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FAQs Rev Proc 2015 56

Safe Harbor Method for Amount to Refresh Qualified Retail and Restaurant Buildings

Rev. Proc. 2015-56, 2015-49 I.R.B. 827, provides certain taxpayers engaged in the trade or business of operating a retail establishment or a restaurant with a safe harbor method of accounting for determining whether expenditures paid or incurred in a remodel or refresh of its retail or restaurant building are deductible under § 162(a) of the Internal Revenue Code, must be capitalized as improvements under § 263(a), or must be capitalized as the costs of property produced by the taxpayer for use in its trade or business under § 263A (“the remodel-refresh safe harbor”).  The procedure requires qualifying taxpayers to assess whether their costs are incurred for a qualified remodel or refresh project on a qualified building.  To the extent that they are, then the revenue procedure provides a safe harbor method for deducting a fixed percentage of its qualified costs as repair and maintenance costs under § 162 and for treating the remaining percentage of its qualified costs as capital expenditures under §§ 263(a) and 263A.

These FAQs are intended to provide assistance to taxpayers on the implementation of the remodel-refresh safe harbor and to provide direction to the Internal Revenue Service (IRS) agents in the examination of taxpayers changing to and using the safe harbor methodology.

Changing a Method of Accounting to Use the Remodel-Refresh Safe Harbor

Q1:  How should a qualified taxpayer (as defined in section 4.01 of Rev. Proc. 2015-56) change its method of accounting to use the remodel-refresh safe harbor under Rev. Proc. 2015-56 for its 2015 taxable year1 for amounts paid to remodel or refresh a qualified building (as defined in section 4.02 of Rev. Proc. 2015-56) if the taxpayer previously filed a change under DCN #1842  for all of its tangible property for its 2014 taxable year?
A1: If a qualified taxpayer filed an automatic change under DCN #184 for its first taxable year beginning on or after January 1, 2014, (“2014 taxable year”) to change all its tangible property costs to deducting repairs and maintenance and to capitalizing improvements under the final tangible property regulations, and this taxpayer wants to change its method of accounting for tangible property costs to utilize the remodel-refresh safe harbor for qualified costs (as defined in section 4.07 of Rev. Proc. 2015-56), then the taxpayer must change its method of accounting for its 2015 taxable year by following the procedures in Rev. Proc. 2015-13, 2015-5 I.R.B. 419, as clarified and modified by Rev. Proc. 2015-33, 2015-24 I.R.B. 1067, and as modified by Rev. Proc. 2016-1, 2016-1 I.R.B. 1.  In addition, the taxpayer must comply with the specific automatic change requirements for the remodel-refresh safe harbor under Rev. Proc. 2015-14, 2015-5 I.R.B. 450, as modified by Rev. Proc. 2015-56, or with the specific requirements of Rev. Proc. 2016-29, 2016-21 I.R.B. 880, which updates and supersedes Rev. Proc. 2015-14 for current automatic changes.  Whether the taxpayer must follow the provisions of Rev. Proc. 2015-14 or Rev. Proc. 2016-29 depends on its taxable year end and the date on which the taxpayer files its Form 3115.

Rev. Proc. 2015-13 and Rev. Proc. 2015-14 -- Automatic Changes filed before May 5, 2016, for a year of change ending before September 30, 2015:

Rev. Proc. 2015-56, which is effective for taxable years beginning on or after January 1, 2014, provides the rules for qualifying, using, and changing to the remodel-refresh safe harbor.  Rev. Proc. 2015-56 added new sections 10.13 and 6.43 to Rev. Proc. 2015-14  to provide procedures for making automatic changes under the remodel-refresh safe harbor for taxpayers that filed these changes within the effective periods and taxable years of Rev. Proc. 2015-14.  Rev. Proc. 2015-14 was effective for Forms 3115 filed on or after January 16, 2015, through May 4, 2016, for a year of change ending on or after May 31, 2014, and before September 30, 20153.    For this period, section 10.13 of Rev. Proc. 2015-14 applied to a qualified taxpayer that wanted to change to the remodel-refresh safe harbor method for its qualified costs, including the making of a late general asset account (GAA) election, as provided under Rev. Proc. 2015-56.  Section 6.43 of Rev. Proc. 2015-14 provided the mechanism whereby a qualified taxpayer could use the automatic change procedures to revoke prior partial disposition elections made under § 1.168(i)-8(d)(2) or Prop. Reg. § 168(i)-8(d)(2) for existing qualified buildings for which the taxpayer uses the remodel-refresh safe harbor, as required under section 5.02(4) of Rev Proc. 2015-564.     

Sections 10.13 and 6.43 of Rev. Proc. 2015-14 also provided transition rules to permit a taxpayer to make automatic changes under the remodel-refresh safe harbor even if they previously filed automatic changes for the same tangible property under the final tangible property regulations, including changes under DCN #184.  Specifically, these sections waived certain eligibility requirements for making automatic changes under Rev. Proc. 2015-13.  In general, under section 5.01 of Rev. Proc. 2015-13, a taxpayer is not eligible to make an automatic change if the taxpayer has requested a change for the same item during any of the five taxable years ending with the year of change (“the 5-year rule”). Sections 6.43(3)(a) and 10.13(3)(a) of Rev. Proc. 2015-14 waived this prohibition for a taxpayer that wants to change its method to the remodel-refresh safe harbor provided that the taxpayer files this change for the taxpayer’s first or second taxable year beginning after December 31, 2013.  Therefore, even if the taxpayer filed method changes under DCN #184 for the same items for its 2014 taxable year, a qualifying taxpayer would have been permitted to use the automatic change procedures under Rev. Proc. 2015-13 and Rev. Proc. 2015-14 to change the treatment of qualifying costs to utilize the remodel-refresh safe harbor or, if necessary, to revoke certain partial disposition elections for its 2015 taxable year, provided this was filed no later than its second taxable year beginning after December 31, 2013.  

Rev. Proc. 2015-13 and Rev. Proc. 2016-29 -- Automatic Changes filed on or after May 5, 2016, for a year of change ending on or after September 30, 2015:

If the taxpayer’s second taxable year beginning after December 31, 2013, ends on or after September 30, 2015, and the taxpayer filed a Form 3115 to make this change on or after May 5, 2016, then this taxpayer would file its automatic change under Rev. Proc. 2015-13 and utilize the specific procedures for automatic changes to utilize the remodel-refresh safe harbor under Rev. Proc. 2016-29.  Rev. Proc. 2016-29 updates and supersedes Rev. Proc. 2015-14 for taxpayers filing automatic changes on or after May 5, 2016, for taxable years ending on or after September 30, 2015.  For taxpayers filing under Rev. Proc. 2016-29, sections 11.10 and 6.20 of Rev. Proc. 2016-29 provide the rules (in addition to the automatic change procedures in Rev. Proc. 2015-13) for making automatic changes to use the remodel-refresh safe harbor and to revoke certain partial disposition elections related to qualified buildings.  Section 11.10 of Rev. Proc. 2016-29 applies to a qualified taxpayer that changes to the remodel-refresh safe harbor, including making a late GAA election, as provided under Rev. Proc. 2015-56.  Section 6.20 permits a qualified taxpayer to revoke certain prior year’s partial disposition elections relating to qualified buildings for which the taxpayer utilizes the remodel-refresh safe harbor.  

For a taxpayer changing to the remodel-refresh safe harbor and wanting to revoke certain prior years’ partial disposition elections as part of this change, sections 11.10 and 6.20 of Rev. Proc. 2016-29 continue to waive certain eligibility requirements for making automatic changes under Rev. Proc. 2015-13.  However, Rev. Proc. 2016-29 revises the period during which these eligibility waivers apply.  While Rev. Proc. 2015-14 waived the 5-year rule for remodel-refresh safe harbor changes for the taxpayer’s first or second taxable year beginning after December 31, 2013, sections 11.10 and 6.20 of Rev. Proc. 2016-29 broaden this period to include any taxable year beginning after December 31, 2013, and ending before December 31, 2016.  The purpose of this revision is to provide relief to a taxpayer that had one or more short taxable years beginning after December 31, 2013, and as a result, had a more limited time to use the eligibility waivers provided in Rev. Proc. 2015-14.  This modification allows this taxpayer to make an automatic change to the remodel-refresh safe harbor, and to revoke prior year’s partial disposition elections, within the same timeframe as a taxpayer with two 12-month calendar taxable years.  Thus, a taxpayer that wants to make an automatic change for its qualified buildings and qualified costs under Rev. Proc. 2015-56 and Rev. Proc. 2016-29, and that previously filed a method change for the same items for a taxable year beginning on or after January 1, 2014, would be permitted to use the automatic change procedures of Rev. Proc. 2015-13 to change to the remodel-refresh safe harbor or, if necessary, to revoke certain partial disposition elections for any taxable year ending before December 31, 2016.  

Q2:  How should a qualified taxpayer change its method of accounting to use the remodel-refresh safe harbor for its 2015 taxable year for amounts paid to remodel or refresh a qualified building under Rev. Proc. 2015-56 if the taxpayer filed a change under DCN #184 for all its tangible property except its qualified building property for its 2014 taxable year?
A2:
 If a qualified taxpayer under the remodel-refresh safe harbor filed an automatic change under DCN #184 for its 2014 taxable year to change all property except qualified buildings, then the taxpayer should file an automatic change for its qualified buildings for any taxable year beginning on or after January 1, 2015, pursuant to the provisions of Rev. Proc. 2015-13 and Rev. Proc. 2015-14, as modified by Rev. Proc. 2015-56, or under Rev. Proc. 2016-29, as discussed in A1 above.  

A qualified taxpayer that did not make a change for its qualified buildings for its 2014 taxable year is not eligible for an extension of time to file an accounting method change for the 2014 taxable year under § 301.9100-3 of the Procedure and Administration Regulations, except in unusual and compelling circumstances.  See section 6.03(4)(b) of Rev. Proc. 2015-13 and § 301.9100-3(c)(2). Instead, the qualified taxpayer would be able to make the changes under sections 11.10 and 6.20 of Rev. Proc. 2016-29 for its 2015 taxable year in accordance with the same procedures discussed in A1.  

Because the taxpayer did not make any changes to apply the tangible property regulations to its qualified buildings for the 2014 taxable year, the taxpayer may have audit exposure on the treatment of its qualified buildings until the taxpayer files its automatic changes for such property to utilize the remodel-refresh safe harbor and to revoke the appropriate partial disposition elections.

Q3:  How should a qualified taxpayer change its method of accounting to use the remodel-refresh safe harbor for its 2015 taxable year if the taxpayer timely filed its original federal tax return for 2015 with a Form 3115 (and filed its duplicate copy of the Form 3115) making a change under DCN #184 for all of its tangible property (including qualified building property), but filed prior to the issuance of Rev. Proc. 2015-56 and,  accordingly, did not implement Rev. Proc. 2015-56 for its qualified buildings for its 2015 taxable year?
A3:  If a qualified taxpayer under the remodel-refresh safe harbor filed a Form 3115 to make an automatic change under DCN #184 (filed both the duplicate copy of the Form 3115 and the original Form 3115 with its timely filed federal tax return) for its qualified buildings or for all tangible property, including its qualified buildings, for its taxable year beginning on or after January 1, 2015, but did not implement Rev. Proc. 2015-56 for its qualified buildings, the taxpayer has two options to properly implement the change to its qualified buildings under the remodel-refresh safe harbor, dependent on when the taxpayer files its Form 3115 for such changes.

First, if the taxpayer has timely filed its federal income tax return for the 2015 taxable year, the taxpayer may file within 6 months from the due date (excluding any extensions) of its federal income tax return for its year of change (in this case, its 2015 taxable year) an amended return with a Form 3115 under the automatic change procedures in Rev. Proc. 2015-13 to change to use the remodel-refresh safe harbor or, if necessary, to revoke its partial disposition elections for qualified buildings, for its 2015 year of change.  Under section 6.03(4)(a) of Rev. Proc. 2015-13, a taxpayer is granted an automatic extension of 6 months from the due date (excluding any extensions) of the federal income tax return for the year of change to file a Form 3115 provided the taxpayer complies with the requirements of that provision.  Under these circumstances, a taxpayer that timely filed its original federal tax return for its 2015 taxable year with a Form 3115 making a DCN #184 change may file an amended return with two new Forms 3115 to change its accounting methods for tangible property.  This taxpayer should file one Form 3115 (duplicate and original) to change to utilize the tangible property regulations (DCN #184) for amounts not eligible for the remodel-refresh safe harbor, and another Form 3115 (duplicate and original) to change its method of accounting for amounts eligible for the remodel-refresh safe harbor, including making its late GAA elections (DCN #222) if applicable, and revoking partial disposition elections for qualified buildings (DCN #221) if applicable.

If the taxpayer’s time to file under section 6.03(4)(a) of Rev. Proc. 2015-13 has expired, then the taxpayer generally cannot make this change for its 2015 taxable year.  See section 6.03(4)(b) of Rev. Proc. 2015-13.  Instead, the taxpayer may timely file a Form 3115 to change to the remodel-refresh safe harbor under DCN #222 for its 2016 taxable year.  If the taxpayer has not yet filed a Form 3115 to change to the tangible property regulations (DCN #184) for amounts not eligible for the remodel-refresh safe harbor, the taxpayer may also file a Form 3115 to do so for its 2016 taxable year.  For both these changes , the taxpayer must meet the eligibility requirements under section 5.01(1) of Rev. Proc. 2015-13 to use the automatic change provisions because The eligibility rules waiver in section 11.08 of Rev. Proc. 2016-29 (DCN #184) does not apply to taxable years beginning on or after January 1, 2016, and the eligibility rules waiver  section 11.10 of Rev. Proc. 2016-29 (DCN #222) does not apply to taxable years ending on or after December 31, 2016.  However, the taxpayer may file these changes using the non-automatic change procedures of Rev. Proc. 2015-13.

In addition, the taxpayer is not permitted to file a Form 3115 for taxable years ending after December 30, 2016, to revoke a partial disposition election for qualified buildings.  The change under section 6.20 of Rev. Proc. 2016-29 to revoke these partial disposition elections can only be made for any taxable year beginning after December 31 2013, and ending before December 31, 2016.  See Rev. Proc. 2016-29, section 6.20(3).  If the taxpayer cannot revoke its partial disposition election for a qualified building within the time or manner provided in section 5.02(4)(b)(ii) of Rev. Proc. 2015-56, then the change in method of accounting to utilize the remodel-refresh safe harbor (DCN #222) must be made on a cut-off basis, beginning in the year of change, for the qualified buildings to which the unrevoked partial disposition election pertains.  See section 5.04(4)(c) of Rev. Proc. 2015-56.

Q4: How should a qualified taxpayer change its method of accounting to use the remodel-refresh safe harbor for its 2015 taxable year if the taxpayer filed its duplicate copy of the Form 3115 making a change under DCN #184 for all of its tangible property (including qualified building property) for the 2015 taxable year prior to the issuance of Rev. Proc. 2015-56, but has not yet filed its federal tax return and original Form 3115 for its 2015 taxable year?
A4:  If a qualified taxpayer under the remodel-refresh safe harbor has not yet filed its original federal tax return and original Form 3115 for its 2015 taxable year, but has filed the duplicate copy of a Form 3115 to make an automatic change under DCN #184 for its tangible property (including its qualified buildings) for its taxable year beginning on or after January 1, 2015, without implementing Rev. Proc. 2015-56 for its qualified buildings, the taxpayer should file two new original Forms 3115 with the correct information with its timely filed federal tax return for the 2015 taxable year.  This taxpayer should file one Form 3115 to change to utilize the tangible property regulations (DCN #184) for amounts not eligible for the remodel-refresh safe harbor, and another Form 3115 to change its method of accounting for amounts eligible for the remodel-refresh safe harbor method, including making its late GAA elections (DCN #222) if applicable, and revoking partial disposition elections for qualified buildings if applicable (DCN #221).  The taxpayer should also file two new duplicate copies of the Forms 3115.   As discussed in A3, under section 6.03(4)(a) of Rev. Proc. 2015-13, a taxpayer is granted an automatic extension of 6 months from the due date (excluding any extensions) of the federal income tax return for the year of change to file a Form 3115 provided the taxpayer complies with the requirements of that provision.  If the taxpayer’s automatic extension under section 6.03(4)(a) of Rev. Proc. 2015-13 has expired, then the taxpayer generally cannot make this change for its 2015 taxable year.

Q5:  Rev. Proc. 2015-56 provides special transition rules that apply for the taxpayer’s first two taxable years beginning after December 31, 2013.  However, a number of retail or restaurant taxpayers had two short taxable years beginning in 2014 and thus are not eligible to use the transition rules for a change to the remodel-refresh safe harbor (DCN #222) or, if necessary, to revoke partial disposition elections for qualified buildings (DCN #221), for the 2015 taxable year.  Will the IRS extend/clarify the transition rules so that such taxpayers may file an automatic method change?
A5:
 Yes.  As discussed above in A1 for changes under Rev. Proc. 2016-29, Rev. Proc. 2016-29 provided relief to these taxpayers by revising certain eligibility rule waivers for making automatic changes to utilize the remodel-refresh safe harbor and for revoking certain partial disposition elections.  Specifically, section 11.10 of Rev. Proc. 2016-29, relating to the remodel-refresh safe harbor under Rev. Proc. 2015-56, and section 6.20 of Rev. Proc. 2016-29, relating to the revocation of certain partial disposition elections for qualified buildings, waive the prohibition on automatic changes for a taxpayer that filed a change for the same item during any of the five taxable years ending with the year of change, or for the final year of the taxpayer’s trade or business, for any taxable year beginning after December 31, 2013, and ending before December 31, 2016.

Qualifying for the Remodel-Refresh Safe Harbor

Rev. Proc. 2015-56 provides certain criteria for taxpayers that want to apply the remodel-refresh safe harbor method for deducting or capitalizing expenditures paid or incurred in a remodel or refresh of a restaurant or retail building.  

In order to use the remodel-refresh safe-harbor, the taxpayer must:

(1) Be a qualified taxpayer (section 4.01);
(2) Pay or incur expenses on a qualified building (section 4.02);
(3) Pay or incur expenses as part of a qualified remodel-refresh project (section 4.03);
(4) Pay or incur remodel-refresh costs (sections 4.04 - 4.05); and
(5) Subtract excluded remodel-refresh costs (section 4.06) from remodel-refresh costs to ascertain qualified costs (section 4.07).  

To use the remodel-refresh safe harbor, a taxpayer must meet each of these criteria and then apply the rules for changing to and applying the methodology to its qualified costs. See section 5 of Rev. Proc. 2015-56; sections 10.13 and 6.43 of Rev. Proc. 2015-14 or sections 11.10 and 6.20 of Rev. Proc. 2016-29.  

Qualified Taxpayer:

For retail taxpayers, a qualified taxpayer is a taxpayer that has an applicable financial statement and is in the trade or business of selling merchandise to customers at retail, for which the taxpayer “reports or conducts” activities within  NAICS codes 44 or 45 (i.e., retail trades).  However, even if a taxpayer reports or conducts within those retail codes, the taxpayer does not qualify if it “primarily” reports or conducts activities with certain excepted NAICS codes.  These exclusions are for taxpayers that primarily report or conduct activities as: (1) automotive dealers, (2) other motor vehicle dealers, (3) gas stations, (4) manufactured home dealers, and (5) nonstore retailers.  See section 4.01(1)(a)-(e) of Rev. Proc. 2015-56.  

For restaurant taxpayers, a qualified taxpayer is a taxpayer that has an applicable financial statement and is in the business of preparing and selling meals, snacks, or beverages to customer order for immediate on-premises and/or off-premises consumption and for which the taxpayer reports or conducts activities within NAICS code 722 (i.e., food services and drinking places).  However, even if a taxpayer reports or conducts activities within the NAICS code for food service and drinking places, the taxpayer does not qualify to utilize Rev. Proc. 2015-56 if it primarily reports or conducts these activities in certain excepted trades or businesses. These include the trades or businesses of: (1) operating hotels and motels, (2) civic and social organizations, (3) amusement parks, (4) theaters, (5) casinos, (6) county clubs, or (7) other recreation facilities or in special food services addressed in NAICS code 7223. See section 4.01(2)(a) and (b) of Rev. Proc. 2015-56.

A qualified taxpayer also includes a taxpayer that owns or leases a qualified building that is leased or sublet to a taxpayer that meets the requirements for qualified retail or restaurant taxpayers and incurs refresh or remodel costs.  This taxpayer may use the remodel-refresh safe harbor if such taxpayer is not a qualifying taxpayer, but its lessee meets the requirements for qualified taxpayer under section 4.01(1) or 4.01(2) of Rev. Proc. 2015-56.

Qualified Buildings:  

A qualified building means each building unit of property used by a qualified taxpayer primarily for selling merchandise to customers at retail or primarily for preparing and selling food or beverages to customer order for immediate consumption on-premises and/or off-premises consumption.  A qualified building includes a building or a portion of a building leased or sublet by a taxpayer to a qualified taxpayer.  See section 4.02 of Rev. Proc. 2015-56.

Q6:  Does Rev. Proc. 2015-56 apply to a retail or restaurant taxpayer that reports or conducts activities both within the retail and food service NAICS codes (i.e., 44, 45, and 722) but also that reports and conducts activities outside of these NAICS codes?  Does the fact that a taxpayer has multiple business activities and reports within multiple NAICS code preclude a taxpayer from using the safe harbor? How does a taxpayer determine whether its primary activity is in a specifically excluded NAICS code?
A6:  A retailer or restaurant operator may be a qualified taxpayer even if it also conducts or reports activities outside of the retail or restaurant trades or business unless the taxpayer or its lessee primarily conducts activities within one or more of the specified exceptions set out in section 4.01(1) and section 4.01(2) of Rev. Proc. 2015-56. Thus, the NAICS code under which the taxpayer formally reports is not determinative; rather, the primary activity that the taxpayer conducts as defined by each NAICS code determines whether the taxpayer is a qualified taxpayer.  Determining a taxpayer’s primary activity is a facts and circumstances analysis that considers criteria such as the portion of the taxpayer’s revenue generated by its qualified business activities compared to the portion of revenue generated by the taxpayer’s excepted business activities, in addition to other factors.  These include, for example, the portion of the taxpayer’s employees that perform qualified, as opposed to excepted activities, the portion of the taxpayer’s property or properties dedicated to qualified, versus excepted, activities, and similar comparisons.

Q7:  If a taxpayer derives the majority of its revenue from conducting catalog and on-line sales from warehouse distribution centers, but the taxpayer also conducts some retail activities in brick-and-mortar stores, can the taxpayer exclude the warehouses as ineligible, but use the remodel-refresh safe harbor for its brick-and-mortar retail store locations?
A7:   In this situation, the first step is to determine whether the taxpayer is a qualified taxpayer using the analysis discussed in A6.  In this case, the initial question is whether the taxpayer primarily conducts its activities as a nonstore retailer, which is an exception to qualified taxpayers under section 4.01(1)(e) of Rev. Proc. 2015-56.  The fact that the majority of the taxpayer’s revenues derives from its online sales rather than its retail locations is important, but not necessarily determinative of whether the taxpayer is primarily a nonstore retailer. If this and other facts and circumstances support that the taxpayer primarily conducts its activities as a nonstore retailer, then the taxpayer does not qualify to use the remodel-refresh safe harbor for any of its building property, including any brick-and-mortar stores in which the taxpayer conducts retail sales.  

In contrast, consider a taxpayer that operates a chain of brick-and-mortar retail stores, but that also sells its goods through online and catalog sales through its warehouse/distribution centers.  Assuming this taxpayer’s primary activity is the operation of its retail stores, and its online activities are not its primary activities, then the taxpayer would be a qualified taxpayer under section 4.01 of Rev. Proc. 2015-56, and it may apply the remodel-refresh safe harbor to its qualified buildings. For those purposes, the taxpayer’s qualified buildings would only include the brick-and-mortar retail stores.  Accordingly, the taxpayer may use the remodel-refresh safe harbor for  qualified costs incurred for its brick-and-mortar stores, but may not use this method for its separate warehouse buildings regardless of whether used to stock their brick-and-mortar stores or to fulfill its online or catalog sales.  

Q8:  As a follow on to Q7, does the legal structure of the taxpayer’s trade or business dictate eligibility?  Could a taxpayer get different results if its warehouses and stores are all in one legal entity as compared to having the warehouses and stores in separate legal entities?
A8:  Yes, a taxpayer could obtain different results based on the legal structure of the business.  Section 1.446-1(d) provides that a taxpayer engaged in two or more separate and distinct trades or businesses may use a different method of accounting for each trade or business.  However, the definition of “qualified taxpayer” in section 4.01(1) of Rev. Proc. 2015-56 is based on the primary business activity of the taxpayer, rather than the activities of a particular trade or business.

In addition, under section 4.03, a qualified taxpayer also includes a taxpayer that owns or leases a qualified building that is leased, or sublet, to another taxpayer that meets the requirements for a qualified taxpayer.  In situations involving lessors and lessees, an important question is which taxpayer is incurring the remodel-refresh costs and whether that taxpayer would have a depreciable interest in the capital expenditures that would otherwise result, but for the application of the safe harbor5.  See § 1.263(a)-3(f) for the treatment of leasehold improvements by lessees and lessors.  

Thus, if a taxpayer conducts more than one trade or business in one legal entity, then the taxpayer will not be eligible to use the remodel-refresh safe harbor for any costs of any property if the taxpayer’s primary activity is included in the exceptions in section 4.01(1) or (2) of Rev. Proc. 2015-56 unless the taxpayer leases the qualified building to a separate taxpayer that is a qualified taxpayer.  In contrast, if two separate and distinct trades or businesses are organized into two separate legal entities, and neither is disregarded, then each entity would be “the taxpayer” for purposes of determining whether it is a qualified taxpayer.
 
For example, assume the taxpayer is primarily in the business of operating hotels, but the taxpayer also operates a restaurant within its hotel property.  If the hotel and restaurant are owned by the same entity, and the taxpayer is primarily in the hotel business, it would not be a qualified taxpayer because section 4.01(2)(a) of Rev. Proc. 2015-56 excludes taxpayers that are primarily in the trade or business of operating hotels and motels.  In that case, the taxpayer would not be permitted to use the remodel-refresh safe harbor for any of its property, including the restaurant property.   

On the other hand, if the taxpayer leases restaurant property in its hotel to a third party or to a separate entity (including a related entity) that primarily conducts business within the food and drink service NAICS code, and this party does not conduct activities in an excluded NAICS code, then the hotel taxpayer may use the remodel-refresh safe harbor for qualifying remodel-refresh costs that it pays or incurs in the qualified building (in this case, the portion of the building that is a restaurant and subject to the lease).  See sections 4.01(3) and 4.02(3) of Rev. Proc. 2015-56.  If the third party or separate entity pays or incurs the qualifying remodel-refresh costs, rather than the hotel taxpayer, then the third party or separate entity may use the remodel-refresh safe harbor for its qualified building (in this case, the portion of the building that is a restaurant and subject to the lease).  

Q9:  For lessors that own shopping malls, it is very common for the lessor to provide tenant allowances to new lessees of existing space. Those costs are subsequently depreciated by the lessor. Is it correct that under section 4.06(5) of Rev. Proc. 2015-56, the initial build-out costs of a portion of a qualified building for a new lessee are not eligible?
A9:  Yes.  Section 4.06 of Rev. Proc. 2015-56 provides a list of “excluded remodel-refresh” costs that must be subtracted from the taxpayer’s remodel-refresh costs in order to compute the total qualified costs to which the safe harbor ratio applies.  Section 4.06(5) excludes “the initial build-out of leased qualified building or a portion thereof, for a new lessee.”  Thus, a lessor that owns a shopping mall and enters a new lease for space in that shopping mall with a new lessee cannot include in its qualified costs any amounts paid for the initial build-out for that new lessee.  This exclusion would apply to initial build-out costs for any new tenant regardless of whether it is the lessor’s first lease of the space or it is for a new lessee of previously leased space.  

Using the Remodel-Refresh Safe Harbor Method

To utilize the remodel-refresh safe harbor method of accounting, the taxpayer is required to comply with certain rules and restrictions set out in section 5.02 of Rev. Proc. 2015-56.  These rules include, for example, maintaining adequate documentation, applying the appropriate percentage to qualified costs, revoking and not using partial disposition elections on qualifying property, placing certain capitalized costs in GAAs, and appropriately classifying capitalized costs under § 168(e).   

Q10:  Rev. Proc. 2015-56 requires that partial dispositions must be reversed in order to use the remodel-refresh safe harbor, but at the same time, it provides that a cut-off method must be used for any store location for which the taxpayer has not reversed partial dispositions.  May a taxpayer that fails to reverse previously taken partial dispositions still use the remodel-refresh safe harbor?
A10:  Yes.  A qualified taxpayer must apply the safe harbor to all qualified buildings, but if the taxpayer has not revoked a partial disposition election it made under § 1.168(i)-8(d)(2) or Prop. Reg. § 1.168(i)-8(d)(2) for any portion of an original qualified building, or any portion of an improvement or addition to an original qualified building, then its change in method of accounting to use the remodel-refresh safe harbor is made on a cut-off basis for the qualified building to which the unrevoked partial disposition election pertains.  Section 5.02(4)(b) and (c) of Rev. Proc. 2015-56.  This means that the taxpayer cannot apply the remodel-refresh safe harbor to qualified costs related to this building and paid before the year of change.  See also section 6, Example 8, of Rev. Proc. 2015-56.  In contrast, the qualified taxpayer must calculate a full § 481(a) adjustment to change its accounting method for qualified costs related to qualified buildings for which it did not any make partial disposition elections, and for costs related to qualified buildings for which the taxpayer timely revoked the partial disposition elections.  

Q11:  Section 5.02(6) of Rev. Proc. 2015-56 requires that a taxpayer include prior year’s improvements that are MACRS property and that are made to qualified buildings in GAAs.  Does this requirement apply to prior year’s improvements that would have been excluded from qualified costs because they comprise excluded remodel-refresh costs under section 2.06 of Rev. Proc. 2015-56?
A11:  In general, yes. Section 5.02(6) of Rev. Proc. 2015-56 requires a qualified taxpayer to make a GAA election under § 168(i)(4) and § 1.168(i)-1(l) to include in a GAA any asset that is MACRS property and that comprises a qualified building.  Thus, a taxpayer must include in GAAs (i) the capital expenditure portion of the qualified costs, (ii) existing qualified buildings (and their structural components) that are MACRS property, and (iii) prior year’s improvements that are MACRS property made to qualified buildings (even if the qualified building is not MACRS property).

However, section 5.02(6)(b) of Rev. Proc. 2015-56 provides two exceptions to the requirements to include existing qualified buildings and prior year’s improvements in GAAs to implement the remodel-refresh safe harbor.  The first exception is for property subject to section 5.02(4)(c) of Rev. Proc. 2015-56.  This section excludes from the GAA requirements existing qualified buildings and prior years’ improvements that are made to a qualified building and placed in service prior to the first taxable year that the qualified taxpayer uses the remodel-refresh safe harbor if the taxpayer has not revoked a partial disposition election under section 5.02(4)(b)(ii) pertaining to that building or improvement.  The second exception is for property subject to section 5.02(5)(b) of Rev. Proc. 2015-56.  This provision excludes from the GAA requirements existing qualified buildings and prior years’ improvements that are made to a qualified building and placed in service prior to the first taxable year that the qualified taxpayer uses the remodel-refresh safe harbor if the taxpayer did not comply with section 5.02(5)(b) of Rev. Proc. 2015-56 where the taxpayer recognized a gain or loss upon the disposition of a component of a qualified building, a structural component of a qualified building, or a component of such structural component either (i) under § 1.168(i)-1T or § 1.168(i)-8T, as applicable, and that component or structural component is not an improvement or addition as described in § 1.168(i)-1T(e)(2)(viii)(B)(5) or § 1.168(i)-8T(c)(4)(ii)(E), as applicable; or (ii) in a taxable year beginning before January 1, 2012, and that component or structural component is MACRS property.  

Other than the exceptions provided above, Rev. Proc. 2015-56 does not provide an exception to the GAA requirements for existing qualified buildings and prior years’ improvements to existing qualified buildings that relate to excluded remodel-refresh costs as defined in section 4.06 of Rev. Proc. 2015-56.  Thus, if amounts relate to qualified buildings, even prior years’ improvements that would have been excluded remodel-refresh costs, these costs must also be included in GAAs as required under section 5.02(6)(a) of Rev. Proc. 2015-56.  

Q12:  Of the 25 percent capitalized amount (i.e., the capital expenditure portion) of a remodel, should taxpayers split between qualified leasehold improvement property and nonresidential real property using any reasonable method, or does the IRS have a specific approach in mind?
A12:  The IRS has a specific approach in mind.  For purposes of classifying the capital expenditure portion of the taxpayer’s qualified costs under § 168(e) for depreciation purposes, the taxpayer must substantiate the extent to which this portion relates to qualified leasehold improvement property under § 168(e)(3)(E)(iv) (“QLIP”), qualified restaurant property under § 168(e)(3)(E)(v) (“QRP”), or qualified retail improvement property under § 168(e)(3)(E)(ix) (“QRIP”), as applicable.  The taxpayer must provide proof of such determination and may allocate the capitalized portion of qualified costs to such QLIP, QRP, or QRIP, as applicable, in accordance with that determination.  The remaining capital expenditure portion is classified as nonresidential real property under § 168(e)(2)(B).  See section 5.02(3)(b)(ii).   If the taxpayer cannot provide substantiation of the portion of capital expenditure that is QLIP, QRP, or QRIP, as applicable, then all of the capital expenditure portion will be considered nonresidential real property under § 168(e)(2)(B).

Coordination with Other Provisions of the Code and Regulations   

Q13:  Can a taxpayer make the election to capitalize repair and maintenance costs under § 1.263(a)-3(n) and concurrently use Rev. Proc. 2015-56?  Are these two provisions mutually exclusive?
A13:  These two provisions are mutually exclusive in both their substantive requirements and their manners of implementation.  Under § 1.263(a)-3(n) (“the election to capitalize repair and maintenance costs”), a taxpayer may elect to capitalize amounts paid for repairs and maintenance to tangible property if the taxpayer capitalizes those amounts for its books and records.  If elected for a taxable year, the taxpayer must capitalize all its repair and maintenance costs that it capitalizes for book purposes, and treat all of these costs as assets subject to the allowance for depreciation at the time they are placed in service.  Section 1.263(a)-3(n) was intended to simplify tax accounting for a taxpayer that found it more practical to capitalize for tax purposes the same costs that it capitalizes for book purposes, rather than applying the improvement analysis to all expenditures.

In contrast, the safe harbor computation required under Rev. Proc. 2015-56 deviates from a taxpayer’s treatment of its expenditures for its books and records.  Under the remodel-refresh safe harbor, a qualified taxpayer begins its computation with the total cost of its book fixed assets additions placed in service for the taxable year, and then makes certain adjustments, including a reduction for “excluded remodel-refresh costs” as defined in section 4.06 of Rev. Proc. 2015-56.  After determining qualified costs, the taxpayer applies the safe harbor ratio to determine the portion of these costs that may be deducted as repairs and maintenance and the portion of these costs that must be capitalized and depreciated.  Thus, the remodel-refresh safe harbor results in both the deduction and capitalization of certain booked costs, and is not based solely on the taxpayer’s capitalization for financial purposes.    

Accordingly, the two provisions provide inherently inconsistent methods for determining capitalized costs.  Also, a taxpayer’s use of Rev. Proc. 2015-56 with  the election to capitalize repair and maintenance costs under § 1.263(a)-3(n)  counters the intent of § 1.263(a)-3(n), which was to provide a simplified mechanism for a taxpayer to determine the amounts that it should capitalize by simply applying its financial accounting treatment.  Thus, Rev. Proc. 2015-56 and § 1.263(a)-3(n) should not be applied or elected in the same taxable year.  Nevertheless, a taxpayer who has elected § 1.236(a)-3(n) for prior taxable years would not be precluded from using Rev. Proc. 2015-56 in a current taxable year, and thereafter.  Assuming it otherwise qualifies for the remodel-refresh safe harbor, this taxpayer could change its method of accounting to use the safe harbor under Rev. Proc. 2015-56, but only for amounts paid or incurred beginning in taxable years for which the taxpayer has not elected to use § 1.263(a)-3(n).  In that case, the taxpayer would continue to depreciate costs that were capitalized under the election to capitalize repair and maintenance costs in previous years, and would utilize the remodel-refresh safe harbor for qualified costs paid or incurred, beginning in the year of change.  A taxpayer may not utilize the election to capitalize repair and maintenance costs under § 1.263(a)-3(n) in the same taxable year it is using the remodel-refresh safe harbor.

Q14:  How does § 110, governing qualified lessee construction allowances, interact with Rev. Proc. 2015-56?  The definition of qualified taxpayer in section 4.01(3) includes a taxpayer that leases a qualified building that is leased, or sublet, to a qualifying retail or restaurant taxpayer. Thus, a lessor may be able to use the remodel-refresh safe harbor for amounts it incurs for the remodel-refresh of a qualified building.  However, for leases of retail and restaurant properties, lessors often use tenant allowances, including qualified lessee construction allowances under § 110.  Under § 110, the lessor typically is treated as the owner of the property while the lessee must exclude amounts for these construction allowances from its gross income.  The scope requirements of Rev. Proc. 2015-56 expressly exclude qualified lessee construction allowances under § 110.  Does this exclusion apply to the landlord, the tenant, or both?
A14:  Both.  Under § 110, a lessee of retail space may exclude from gross income any amount received in cash from a lessor under a short-term lease of retail space for the purpose of constructing or improving qualified long-term real property for use in the lessee’s trade or business to the extent the amount is expended by the lessee in the taxable year received on the construction or improvement of such property.  Section 110 and the regulations thereunder also require the lessor to treat these amounts as nonresidential real property under § 168(e)(2)(B) that is owned by the lessor for purposes of depreciation and determining gain or loss.  As discussed above, the scope provisions of section 3.02(4) of Rev. Proc. 2015-56 specifically exclude expenditures treated as qualified lessee construction allowances under § 110 and the accompanying regulations.  Thus, neither the lessee nor the lessor may apply Rev. Proc. 2015-56 to the extent that any payments from the lessor to the lessee are treated as qualified leasehold construction allowances pursuant to § 110.

For further information contact Merrill Feldstein of the Office of Associate Chief Counsel (Income Tax & Accounting) at 202-317-5100 (not a toll free call).

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Footnotes

1. Unless otherwise specified, all references to “2015 taxable year” and “2016 taxable year” refer to the calendar year ending on December 31st of the stated year.

2. DCN #184 refers to a change to deducting amounts paid or incurred for repair and maintenance or to capitalizing amounts paid for improvements to tangible property, and to depreciating such amounts, if applicable, in compliance with the final tangible property regulations under §§ 162 and 263(a).

3. But see section 3.02 of Rev. Proc. 2015-33 (providing additional time to file method changes under Rev. Proc. 2011-14, 211-4 I.R.B. 330, and Rev. Proc. 2015-13) .

4. Generally, under section 5.02(4)(b)(i) of Rev. Proc. 2015-56, a qualified taxpayer is required to revoke partial disposition elections made under § 1.168(i)-8(d)(2) or Prop. Reg. § 168(i)-8(d)(2) for any portion of an original qualified building, or any portion of an improvement or addition to such building, for which the taxpayer changes to the remodel-refresh safe harbor with a full § 481(a) adjustment.  If the taxpayer made a partial disposition election for such qualifying property, the taxpayer is permitted to use (i) section 5.02(4)(b)(ii)(A) of Rev. Proc. 2015-56 to file an amended return to revoke the partial disposition election no later than the due date, including extensions, of the taxpayer’s federal tax return for the first taxable year it uses the remodel-refresh safe harbor, provided the period of limitations on assessment under § 6501(a) has not expired for the taxable year for which the partial disposition election was made; or (ii) section 5.02(4)(b)(ii)(B) of Rev. Proc. 2015-56 to file a Form 3115, Application for Change in Accounting Method, to revoke the partial disposition election by using the automatic change provisions under section 6.43 of Rev. Proc. 2015-14, but only for the taxpayer’s first or second taxable year beginning after December 31, 2013.

5. Amounts capitalized by the lessor as a leasehold improvement should not be capitalized by the lessee.  Section 1.263(a)-3(f)(3)(i).  Similarly, even if they are both qualifying taxpayers, the lessor and the lessee cannot both use the refresh-remodel safe harbor for the same amounts.