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LB&I Directive for Determining When "Substantially All" of a Major Component (as Defined in Revenue Procedure 2013-24) has been Replaced under I.R.C. Section 263(a)

July 06, 2015

LB&I Control No. LB&I-04-0315-002
Impacted IRM 4.51.2

MEMORANDUM FOR ALL LARGE BUSINESS AND INTERNATIONAL DIVISION EMPLOYEES
FROM: Heather C. Maloy /s/ Heather C. Maloy
Commissioner, Large Business & International Division
SUBJECT: Large Business & International Directive for Determining When “Substantially All” of a Major Component (as Defined in Revenue Procedure 2013-24) has been Replaced under I.R.C. Section 263(a)

 

Introduction

This memorandum provides direction to the field in the examination of a taxpayer that has properly changed to the method of accounting provided in Rev. Proc. 2013-24, 2013-22 I.R.B. 1142, for steam or electric generation property. The revenue procedure provides definitions of units of property and major components that taxpayers may use to determine whether expenditures to maintain, replace, or improve steam or electric power generation property must be capitalized under I.R.C. § 263(a).

This directive provides instructions to the field on determining whether a major component pertaining to steam or electric generation property is replaced under Treas. Reg. § 1.263(a)-3(k). Specifically, this directive provides that a major component Is replaced if "substantially all" of the major component is replaced.

Background

Taxpayers that generate steam or electric power incur significant expenditures to maintain, replace, and improve generation property.  Whether these expenditures are deductible as repairs under I.R.C. § 162 or must be capitalized as improvements under I.R.C. § 263(a) depends on whether the expenditures improve a unit of property.  The regulations under I.R.C. § 263(a) generally require taxpayers to capitalize as improvements expenditures that constitute a betterment to a unit of property, restore a unit of property, or adapt a unit of property to a new or different use.  In general, under I.R.C. § 263(a) the cost of replacing a unit of property or major component must be capitalized. Treas. Reg. § 1.263(a)-2; Treas. Reg. §.1.263(a)-3(d).

A generation plant is composed of numerous functionally interdependent items of machinery and equipment, and it can be difficult to identify which items constitute discrete units of property, major components, or something else. As a consequence, taxpayers and the Internal Revenue Service often disagree about whether the cost to replace a particular item is a capital or deductible expense.

Rev. Proc. 2013-24 provides definitions of units of property and major components for steam or electric generation property that, if used in accordance with the requirements set forth in Rev. Proc. 2013-24, will not be challenged by the IRS under § 263(a) and the regulations thereunder.  This directive sets forth instructions to the field related to examination activity of taxpayers that have changed their method of accounting to use the unit of property and major component definitions provided in Rev. Proc. 2013-24.  

Specifically, this directive provides direction to the field in examinations when "substantially all" of a major component has been replaced for purposes of determining whether the expenditure is 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. See Treas. Reg. §1.263(a)-3(k)(1)(vi). Similar direction is provided where a unit of property that has no structural components has been replaced. This directive only applies to major components, or units of property that have no major components, specifically identified in Rev. Proc. 2013-24.

Planning and Examination Guidance - Tax Years Ending On or After December 31, 2012

When examining returns of utility companies that generate steam or electric power for taxable years ending on or after December 31, 2012, examiners should not challenge the following "substantially all" determination for taxpayers adopting the method of accounting set forth in Rev. Proc. 2013-24.

  • Agents should not challenge a taxpayer's treatment of its expenditures when substantially all of a major component (or of a unit of property that has no major components) has been replaced and properly capitalized.  For this purpose, the term "substantially all" means 80 percent or more.
  • Agents generally should not challenge a taxpayer's treatment of its expenditures to replace a major component (or unit of property that has no major components) as not required to be capitalized if "less than substantially all" of the major component (or unit or property that has no major components) has been replaced. For this purpose, the term "less than substantially all" means less than 80 percent. If Agents believe that such expenditures should be capitalized as an improvement (e.g., a betterment, an adaptation to a new and different use, etc.), Agents may challenge the taxpayer's treatment of the expenditures but only after consultation and concurrence by their assigned Counsel, and their Director of Field Operations.
  • Agents should not challenge the use of either of the following measurement methodologies to substantiate that less than substantially all of a major component (or a unit of property that has no major components) has been replaced---
    • Comparing the actual replacement cost recorded on the taxpayer's financial statements to the undepreciated financial statement cost of the major component (or the unit of property has no major components), or
    • Comparing the actual replacement cost recorded on the taxpayer's financial statements to the estimated replacement cost of the entire major component (or the entire unit of property that has no major components).
  • Agents should not treat as a method of accounting a measurement methodology used by a taxpayer to substantiate that less that substantially all of a major component has been replaced. Therefore, a change in measurement methodology should not be challenged as an unauthorized change in method of accounting.
  • This directive only clarifies when a major component (or a unit of property that has no major components) is replaced. The ultimate determination of whether an expenditure involving the replacement of "less than substantially all" of a major component (or a unit of property that has no major components) is deductible is based on application of the regulations. As noted above, however, challenges to the deduction of an expenditure involving replacement of less than substantially all of a major component (or a unit of property that has no major components) must be coordinated with Counsel and approved by the Agent's Director of Field Operations.

If you have any questions, please contact the IPG for Deductible and Capital Expenditures.

This Directive is not an official pronouncement of law and cannot be used, cited, or relied upon as such. In addition, nothing in this Directive should be construed as affecting the operation of any other provision of the Internal Revenue Code, Treasury Regulations, or guidance thereunder.

cc:  Division Counsel, LB&I
      Chief, Appeals

Page Last Reviewed or Updated: 07-Jul-2016