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LB&I Directive on the Examination of Taxpayers Using the Safe Harbor Methods of Accounting for Cable Network Assets

April 16, 2015

LB&I Control No: LB&I-04-0415-003
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: LB&I Directive on the Examination of Taxpayers Using the Safe Harbor Methods of Accounting for Cable Network Assets

This memorandum provides direction to the field in the examination of taxpayers using the safe harbor methods of accounting for cable network assets described in Rev. Proc. 2015-12, 2015-2 I.R.B. 266 (Rev. Proc. 2015-12).  Rev. Proc. 2015-12 provides safe harbor approaches to determine:

1. Whether expenditures to maintain, replace, or improve cable network assets may be deducted or must be capitalized;

2. Whether the costs of customer drops and customer premise equipment (CPE) may be deducted or must be capitalized;

3. Treatment of the asset and placed in service date of a node and fiber optic cable for depreciation purposes; and

4. Whether for depreciation purposes cable distribution network assets are primarily used for providing one-way or two-way communication services.

I.  Methods for Deductible or Capital Expenditures for Network Assets and Customer Drops

Background

Cable system operators and their affiliates that provide video, high-speed internet, and voice-over-internet-protocol (VOIP) telephone services incur significant expenditures to maintain, replace, and improve network property.  Whether these costs may be deducted as repairs under I.R.C. section 162 or must be capitalized as improvements under section 263(a) depends on whether the costs are for a betterment to the unit of property, restore the unit of property, or adapt the unit of property to a new or different use.  See Treas. Reg. §§ 1.162-4 and 1.263(a)-3(d).  Cable network assets include property consisting of operating plant and equipment that receive signals and convey signals between the headend and customer premises, including signal-receiving equipment, encoding and decoding devices, cables, connectors, switches, amplifiers, and distribution equipment at or near customer locations.  Capitalization principles can be particularly difficult to apply to cable network assets because determining the units of property that comprise the network assets is difficult.  As a result, taxpayers and the Internal Revenue Service (“Service”) have often disagreed whether the replacement of a particular item is an improvement that must be capitalized.  

To resolve this issue in a manner that conserves the resources of both the Service and taxpayers, the Treasury Department and the Service issued Rev. Proc. 2015-12.  Revenue Procedure 2015-12 provides two alternative safe harbor approaches to determine whether expenditures to maintain, replace, or improve cable network assets may be deducted as repairs under section 162 or must be capitalized as improvements under section 263(a) or as property produced by the taxpayer under section 263A: (1) a “network asset maintenance allowance” method and (2) a “units of property” method.  

Revenue Procedure 2015-12 also provides two alternative methods for determining whether the costs of customer drops may be deducted as repairs under section 162 or must be capitalized as improvements under section 263(a) or as property produced by the taxpayer under section 263A: (1) a “specific identification” method, and (2) a safe harbor allocation method.   

Revenue Procedure 2015-12 is effective for taxable years ending after December 31, 2013.  The eligibility rules in section 5.01(1)(d) and (f) of Rev. Proc. 2015-13, 2015-5 I.R.B. 419, do not apply to a cable system operator that changes to a method of accounting provided in section 5, section 6, or section 7 of Rev. Proc. 2015-12 for its first or second taxable year ending after December 31, 2013.

The use of the safe harbor methods of accounting under section 263(a) provided by Rev. Proc. 2015-12 are only permitted under the terms and conditions contained therein and should not be considered for purposes of resolving capitalization issues in prior open exam years.  This directive provides instruction for addressing open exam years.

Application

This directive applies to the examination activity of positions taken on original returns relating to the following issues (hereinafter “Issues”).1   

1. Whether costs incurred to maintain, replace, or improve cable network assets may be deducted under section 162 or must be capitalized under section 263(a) or section 263A, see designated change number 2082;  

2. Whether costs incurred for customer drops and CPE installations may be deducted under section 162 or must be capitalized under section 263(a) or section 263A, see designated change number 2093;  and

3. Any correlative issues involving the disposition of structural components of a building or dispositions of cable network assets (other than a building or its structural components), see designated change numbers 205 and 206, respectively4.

Examination of Tax Years Ending Before January 1, 2014

1. You should discontinue current exam activity with regard to the Issues;

2. You should not begin any new exam activity with regard to the Issues;  

3. You should take the following steps to discontinue the exam activity with regard to the Issues:

a) Withdraw Forms 4564, Information Document Request, or portions thereof, relating to the development of these Issues.

b) Withdraw all currently issued Forms 5701, Notice of Proposed Adjustment, which propose an adjustment to these Issues.

c) Develop and issue a new Form 5701 with a Form 886-A, Explanation of Adjustments, containing the following language:

The Service neither accepts nor rejects the position taken in the tax return related to the method to determine the proper treatment of amounts incurred to repair tangible property. [Insert taxpayer name] will be allowed a two-year period to adopt the appropriate method of accounting provided in Rev. Proc. 2015-12.  If an appropriate method is adopted, a change in method of accounting can be made in accordance with section 5, 6, or 7 of the applicable Rev. Proc. for all property (designated change numbers 208 and 209).  If [Insert taxpayer name] has not changed its accounting method consistent with Rev. Proc. 2015-12 in its first or second taxable year ending after December 31, 2013, then the repair expense will be subject to risk assessment and possible examination for tax years ending on or after December 31, 2015.

d) After the taxpayer has signed the Form 5701 with the Form 886A, Explanation of Adjustments, upload the documents into the Information Management System (IMS) to substantiate for the subsequent examination team that the taxpayer was notified that the Service has discontinued examination of the Issues.  Input into IMS as follows: UIL 263.14-01; and Issue Tracking Attribute Code 1400.

e) Retain copies of pertinent workpapers in the IMS file or other central location permitted by IRM 4.46.7.2.3(3)(c) and (d).  

f) Complete the Form 5346, Examination Information Report, in accordance with the specific instructions provided for this issue located on the Deductible and Capital Expenditures Issue Practice Group (DCE IPG) website.

Examination of Tax Years Ending After December 31, 2013

When examining returns of cable companies for taxable years ending after December 31, 2013, examiners should determine if the taxpayer filed a Form 3115, Application for Change in Accounting Method, to change to any of the methods provided in sections 5 (Network Asset Maintenance Allowance Method for Cable Network Assets); 6 (Units of Property for Cable Network Assets); or 7 (Customer Drop and CPE Installation Costs) of Rev. Proc. 2015-12.

1. If the taxpayer changes to any of the methods provided in sections 5, 6, or 7, then the examiner should determine if the change is consistent with Rev. Proc. 2015-12 (including whether the section 481(a) adjustment was accurately computed).  If the change is not consistent, then a determination needs to be made whether the taxpayer correctly changed to the method, and the examiner, if needed, may consult with the Deductible and Capital Expenditure IPG for further assistance.

2. Section 481(a) adjustment

a. A change in method of accounting under Rev. Proc. 2015-12 requires a § 481(a) adjustment.  It does not include any amount for any taxable year attributable to property for which the taxpayer elected to apply the repair allowance.

b. If, prior to the issuance of Rev. Proc. 2015-12, the taxpayer filed a Form 3115 to change the treatment of expenditures for cable property, then the section 481(a) adjustment resulting from a change under Rev. Proc. 2015-12 (“new section 481(a) adjustment”) should account for any previous section 481(a) adjustment (“old section 481(a) adjustment”).

c. The new section 481(a) adjustment must properly account for cable property repair expenses that were computed under the taxpayer’s prior method and deducted under section 162 in the interim years between the old and new section 481(a) adjustments.

3. If the taxpayer does not change to either safe harbor method provided in sections 5 or 6 or one of the safe harbors in section 7 of Rev. Proc. 2015-12 for the first taxable year ending after December 31, 2013, then the examiner should not commence any examination activity with respect to the Issues since the taxpayer could still change to the method for the second taxable year ending after December 31, 2013.

4. If the taxpayer does not change to either safe harbor method provided in sections 5 and 6 or one of the safe harbors in section 7 of Rev. Proc. 2015-12 for the first or second taxable year ending after December 31, 2013, then the agent should perform a risk assessment to determine the materiality of the repair deduction claimed with respect to the cable property.  If the result of the risk assessment is deemed to be material, the examiner should examine the deduction under section 263(a) and the Treasury Regulations thereunder5.  

II.  Prior Guidance Clarified and Expanded

Two other areas covered in Rev. Proc. 2015-12 involve treatment of the asset and placed in service date of a node and fiber optic cable for depreciation purposes and whether cable distribution network assets are primarily used for providing one-way or two-way communication services for depreciation purposes.  Both of these areas were previously discussed in Rev. Proc. 2003-63, 2003-2 C.B. 304, and are either clarified or expanded upon in Rev. Proc. 2015-12.  Revenue Procedure 2003-63 was superseded by Rev. Proc. 2015-12.  

Examination of Tax Years Ending Before January 1, 2014

For taxable years ending on or before December 31, 2013, the examiner should make sure the taxpayer followed the guidance described in Rev. Proc. 2003-63.  See Rev. Proc. 2015-14 section 6.08(1).

Examination of Tax Years Ending After December 31, 2013

Section 8 of Rev. Proc. 2015-12 provides the same safe harbor method provided in Rev. Proc. 2003-63 under which a fiber optic transfer node and trunk line consisting of fiber optic cable used in a cable distribution system are treated as the asset for depreciation purposes.  Section 8, however, clarified the definitions in that section and they apply only for purposes of §§ 167 and 168.

For tax years ending after December 31, 2013, as under sections 5, 6, and 7, the taxpayer under section 8 can change to the safe harbor in the first or second taxable year ending after December 31, 2013.  The examiner should make sure the taxpayer followed the correct methods to change under Rev. Proc. 2015-12 and Rev. Proc. 2015-14 section 6.42.

Section 9 of Rev. Proc. 2015-12 - Primary Use Determination

In determining whether a tested asset is primarily used for providing one-way or two-way communication services to subscribers, a cable system operator must determine primary use by using any reasonable manner that is consistently applied to the tested asset.  Revenue Procedure 2003-63, first addressed methods in determining primary use.  Section 9 of Rev. Proc. 2015-12 further clarifies that determining primary use solely by bandwidth is not reasonable and provides that a reasonable manner includes, but is not limited to, determining primary use by gross receipts or by subscriber count for each service within the applicable cable system.  In addition, section 9 provides a safe harbor manner for determining whether a tested asset is primarily used for providing one-way (7-year property) or two-way (15-year) communication services to subscribers.  The safe harbor manner for making the determination, if properly applied, will not be challenged by the Service.  A taxpayer may use different reasonable manners to determine primary use from taxable year to taxable year.

Under section 9 of Rev. Proc. 2015-12, if there is a change in the classification of the asset, taxpayers are to follow the change in use guidelines under Treasury Regulation section 1.168(i)-4.  Examiners will determine if the safe harbor was applied properly and, if applicable, whether the application of the regulations for change in use was done correctly.  

Contacts

For further guidance regarding this directive, please contact the Deductible and Capital Expenditures Issue Practice Group or the Methods of Accounting & Timing Issue Practice Group.  

This Directive is not an official pronouncement of law and cannot be used, cited, or relied upon as such.

cc:  Division Counsel, LB&I
      Chief, Appeals

 

Footnotes:

[1]  For guidance on claims or amended returns you should consult with the Deductible and Capital Expenditures Issue Practice Group.  

[2]  Rev. Proc. 2015-14, list of automatic changes, section 3.21.

[3]  Rev. Proc. 2015-14, list of automatic changes, section 3.21.

[4]  Rev. Proc. 2015-14, list of automatic changes, sections 6.38 and 6.39.

[5]  Likewise, if a taxpayer files a Form 3115, not to change to one of the mentioned safe harbors but to a different method, the agent should perform a risk assessment and examine the issue as needed.