class life of the unit of property as a result of the taxpayer’s use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. Amounts paid for betterments do not keep the unit of property in an ordinarily efficient operating condition; however, the replacement of minor parts with improved but comparable parts generally does not result in a betterment. Thus, for example, the safe harbor includes amounts paid for replacement parts that the taxpayer expects to replace more than once during the class life of the unit of property, even if the replacement part is an improved but comparable part. As part of the safe harbor provisions, these new proposed regulations provide a list of relevant considerations to be taken into account in determining whether an amount is paid for routine maintenance. These considerations include the recurring nature of the activity, industry practice, manufacturer recommendations, taxpayer experience and the treatment of the activity on the taxpayer’s AFS. The safe harbor maintenance rule specifically applies to maintenance activities performed on rotable or temporary spare parts, but reminds taxpayers that under the rules proposed in §1.162-3(b) of these new proposed regulations, the capitalized costs associated with rotable and temporary spare parts (that is, acquisition costs) may be deducted only in the taxable year in which the rotable or temporary spare part is discarded.

One concern with establishing a maintenance safe harbor that includes the costs of replacement parts is creating an incentive for taxpayers to componentize assets in an effort to recover basis upon the removal of a component while deducting the replacement cost as a repair or maintenance expense. Therefore, the safe harbor does not apply to the cost of replacement components in situations in which the taxpayer has taken into account the basis of the component being replaced in determining gain or loss resulting from a sale or exchange of the replacement component, has taken a loss related to the retirement of the component, or has taken a basis adjustment related to a casualty event under section 165.

The safe harbor is intended to operate only as a safe harbor in which qualifying costs will be deemed not to constitute an improvement. The IRS and Treasury Department recognize that many activities that do not qualify for the safe harbor nonetheless may be activities that do not give rise to capitalization of costs under section 263(a). Additionally, costs deductible under the maintenance safe harbor may be required to be capitalized under section 263A to other property produced or acquired for resale.

The 2006 proposed regulations used the term “material increase in value” to generally describe the concept of a betterment. In general, commentators agreed with the standards outlined in the 2006 proposed regulations to determine whether an amount paid materially increases the value of property. However, commentators differed on whether taxpayers should be allowed to override the material increase in value test by proving that the activity did not actually increase fair market value. Consistent with the preamble to the 2006 proposed regulations, the IRS and Treasury Department continue to think that whether an amount paid should be capitalized as a betterment to a unit of property depends upon the purpose, the physical nature, and the effect of the work for which the amounts were paid, and not upon an analysis of the fair market value of the property before and after the work. Therefore, to clarify this distinction, these new proposed regulations change the name of the material increase in value test to the betterment test. The general rule focuses on betterments to the condition of the property, the costs of which should be capitalized as an improvement if the betterment is material, regardless of whether the betterment increases the fair market value.

Commentators noted that the general concept of a betterment is difficult to apply and suggested that the language in the regulations better define what types of events would give rise to a betterment. Additionally, commentators pointed out that some of the betterment tests were redundant. The IRS and Treasury Department agree that the general concept of a betterment or improvement can be difficult to apply. In developing these new proposed regulations, consideration was given to retaining the rules provided in the current regulations without providing clarification of material increase in value, prolong useful life, and new or different use. The principal concern in providing detailed rules on the concept of an improvement is the potential to create controversy in areas where none currently exists, which would undermine one of the primary purposes of the project.

Nonetheless, because commentators generally did not oppose the tests provided for material increase in value under the 2006 proposed regulations, these new proposed regulations continue to provide an exclusive list of tests that determine whether an amount paid results in a betterment in an attempt to further solicit comments in this area. The IRS and Treasury Department specifically request comments as to whether the exclusive list of tests with respect to improvements provides additional certainty in this area and if not, why. Given the continuing evaluation of this area, taxpayers should be particularly aware that no reliance should be placed on the rules provided in these new proposed regulations until such rules are finalized.

The tests included in the original proposed regulations have been reorganized in these new proposed regulations in an attempt to provide additional clarification. Under these new proposed regulations, an amount paid results in a betterment if it:

(i) Ameliorates a material condition or material defect that existed prior to the acquisition or arose during the production of the property,

(ii) Results in a material addition to the unit of property (including a physical enlargement, expansion, or extension), or

(iii) Results in a material increase in the capacity, productivity, efficiency, strength, or quality of the unit of property or its output.

This rule generally follows the rule contained in the 2006 proposed regulations but clarifies, in response to comments received, that capitalization is only required to the extent the condition or defect is considered material. Commentators noted that a taxpayer may not know of a condition or defect that exists at the time property is acquired and that requiring capitalization of costs in this situation would create a hardship for those taxpayers. Although taxpayers may not be aware of defects that exist at the time of acquisition, the remedial activity being performed necessarily results in a betterment, regardless of whether the activity actually increases the fair market value of the property. The rule provided in these proposed regulations is consistent with established case law. See United Dairy Farmers, Inc. v. United States, 267 F.3d 510 (6^th Cir. 2001); Dominion Resources, Inc. v. United States, 219 F.3d 359 (4^th Cir. 2000).

Moreover, adopting a rule based on a taxpayer’s knowledge at the time of acquisition or production would be difficult to administer. The IRS and Treasury Department recognize that application of this rule to used property acquired by a taxpayer will result in some costs that would otherwise be deductible as repair costs being capitalized the first time the repairs are performed (if the condition or defect is material) if the nature of the activities is to correct the effects of wear and tear that was not caused by the taxpayer’s use of the property. This result is consistent with the routine maintenance safe harbor, which requires the activities under that safe harbor to be performed as a result of the taxpayer’s own use of the property.

The IRS and Treasury Department understand that certain cases exist in which a taxpayer contaminates property during its operations, the taxpayer disposes of the property, and the taxpayer reacquires the property to clean up the contamination. Under the proposed rule, a taxpayer would be required to capitalize the costs incurred to clean up the property even though it was the taxpayer’s own activities that contaminated the property. The IRS and Treasury Department request comments regarding the appropriate treatment of environmental remediation costs in these circumstances, considering that the remediation is performed as a result of the taxpayer’s own use of the property. The IRS and Treasury Department also request comments regarding how to determine whether the contamination was due solely to the taxpayer’s prior operations or, if an interim owner may have added to the contamination, how to determine the appropriate treatment of remediation costs in that circumstance.

This rule applies both to material increases in the capacity, efficiency, strength, or quality of the unit of property itself as well as to material increases in the capacity, efficiency, strength, or quality of the output of the unit of property.

Commentators requested that, to the extent possible, additional guidance be provided with respect to how the betterments rules, including materiality, should be applied. The IRS and Treasury Department considered various possible bright-line rules with respect to materiality, but determined that each rule was inappropriate under certain circumstances. For example, the IRS and Treasury Department considered a rule that presumed materiality if the amounts paid are capitalized in the taxpayer’s financial statements as a permanent improvement, that is, the betterment is capitalized in the taxpayer’s financial statements over the remaining economic useful life of the unit of property or longer. The IRS and Treasury Department think that financial statement treatment is an important factor in determining materiality, because if the activity is material enough to treat as an improvement for financial statements, then generally it should be a material improvement for tax purposes. However, this bright-line rule was not adopted because the IRS and Treasury Department recognize that the standards used for financial statement purposes for capitalization of improvements do not coincide with the rules for capitalization of improvements in these proposed regulations. For example, some taxpayers may defer major maintenance expenses and amortize the expenses over the period until the next maintenance cycle rather than immediately expensing the costs for financial statement purposes. The taxpayer’s reason for not immediately expensing the cost for financial statement purposes (that is, treating the cost as a deferred expense or as a material capital expenditure) may not be readily apparent to the IRS, creating administrative burden and a potential source of controversy. Therefore, under these new proposed regulations, materiality will be based upon the facts and circumstances in each case. Examples are provided to illustrate to the application of materiality.

The 2006 proposed regulations specifically provided that the appropriate comparison for determining whether an amount paid results in a betterment is made by comparing the condition of the unit of property immediately after the expenditure with the condition of the property prior to the circumstances necessitating the expenditure. These new proposed regulations retain the same comparison test.

The 2006 proposed regulations provided that, consistent with section 263(a)(2), a taxpayer must capitalize amounts paid that restore a unit of property. The 2006 proposed regulations provided that amounts paid restore a unit of property only if they substantially prolong the economic useful life of the unit of property, and provided four rules for making that determination. The restoration of property rules contained in the 2006 proposed regulations were criticized by commentators as being overbroad and difficult to apply. In particular, the AFS definition of economic useful life and the bright-line one-year rule were denounced as providing inappropriate results. In response, these new proposed regulations make numerous modifications to the 2006 proposed regulations.

These new proposed regulations continue to require a taxpayer to capitalize amounts paid to restore a unit of property. However, the one-year rule and the AFS conformity requirement for economic useful life have been removed. These new proposed regulations provide a series of bright-line rules to determine when an amount paid is deemed to restore property. Although some commentators criticized rules that deem the cost of certain activities to be capitalized as restorations, the IRS and Treasury Department think that bright lines under this test will reduce controversy and help ease administration. These rules also expand on the rules provided in the 2006 proposed regulations with regard to the restoration of property after a casualty loss.

Section 263(a)(2) states that no deduction is allowed for any amount paid in restoring property or in making good the exhaustion thereof for which an allowance is or has been made. The IRS and Treasury Department think that this language requires capitalization of a replacement component if the taxpayer removes the basis of the replaced component from its books and records and takes the basis of the replaced component into account in its tax return. If a taxpayer takes into account the basis of a replaced component in its tax return, then the replacement of that component “makes good the exhaustion thereof for which an allowance has been made.” Therefore, these new proposed regulations provide that if the taxpayer has properly taken a portion of the existing adjusted basis of the restored asset into account in the computation of gain or loss on a sale or exchange, or as a retirement loss or other loss under the Code, the replacement of that component will be deemed to restore the unit of property.

The 2006 proposed regulations required a taxpayer to capitalize amounts paid to repair property if the taxpayer properly deducted a casualty loss under section 165 with respect to a unit of property and the amounts paid restore the unit of property to a condition that is the same or better than before the casualty. The casualty loss rule provided in the 2006 proposed regulations was criticized. In general, commentators thought there should be no link between the recognition of a casualty loss under section 165 and the determination of whether the cost to replace the property destroyed (in part or in whole) after a casualty event constitutes a capital expenditure. However, significant authority implies that a casualty-type event generally may only be characterized either as an extraordinary event (thus giving rise to a “loss” under section 165), or as an ordinary and necessary event in the operation of a trade or business (thus giving rise to an ordinary and necessary deduction under section 162). See, e.g., R. R. Hensler, Inc. v. Commissioner, 73 T.C. 168, 179 (1979), acq., (1980-2 C.B. 1); Hubinger v. Commissioner, 36 F.2d 724, 726 (2d Cir. 1929), cert. denied, 281 U.S. 741 (1930). Thus, a casualty is not an ordinary event, and the cost to repair property damaged by a casualty is not an ordinary expense. Stated differently, a loss under section 165 represents a destruction of property necessitating a replacement, which is capital, while an ordinary event generally represents damage to property necessitating a repair, which may or may not be capital. Because the restoration cost resulting from a loss is not ordinary, it is not allowed as an ordinary and necessary expense under section 162, but is treated as a capital expenditure under section 263(a). Although it is clear that a casualty event generally results in two economic costs to the taxpayer (the destruction of the previously invested capital and the costs to replace the destruction), the event giving rise to both of these costs is the same.

These new proposed regulations generally require consistent characterization of all costs arising from a single event. Therefore, under the rules provided in these new proposed regulations, a taxpayer that experiences an extraordinary loss event sufficiently destructive to invoke the provisions of section 165 will be required to treat the resulting restoration costs as a capitalized replacement of the destroyed property. This rule is required to ensure consistency in tax treatment among similarly situated taxpayers. For example, a taxpayer whose property is completely destroyed by a casualty event is required to capitalize the restoration of the loss because the restoration results in the replacement of the destroyed property with an entirely new unit of property. However, without a consistency rule, a taxpayer who experiences the same casualty event but only has part of a unit of property destroyed might argue that the cost to replace the destroyed portion of the unit of property is deductible because it simply returns the unit of property as a whole to its pre-casualty state. Allowing this type of disparity in tax treatment would provide an incentive to characterize destructions of property as partial destructions in order to leave open the position that a deduction may be taken for both the destruction of property resulting from the casualty event, as well as the ordinary and necessary expense of replacing the destroyed property. This rule also eliminates the dual characterization of minor costs incurred for items such as broken windows or blown-off shingles as both a casualty loss under section 165 and an ordinary and necessary expense under section 162.

Commentators noted that a rule requiring the capitalization of restoration costs following the recognition of a casualty loss would unfairly burden taxpayers that routinely experience extraordinary loss events in their trade or business. However, it should be noted that under these new proposed regulations, capitalization is required only if a loss or basis adjustment to the property is recognized by the taxpayer with respect to the event.

Various judicial authorities have held that events that generally are viewed as extraordinary loss events may nonetheless be considered ordinary occurrences in a particular industry. See Atlantic Greyhound Corp. v. United States, 111 F. Supp. 953 (Ct. Cl. 1953). In this situation, the costs to replace property destroyed in what would normally be characterized as a casualty event may result in an ordinary and necessary expenditure under section 162 rather than a loss under section 165. In this regard, the IRS and Treasury Department will consider providing guidance on what types of events may be considered ordinary in a particular industry. Taxpayers are encouraged to provide comments on this issue.

Commentators also noted that the rule provided in the 2006 proposed regulations created a disparity between taxpayers that recognized a loss under section 165 and taxpayers that received untaxed insurance proceeds as a result of a casualty event and adjusted the basis of the damaged asset accordingly. These new proposed regulations eliminate this disparity.

Similar to the 2006 proposed regulations, these new proposed regulations provide additional circumstances in which a restoration is deemed to occur. Capitalization is required for amounts paid to return a unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and can no longer function for its intended purpose. The IRS and Treasury Department anticipate that these types of restorations will occur either as a result of lack of maintenance by the taxpayer or after the end of the property’s useful life. A unit of property that is damaged by a casualty is not considered to be deteriorated to a state of disrepair.

These new proposed regulations also require capitalization of amounts paid to rebuild a unit of property to a like-new condition after the end of its economic useful life. The IRS and Treasury Department anticipate that this standard will apply to the traditional rebuilding of a unit of property to return it to a like-new condition. In general, a restoration under this rule will not result from routine maintenance activities, even if performed near the end of the useful life of the property, but instead represents a fundamental renewal of the economic useful life of the asset.

Similar to the 2006 proposed regulations, the new proposed regulations require capitalization of amounts paid to replace a major component or substantial structural part of a unit of property. In response to comments regarding the uncertainty in applying this standard, these new proposed regulations define the term “major component or substantial structural part.” Specifically, these new proposed regulations provide that the replacement of a major component or substantial structural part will be deemed to occur only if (a) the replacement costs constitute 50 percent or more of the replacement cost of the unit of property or (b) the replacement part or parts constitute 50 percent or more of the physical structure of the unit of property. These 50 percent thresholds apply solely for purposes of the restoration rules and are not intended to be applied to the betterment or new or different use rules.

In general, these new proposed regulations contain the rules set forth in the 2006 proposed regulations with respect to the capitalization of amounts paid to adapt property to a new or different use. However, these new proposed regulations remove the parenthetical contained in the 2006 proposed regulations relating to “structural alterations to the unit of property.” Commentators noted that, although permanent structural alterations may result in adapting property to a new or different use, those alterations also could result in betterments to the unit of property and, in certain circumstances, could constitute routine maintenance. Commentators also noted that adapting property to a new or different use does not necessarily make the property better or increase its value, but nevertheless is a capital expenditure. Therefore, the new or different use rules are provided separately from the betterment rules in these new proposed regulations.

These new proposed regulations also clarify that amounts paid w