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Bulletin No.

2006-39
September 25, 2006

HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.

INCOME TAX Special rules apply to the allocable amount of interest expense
allowed in determining the net U.S. taxable income. Additional
rules for foreign banking corporations are also applicable. Cer-
Rev. Rul. 2006–46, page 511. tain clarifications and conforming updates are also made to the
Conservation Security Program (CSP). This ruling holds 1996 final regulations under section 1.882–5.
that the Conservation Security Program is substantially similar
to the type of programs described in section 126(a)(1) through T.D. 9282, page 512.
(8) of the Code within the meaning of section 126(a)(9). As a Final regulations under sections 162(k) and 404(k) of the Code
result, all or a portion of cost-share payments received under provide that a payment in redemption of employer securities
the CSP is eligible for exclusion from gross income to the extent held by an employee stock ownership plan (ESOP) is not de-
permitted by section 126. ductible.

Rev. Rul. 2006–47, page 511. REG–168745–03, page 532.


Fringe benefits aircraft valuation formula. The Standard Proposed regulations under section 263 of the Code explain
Industry Fare Level (SIFL) cents-per-mile rates and terminal how section 263(a) applies to amounts paid to acquire, pro-
charge in effect for the second half of 2006 are set forth for duce, or improve tangible property. The proposed regula-
purposes of determining the value of noncommercial flights tions clarify what amounts must be capitalized, rather than de-
on employer-provided aircraft under section 1.61–21(g) of the ducted currently, and how those capitalized amounts should be
regulations. treated. A public hearing is scheduled for December 19, 2006.

Rev. Rul. 2006–48, page 516. Notice 2006–82, page 529.


LIFO; price indexes; department stores. The July 2006 Extension of replacement period for livestock sold on
Bureau of Labor Statistics price indexes are accepted for use account of drought. This notice explains the circumstances
by department stores employing the retail inventory and last-in, under which the 4-year replacement period under section
first-out inventory methods for valuing inventories for tax years 1033(e)(2) of the Code is extended for livestock sold on
ended on, or with reference to, July 31, 2006. account of drought. The notice informs taxpayers that the
Service will publish an annual list of counties that experienced
T.D. 9281, page 517. exceptional, extreme, or severe drought conditions, which a
REG–120509–06, page 570. taxpayer can use to determine if an extension is available.
Final, temporary, and proposed regulations under sections 882
and 884 of the Code state that foreign corporations engaged
in a trade or business within the United States are subject to tax
on their income that is treated as effectively connected with the
trade or business. Expenses related to that income are alloca-
ble and deductible against the effectively connected income to
determine the foreign corporation’s net U.S. taxable income.

(Continued on the next page)

Announcements of Disbarments and Suspensions begin on page 572.


Finding Lists begin on page ii.
Index for July through September begins on page iv.
EMPLOYEE PLANS

T.D. 9282, page 512.


Final regulations under sections 162(k) and 404(k) of the Code
provide that a payment in redemption of employer securities
held by an employee stock ownership plan (ESOP) is not de-
ductible.

ADMINISTRATIVE

REG–145154–05, page 567.


Proposed regulations under 31 USC 9701 implement new user
fees for the Special Enrollment Examination (SEE) for enrolled
agents, the application for enrollment of enrolled agents, and
the renewal of such enrollment. The user fee that the IRS cur-
rently charges applicants in order to take the SEE is being mod-
ified to reflect the change in the IRS costs of administering the
exam program as a result of the contracting out of the exam.
The regulations establish an $11 per applicant user fee for the
SEE and separate $125 user fees for the enrollment and re-
newal of enrollment process. A public hearing is scheduled for
September 29, 2006.

Rev. Proc. 2006–38, page 530.


Low-income housing credit. This procedure publishes the
amounts of unused housing credit carryovers allocated to qual-
ified states under section 42(h)(3)(D) of the Code for calendar
year 2006.

September 25, 2006 2006–39 I.R.B.


The IRS Mission
Provide America’s taxpayers top quality service by helping applying the tax law with integrity and fairness to all.
them understand and meet their tax responsibilities and by

Introduction
The Internal Revenue Bulletin is the authoritative instrument of court decisions, rulings, and procedures must be considered,
the Commissioner of Internal Revenue for announcing official and Service personnel and others concerned are cautioned
rulings and procedures of the Internal Revenue Service and for against reaching the same conclusions in other cases unless
publishing Treasury Decisions, Executive Orders, Tax Conven- the facts and circumstances are substantially the same.
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
The Bulletin is divided into four parts as follows:
Superintendent of Documents on a subscription basis. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis. Part I.—1986 Code.
This part includes rulings and decisions based on provisions of
It is the policy of the Service to publish in the Bulletin all sub- the Internal Revenue Code of 1986.
stantive rulings necessary to promote a uniform application of
the tax laws, including all rulings that supersede, revoke, mod- Part II.—Treaties and Tax Legislation.
ify, or amend any of those previously published in the Bulletin. This part is divided into two subparts as follows: Subpart A,
All published rulings apply retroactively unless otherwise indi- Tax Conventions and Other Related Items, and Subpart B, Leg-
cated. Procedures relating solely to matters of internal man- islation and Related Committee Reports.
agement are not published; however, statements of internal
practices and procedures that affect the rights and duties of
taxpayers are published. Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these
subjects are contained in the other Parts and Subparts. Also
Revenue rulings represent the conclusions of the Service on the included in this part are Bank Secrecy Act Administrative Rul-
application of the law to the pivotal facts stated in the revenue ings. Bank Secrecy Act Administrative Rulings are issued by
ruling. In those based on positions taken in rulings to taxpayers the Department of the Treasury’s Office of the Assistant Sec-
or technical advice to Service field offices, identifying details retary (Enforcement).
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements. Part IV.—Items of General Interest.
This part includes notices of proposed rulemakings, disbar-
ment and suspension lists, and announcements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be The last Bulletin for each month includes a cumulative index
relied on, used, or cited as precedents by Service personnel in for the matters published during the preceding months. These
the disposition of other cases. In applying published rulings and monthly indexes are cumulated on a semiannual basis, and are
procedures, the effect of subsequent legislation, regulations, published in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2006–39 I.R.B. September 25, 2006


Place missing child here.

September 25, 2006 2006–39 I.R.B.


Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 42.—Low-Income (SIFL) cents-per-mile rates and terminal under the base aircraft valuation formula
Housing Credit charge in effect for the second half of 2006 (also known as the Standard Industry Fare
are set forth for purposes of determining Level formula or SIFL) by multiplying
26 CFR 1.42–14: Allocation rules for post-1989 the value of noncommercial flights on the SIFL cents-per-mile rates applicable
State housing credit ceiling amounts.
employer-provided aircraft under section for the period during which the flight was
Guidance is provided to state housing credit agen- 1.61–21(g) of the regulations. taken by the appropriate aircraft multiple
cies of qualified states that request an allocation provided in section 1.61–21(g)(7) and then
of unused housing credit carryover under section Rev. Rul. 2006–47 adding the applicable terminal charge. The
42(h)(3)(D) of the Internal Revenue Code. See Rev. SIFL cents-per-mile rates in the formula
Proc. 2006-38, page 530. For purposes of the taxation of fringe and the terminal charge are calculated by
benefits under section 61 of the Inter- the Department of Transportation and are
nal Revenue Code, section 1.61–21(g) of
Section 61.—Gross Income the Income Tax Regulations provides a
reviewed semi-annually.
Defined rule for valuing noncommercial flights
The following chart sets forth the termi-
nal charges and SIFL mileage rates:
26 CFR 1.61–21: Taxation of fringe benefits. on employer-provided aircraft. Section
1.61–21(g)(5) provides an aircraft valua-
Fringe benefits aircraft valuation for- tion formula to determine the value of such
mula. The Standard Industry Fare Level flights. The value of a flight is determined

Period During Which Terminal SIFL Mileage


the Flight Is Taken Charge Rates
7/1/06 - 12/31/06 $37.85 Up to 500 miles
= $.2071 per mile
501–1500 miles
= $.1579 per mile
Over 1500 miles
= $.1518 per mile

DRAFTING INFORMATION income to the extent permitted by section stewardship of agricultural lands by pro-
126. viding financial assistance to agricultural
The principal author of this revenue producers who maintain and enhance nat-
ruling is Kathleen Edmondson of the Rev. Rul. 2006–46 ural resources. The CSP is administered
Office of Division Counsel/Associate by the U.S. Department of Agriculture
Chief Counsel (Tax Exempt/Govern- ISSUE (USDA). An agricultural producer who
ment Entities). For further information wishes to participate in the CSP must enter
regarding this revenue ruling, contact Is the Conservation Security Program into a long-term conservation security con-
Ms. Edmondson at (202) 622–0047 (not a (CSP) within the scope of § 126(a)(9) so tract with the USDA’s Natural Resources
toll-free call). that cost-share payments received under Conservation Service (NRCS). The CSP is
the CSP are eligible for exclusion from available to agricultural producers owning
gross income to the extent permitted by private agricultural land (including crop-
Section 126.—Certain § 126? land, grassland, prairie land, improved
Cost-Sharing Payments pasture land, rangeland, land under the
FACTS jurisdiction of an Indian tribe, or forested
Conservation Security Program land that is an incidental part of an agri-
(CSP). This ruling holds that the Con- The CSP, authorized under the provi- cultural operation). The NRCS, using
servation Security Program is substan- sions of §§ 1238–1238C of the Food Secu- the USDA’s Commodity Credit Corpo-
tially similar to the type of programs rity Act of 1985, Pub. L. No. 99–198, 99 ration, provides contract payments that
described in section 126(a)(1) through (8) Stat. 1354, as amended by the Farm Se- may include (1) an annual stewardship
of the Code within the meaning of section curity and Rural Investment Act of 2002, component for the existing base level con-
126(a)(9). As a result, all or a portion of Pub. L. No. 107–171, 116 Stat. 134, 16 servation treatment; (2) an annual existing
cost-share payments received under the U.S.C. §§ 3838–3838c, is a voluntary pro- practice component for maintaining exist-
CSP is eligible for exclusion from gross gram that supports ongoing conservation ing conservation practices; (3) a one-time

2006–39 I.R.B. 511 September 25, 2006


new practice component for additional § 126(b), the excludable portion of a pay- payments and are not excludable from
needed practices; and (4) an enhancement ment is limited to the portion that (1) is gross income.
component for exceptional conservation determined by the Secretary of Agricul- See § 126(b) and § 16A.126–1 to de-
effort and additional conservation prac- ture to be made primarily for the purpose termine the extent to which cost-share
tices or activities that provide increased of conserving soil and water resources, payments under the existing practice, new
resource benefits beyond the prescribed protecting or restoring the environment, practice, and enhancement components
level. Payments for practices included improving forests, or providing a habitat are excludable from gross income under
in the existing practice and new practice for wildlife, (2) does not substantially § 126.
components are limited, under 16 U.S.C. increase the income derived from the
§ 3838c, to 75 percent (or, in the case of a property, and (3) is not properly associ- DRAFTING INFORMATION
beginning farmer or rancher, 90 percent) ated with a deductible expense. Payments
The principal author of this revenue rul-
of the average county costs of the practices in the nature of rent or compensation for
ing is Jennifer C. Bernardini of the Office
for the 2001 crop year. Payments under services do not qualify for the exclusion.
of Associate Chief Counsel (Passthroughs
the stewardship component are not limited See § 126(b) and § 16A.126–1, relating to
& Special Industries). For further informa-
to the taxpayer’s costs but are instead a the partial exclusion of certain cost-share
tion regarding this revenue ruling, contact
percentage of the rental rate applicable to payments, to determine what portion of the
Jennifer C. Bernardini at (202) 622–3120
the land, as determined by the NRCS. Pay- cost-share payments is excludable from
(not a toll-free call).
ments under the enhancement component gross income under § 126.
may be based either on an activity’s cost
or on its expected conservation benefits. HOLDING
Section 162.—Trade or
The Secretary of Agriculture has deter- Business Expenses
The Internal Revenue Service accepts
mined that payments under the CSP are
USDA’s conclusion that the CSP is a small
primarily for the purpose of conserving 26 CFR 1.162(k)–1: Disallowance of deduction for
watershed program. Accordingly, the CSP reacquisition payments.
soil and water resources or protecting and
will be treated for purposes of § 126 as a
restoring the environment. In addition, the 26 CFR 1.404(k)–3: Disallowance of deduction for
small watershed program administered by
Secretary of Agriculture has informed the reacquisition payments.
the Secretary of Agriculture. In addition,
Treasury Department that USDA believes
the Commissioner has determined that the
the CSP is a small watershed program.
CSP is substantially similar to the type of
T.D. 9282
programs described in § 126(a)(1) through
LAW AND ANALYSIS DEPARTMENT OF
(8).
Payments for practices included in the THE TREASURY
Under § 126(a), gross income does not
existing practice and new practice com- Internal Revenue Service
include the excludable portion of pay-
ments received under certain conservation
ponents are limited to a percentage of the 26 CFR Part 1
average county costs of the practices and
programs set forth in § 126(a)(1) through
(8). Section 126(a)(9) provides that a
qualify as cost-share payments. The cost- Dividends Paid Deduction for
share payments received under the exist- Stock Held in Employee Stock
small watershed program administered by
ing practice and new practice components
the Secretary of Agriculture also is eligi- Ownership Plan
of the CSP are eligible for exclusion from
ble for § 126 treatment if the Secretary of
gross income to the extent permitted by AGENCY: Internal Revenue Service
the Treasury determines that the program
§ 126. (IRS), Treasury.
is substantially similar to the type of pro-
Payments under the stewardship com-
grams described in § 126(a)(1) through
ponent are based on the rental rate applica- ACTION: Final regulations.
(8). See § 16A.126–1(d) of the Temporary
ble to the land and are not cost-share pay-
Income Regulations Relating To The Par- SUMMARY: This document contains
ments that are excludable from gross in-
tial Exclusion For Certain Cost-Sharing final regulations under sections 162(k)
come.
Payments for rules permitting the Com- and 404(k) of the Internal Revenue Code
Payments under the enhancement com-
missioner to make these determinations (Code) providing that a payment in re-
ponent qualify as cost-share payments if
and announce them in the Internal Rev- demption of employer securities held by
they are based on an activity’s cost rather
enue Bulletin and for the definition of an employee stock ownership plan (ESOP)
than on its expected conservation benefits.
“small watershed.” is not deductible. These regulations gen-
The cost-share payments received under
If the Commissioner has determined erally affect administrators of, employers
the enhancement component are eligible
that a program is substantially similar maintaining, participants in, and benefi-
for exclusion from gross income to the ex-
to the types of programs described in ciaries of ESOPs. In addition, they will
tent permitted by § 126. Payments under
§ 126(a)(1) through (8), taxpayers re- affect corporations that make distributions
the enhancement component based on the
ceiving cost-share payments under that in redemption of stock held in an ESOP.
activity’s expected conservation benefits
program must determine what portion
rather than on its cost are not cost-share
of the cost-share payments is excludable DATES: Effective Date: These regulations
from gross income under § 126. Under are effective on August 30, 2006.

September 25, 2006 512 2006–39 I.R.B.


Applicability Dates: These regulations pants) with respect to which the dividend is Rul. 2001–6, payments in redemption of
apply with respect to payments to reac- paid. Under section 404(k)(4), the deduc- stock held by an ESOP that are used to
quire stock that are made on or after and tion is allowable in the taxable year of the make distributions to terminating ESOP
amounts paid or incurred on or after Au- corporation in which the dividend is paid participants constitute an evasion of tax-
gust 30, 2006. See §§1.162(k)–1(c) and or distributed to the participant or benefi- ation under section 404(k)(5)(A) and are
1.404(k)–3, Q&A–2. ciary. not applicable dividends under section
Prior to 2002, section 404(k)(5)(A) pro- 404(k)(1). Moreover, the notice states that
FOR FURTHER INFORMATION vided that the Secretary may disallow the any deduction for such payments in re-
CONTACT: John T. Ricotta at (202) deduction under section 404(k) for any demption of stock is barred under section
622–6060 with respect to section 404(k) dividend if the Secretary determines that 162(k).
or Jean R. Brenner at (202) 622–7790 with such dividend constitutes, in substance, an Notice 2002–2 (Q&A–7) also discusses
respect to section 162(k) (not toll-free evasion of taxation. Section 662(b) of the the tax treatment of section 404(k) divi-
numbers). Economic Growth and Tax Relief Recon- dend distributions, stating that dividends
ciliation Act of 2001 (115 Stat. 38, 2001) paid in cash to a participant (rather than
SUPPLEMENTARY INFORMATION:
amended section 404(k)(5)(A) to provide reinvested at the option of the partici-
Background that the Secretary may disallow a deduc- pant under section 404(k)(2)(A)(iii)) are
tion under section 404(k) for any divi- taxable without regard to the return of
This document contains final regu- dend the Secretary determines constitutes, basis provisions under section 72, and are
lations (26 CFR Part 1) under sections in substance, an avoidance or evasion of not subject to the consent requirements
162(k) and 404(k) of the Code. taxation. of section 411(a)(11) or the distribution
Section 162(k)(1) generally provides Rev. Rul. 2001–6, 2001–1 C.B. restrictions of section 401(k)(2)(B). In ad-
that no deduction otherwise allowable un- 491 (see §601.601(d)(2) of this chapter), dition, the notice provides that dividends
der chapter 1 of the Code is allowed for states that distributions to participants of paid to participants under section 404(k)
any amount paid or incurred by a corpora- amounts paid by an employer to reacquire are not eligible rollover distributions under
tion in connection with the reacquisition of shares of its stock from the employer’s section 402(c), even if the dividends are
its stock or the stock of any related person ESOP (redemption proceeds) are made distributed at the same time as amounts
(as defined in section 465(b)(3)(C)). The in connection with the reacquisition of that do constitute an eligible rollover dis-
legislative history of section 162(k) states the employer’s stock and that section tribution (or are reported on Form 1099-R
that the phrase “in connection with” is 162(k)(1) therefore bars the deduction (Distributions From Pensions, Annuities,
“intended to be construed broadly.” H.R. under these circumstances regardless of Retirement or Profit-Sharing Plans, IRAs,
Conf. Rep. No. 99–841, at 168 (1986). whether the distributions to participants Insurance Contracts, etc.) in accordance
Section 404(k)(1) provides a deduction would otherwise be deductible under sec- with Announcement 85–168).1 See also
for an applicable dividend paid in cash by tion 404(k). The revenue ruling also states § 1.402(c)–2, Q&A–4(e), under which
a C corporation with respect to applica- that the treatment of redemption proceeds dividends paid on employer securities un-
ble employer securities held by an ESOP, as “applicable dividends” under section der section 404(k) are not eligible rollover
as defined in section 4975(e)(7). Section 404(k) would produce such anomalous distributions under section 402(c).
404(k)(2) generally provides that the term results that the section cannot reasonably In Boise Cascade Corporation v.
applicable dividend means any dividend be construed as encompassing such pay- United States, 329 F.3d 751 (9th Cir.
which, in accordance with the plan provi- ments. The revenue ruling states that the 2003), the Court of Appeals for the Ninth
sions, is either paid in cash to plan partic- application of section 404(k) to redemp- Circuit held that payments made by the
ipants or beneficiaries or paid to the plan tion proceeds not only would allow em- issuer of stock to redeem its stock held
and distributed in cash to participants or ployers to claim deductions for payments by its ESOP were deductible as dividends
beneficiaries not later than 90 days after that do not represent true economic costs, paid under section 404(k), and that the
the close of the plan year in which paid. but also, as further explained below, would deduction was not precluded by section
An applicable dividend also includes a div- vitiate important rights and protections for 162(k). The IRS issued Chief Coun-
idend which, at the election of participants recipients of ESOP distributions. Finally, sel Notice 2004–038 (October 1, 2004)
or their beneficiaries, is payable as pro- the ruling states that a deduction would (available at www.irs.gov/foia through the
vided in the preceding sentence or paid to be disallowed under section 404(k)(5)(A) electronic reading room) to indicate that it
the plan and reinvested in qualifying em- because a deduction under these circum- disagreed with the Court’s interpretation
ployer securities. Finally, an applicable stances would constitute, in substance, an and would continue to assert in any matter
dividend also includes a dividend that is evasion of taxation. in controversy outside the Ninth Circuit
used to make payments on a loan described These positions were reiterated in that sections 162(k) and 404(k) disallow
in section 404(a)(9), the proceeds of which Notice 2002–2, Q&A–11, 2002–2 C.B. a deduction for payments to reacquire
were used to acquire the employer secu- 285 (See §601.601(d)(2) of this chapter), employer securities held by an ESOP. For
rities (whether or not allocated to partici- which states that, in accordance with Rev. any matter in controversy within the Ninth

1 Announcement 85–168, 1985–48 I.R.B. 40, states that section 404(k) distributions are reportable as dividends on a recipient’s tax return and that such distributions are fully taxable without
regard to return of basis.

2006–39 I.R.B. 513 September 25, 2006


Circuit, agents or district counsel attorneys Explanation of Provisions ceeds should not be characterized as an
are to consult the National Office. avoidance or evasion of taxation within
A notice of proposed rulemaking con- With respect to the treatment of pay- the meaning of section 404(k)(5). Finally,
taining proposed regulations under sec- ments in redemption of employer securi- the commentator argued that, because the
tions 162(k) and 404(k) was issued on Au- ties, these final regulations adopt the rule legislative history to section 162(k) does
gust 25, 2005 (REG–133578–05, 2005–39 of the proposed regulations under which not specifically refer to section 404(k)
I.R.B. 610 [70 FR 49897]) to address two payments made to reacquire stock held by dividends and section 162(k) was enacted
issues: 1) which corporation is entitled an ESOP are not deductible under section only two years after section 404(k), sec-
to the deduction for applicable dividends 404(k) because such payments do not con- tion 162(k) does not preclude a deduction
under section 404(k) where the payor stitute applicable dividends under section for a redemptive dividend under section
and employer are different entities; and 404(k)(2) and a deduction for such pay- 404(k).
2) whether a payment in redemption of ments would constitute, in substance, an These arguments are unpersuasive. Al-
employer securities held by an ESOP is avoidance or evasion of taxation within the though the present value of expected fu-
deductible. The issue in the proposed meaning of section 404(k)(5). These final ture dividends is an element of the value
regulations concerning which corporation regulations also adopt the rule of the pro- of shares of stock at any point in time, and
is entitled to the deduction for applicable posed regulations that explicitly provides Congress did authorize a current deduc-
dividends under section 404(k) is expected that section 162(k) disallows any deduc- tion for the value of stock contributions
to be addressed in future regulations. tion, including any deduction under sec- to qualified plans, as well as a later de-
The notice of proposed rulemaking in- tion 404(k), for amounts paid or incurred duction for certain dividends paid on those
cluded proposed regulations under section by a corporation in connection with the shares under section 404(k), these deduc-
404(k) that would provide that payments reacquisition of its stock or the stock of tions are carefully limited to dividends ac-
made to reacquire stock held by an ESOP any related person (as defined in section tually paid in certain specified ways while
are not deductible under section 404(k) 465(b)(3)(C)). In addition, these final reg- the stock is held by the ESOP. There is
because such payments would not con- ulations adopt the rule of the proposed reg- no evidence that Congress intended to au-
stitute applicable dividends under section ulations providing that amounts paid or in- thorize yet another deduction for the full
404(k)(2) and a deduction for such pay- curred in connection with the reacquisition value of the shares upon their redemption.
ments would constitute, in substance, an of stock include amounts paid by a corpo- To allow a deduction for redemption pro-
avoidance or evasion of taxation within ration to reacquire its stock from an ESOP ceeds would be to allow a second deduc-
the meaning of section 404(k)(5) because that are then distributed by the ESOP to its tion that includes the present value of div-
it would allow a corporation to claim participants (or their beneficiaries) or oth- idends that are paid out after the date of
two deductions for the same economic erwise used in a manner described in sec- distribution from the ESOP, contrary to the
cost. It also included proposed regula- tion 404(k)(2)(A). intent of the statute. Moreover, the amount
tions under section 162(k) providing that These provisions aroused little opposi- of the deduction with respect to a redemp-
section 162(k), subject to certain excep- tion and only two comments were received tion could be many times the amount that
tions, would disallow any deduction for regarding the treatment of payments made would be deducted for that year for a con-
amounts paid or incurred by a corporation to reacquire stock. A trade association rep- ventional dividend. (In fact, permitting a
in connection with the reacquisition of its resenting companies that sponsor ESOPs second deduction for the full value of the
stock or the stock of any related person supported the position of the proposed shares would allow a corporation to claim
(as defined in section 465(b)(3)(C)). Fi- regulations that a repurchase of shares of one deduction for a share of stock con-
nally, the proposed regulations provided ESOP stock from ESOP participants in tributed to an ESOP and allocated to an
that amounts paid or incurred in connec- a stock redemption does not qualify as a employee early in a tax year and another
tion with the reacquisition of stock include deductible dividend under section 404(k). deduction if the share is redeemed to make
amounts paid by a corporation to reacquire The other commentator disagreed with a distribution to the employee later in the
its stock from an ESOP that are then dis- the position in the proposed regulations, same tax year.) There is a no indication
tributed by the ESOP to its participants (or arguing that redemptions of stock held by that such a result was intended and there is
their beneficiaries) or otherwise used in a an ESOP that are recharacterized as divi- no obvious purpose that would be served
manner described in section 404(k)(2)(A). dends under section 302 nevertheless are by such a result.
A public hearing on the proposed reg- proper dividends that should be treated the Congress recognized that an arrange-
ulations was held on January 18, 2006. same as ordinary dividends paid with re- ment that might be argued to come within
After consideration of the comments spect to stock held by an ESOP. The com- the literal language of section 404(k) might
received, these final regulations adopt mentator argued that, by enacting section nevertheless be inconsistent with its pur-
without material change the provisions 404(k), Congress intended to allow a dou- pose. Congress therefore granted authority
of the proposed regulations concerning ble deduction for contributions to purchase to the Secretary, in section 404(k)(5)(A),
payments in redemption of employer se- employer stock because the value of stock to disallow a deduction for any dividend
curities held by an ESOP. purchased with employer contributions that the Secretary finds to be, in substance,
includes the present value of expected an evasion of taxation. The statute was
future dividends. Thus, the commentator clarified, for years beginning in 2002, to
argued, a deduction for redemptive pro- explicitly broaden that authority to permit

September 25, 2006 514 2006–39 I.R.B.


the Service to disallow any deduction that provided to the employee as required by Effective Date
is an avoidance or evasion of taxation. A section 402(f) would have to identify the
deduction for redemption proceeds is both loss of this valuable right to the partici- Section 1.162(k)–1 applies with respect
excessive in amount and inconsistent with pant. See §1.402(c)–2, Q&A–4(e). to amounts paid or incurred on or after
the purpose of section 404(k), so that this is Congress also provided for other spe- August 30, 2006.
clearly an appropriate case for the author- cial treatment for applicable dividends un- Section 1.404(k)–3 applies with respect
ity under section 404(k)(5)(A) to be exer- der section 404(k) that would be incon- to payments to reacquire stock that are
cised.2 sistent with redemption of a normal bene- made on or after August 30, 2006. Rev.
The IRS and Treasury Department fit distribution being treated as an applica- Rul. 2001–6 remains in effect for all peri-
also continue to believe, as provided in ble dividend under section 404(k). Section ods, including periods before the effective
Rev. Rul. 2001–6, that a deduction for 72(t)(2)(A)(vi) provides for an exception date of this regulation.
redemption of benefit distributions is to the 10 percent additional income tax for
Special Analyses
appropriately disallowed under section early distributions for dividends paid with
404(k)(5)(A) because a deduction under respect to stock of a corporation which are It has been determined that this Trea-
these circumstances would constitute, in described in section 404(k). Further, sec- sury decision is not a significant regula-
substance, an evasion of taxation. As tion 404(k)(5)(B) provides that a plan will tory action as defined in Executive Order
stated in Rev. Rul. 2001–6, the treatment not violate the requirements of sections 12866. Therefore, a regulatory assessment
of redemption proceeds as “applicable 401, 409, or 4975(e)(7) or be engaging in a is not required. It also has been deter-
dividends” under section 404(k) would prohibited transaction merely by reason of mined that section 553(b) of the Admin-
produce such anomalous results that the distributing an applicable dividend under istrative Procedure Act (5 U.S.C. chapter
section cannot reasonably be construed section 404(k). Thus, for example, a distri- 5) does not apply to these regulations, and
as encompassing such payments. As one bution of an applicable dividend under sec- because the regulations do not impose a
example, if a redemption of a benefit tion 404(k) is not subject to the prohibition collection of information on small entities,
distribution were an applicable dividend against in-service distributions of amounts the Regulatory Flexibility Act (5 U.S.C.
under section 404(k), there would be no attributable to elective deferrals under sec- chapter 6) does not apply. Pursuant to sec-
reason why such a redemption could only tion 401(k)(2). Clearly, these broad ex- tion 7805(f) of the Code, the proposed reg-
occur once with respect to a participant, so ceptions under section 72(t)(2)(A)(vi) and ulations preceding these regulations were
that multiple redemptions (or theoretically 404(k)(5)(B) were not intended to apply to submitted to the Chief Counsel for Advo-
even an unlimited number of redemp- normal benefit distributions from ESOPs, cacy of the Small Business Administration
tions3) might be possible, a result that is essentially at the election of the employer for comment on its impact on small busi-
clearly not consistent with the intent of or distributee. ness.
section 404(k). Finally, even if the IRS declined
Further, as described in Rev. Rul. to exercise its authority under section Drafting Information
2001–6, the application of section 404(k) 404(k)(5)(A), the plain language of sec-
to redemption amounts also would viti- tion 162(k) precludes the deduction for The principal authors of these reg-
ate important rights and protections for payments by a corporation to redeem its ulations are John T. Ricotta, Office of
recipients of ESOP distributions. These stock including deductions otherwise al- Division Counsel/Associate Chief Coun-
important rights and protections include lowed under section 404(k). As described sel (Tax Exempt and Government Entities)
the right to apply the return of basis pro- under the Background section of this pre- and Jennifer D. Sledge, Office of Asso-
visions under section 72 (whereas an amble, section 162(k) provides that “no ciate Chief Counsel (Corporate). How-
applicable dividend under section 404(k) deduction otherwise allowable shall be ever, other personnel from the IRS and the
is includible in gross income without re- allowed under this chapter for any amount Treasury Department participated in the
gard to return of basis under section 72), paid or incurred by a corporation in con- development of these regulations.
and the protection against involuntary nection with the reacquisition of its stock” *****
cash-outs (section 411(a)(11)). See sec- (emphasis added) and section 404(k) is in
tion 72(e)(5)(D), and Q&A–7 of Notice the same chapter as section 162(k). The Adoption of Amendments to the
2002–2, 2002–1 C.B. 285. Similarly, if commentator’s attempt to avoid the effect Regulations
redemption amounts distributed as a nor- of the plain language of the statute by ref-
Accordingly, 26 CFR part 1 is amended
mal benefit distribution were treated as an erence to a supposed negative inference in
as follows:
applicable dividend under section 404(k), the legislative history is unavailing.
then a participant would not have the right Accordingly, these regulations adopt
to elect a direct or indirect rollover with the rule in the proposed regulations with-
respect to redemption proceeds that are out material change.
distributed from the ESOP, and any notice
2Given the special rules of section 409(h) which generally entitle participants to receive cash for employer securities that are not publicly traded, if Congress had so intended, it would likely
have identified the interaction of these provisions in light of the potentially large additional deductions such a rule would permit. Cf., Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934).
3 For example, a plan participant might elect to have his or her account balance redeemed to the extent invested in employer securities, and then promptly have the cash reinvested in employer
securities, and then could immediately repeat this redemption/reinvestment process with no theoretical limit.

2006–39 I.R.B. 515 September 25, 2006


PART 1—INCOME TAXES only stock which is redeemable upon the Eric Solomon,
demand of the shareholder. Acting Deputy Assistant Secretary
Paragraph 1. The authority citation for (c) Effective date. This section applies of the Treasury (Tax Policy).
part 1 is amended by adding entries in nu- with respect to amounts paid or incurred on
(Filed by the Office of the Federal Register on August 29,
merical order to read as follows: or after August 30, 2006. 2006, 8:45 a.m., and published in the issue of the Federal
Authority: 26 U.S.C. 7805 * * * Par. 3. Section 1.404(k)–3 is added to Register for August 30, 2006, 71 F.R. 51471)
Section 1.162(k)–1 is also issued under read as follows:
section 26 U.S.C. 162(k). * * *
Section 1.404(k)–3 is also issued §1.404(k)–3 Disallowance of deduction Section 472.—Last-in,
under sections 26 U.S.C. 162(k) and for reacquisition payments. First-out Inventories
404(k)(5)(A). * * * 26 CFR 1.472–1: Last-in, first-out inventories.
Par. 2. Section 1.162(k)–1 is added to Q–1: Are payments to reacquire stock
read as follows: held by an ESOP applicable dividends that LIFO; price indexes; department
are deductible under section 404(k)(1)? stores. The July 2006 Bureau of Labor
§1.162(k)–1 Disallowance of deduction A–1: (a) Payments to reacquire stock Statistics price indexes are accepted for
for reacquisition payments. held by an ESOP, including reacquisition use by department stores employing the
payments that are used to make benefit dis- retail inventory and last-in, first-out in-
(a) In general. Except as provided tributions to participants or beneficiaries,
in paragraph (b) of this section, no de- ventory methods for valuing inventories
are not deductible under section 404(k) be- for tax years ended on, or with reference
duction otherwise allowable is allowed cause—
under Chapter 1 of the Internal Revenue to, July 31, 2006.
(1) Those payments do not consti-
Code for any amount paid or incurred tute applicable dividends under section
by a corporation in connection with the Rev. Rul. 2006–48
404(k)(2); and
reacquisition of its stock or the stock of (2) The treatment of those payments The following Department Store In-
any related person (as defined in section as applicable dividends would constitute, ventory Price Indexes for July 2006 were
465(b)(3)(C)). Amounts paid or incurred in substance, an avoidance or evasion of issued by the Bureau of Labor Statistics.
in connection with the reacquisition of taxation within the meaning of section The indexes are accepted by the Inter-
stock include amounts paid by a corpora- 404(k)(5). nal Revenue Service, under § 1.472–1(k)
tion to reacquire its stock from an ESOP (b) See also §1.162(k)–1 concerning the of the Income Tax Regulations and Rev.
that are used in a manner described in disallowance of deductions for amounts Proc. 86–46, 1986–2 C.B. 739, for ap-
section 404(k)(2)(A). See §1.404(k)–3. paid or incurred by a corporation in con- propriate application to inventories of
(b) Exceptions. Paragraph (a) of this nection with the reacquisition of its stock department stores employing the retail
section does not apply to any— from an ESOP. inventory and last-in, first-out inventory
(1) Deduction allowable under section Q–2: What is the effective date of this methods for tax years ended on, or with
163 (relating to interest); section? reference to, July 31, 2006.
(2) Deduction for amounts that are A–2: This section applies with respect The Department Store Inventory Price
properly allocable to indebtedness and to payments to reacquire stock that are Indexes are prepared on a national basis
amortized over the term of such indebted- made on or after August 30, 2006. and include (a) 23 major groups of depart-
ness; ments, (b) three special combinations of
(3) Deduction for dividends paid Mark E. Matthews, the major groups — soft goods, durable
(within the meaning of section 561); or Deputy Commissioner for goods, and miscellaneous goods, and (c) a
(4) Amount paid or incurred in connec- Services and Enforcement. store total, which covers all departments,
tion with the redemption of any stock in a including some not listed separately, ex-
regulated investment company that issues Approved August 22, 2006.
cept for the following: candy, food, liquor,
tobacco, and contract departments.

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE


INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
Percent Change
from July 2005
Groups July 2005 July 2006 to July 20061
1. Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495.0 465.0 -6.1
2. Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517.7 488.7 -5.6
3. Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629.0 655.7 4.2
4. Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 867.0 875.4 1.0
5. Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548.0 557.7 1.8

September 25, 2006 516 2006–39 I.R.B.


BUREAU OF LABOR STATISTICS, DEPARTMENT STORE
INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
Percent Change
from July 2005
Groups July 2005 July 2006 to July 20061
6. Women’s Underwear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541.2 546.8 1.0
7. Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339.7 343.8 1.2
8. Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . 580.5 544.5 -6.2
9. Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . 321.7 327.3 1.7
10. Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520.6 514.2 -1.2
11. Men’s Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552.6 550.3 -0.4
12. Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386.1 371.3 -3.8
13. Jewelry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 870.2 898.0 3.2
14. Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809.2 822.9 1.7
15. Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 997.1 995.1 -0.2
16. Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599.1 602.4 0.6
17. Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609.8 614.1 0.7
18. Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712.2 697.1 -2.1
19. Major Appliances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203.5 204.2 0.3
20. Radio and Television. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38.9 35.8 -8.0
21. Recreation and Education2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77.9 76.3 -2.1
22. Home Improvements2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137.6 139.6 1.5
23. Automotive Accessories2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115.1 120.7 4.9

Groups 1–15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537.3 538.3 0.2


Groups 16–20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379.6 373.2 -1.7
Groups 21–23: Misc. Goods2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93.0 93.4 0.4

Store Total3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481.6 480.8 -0.2

1
Absence of a minus sign before the percentage change in this column signifies a price increase.
2
Indexes on a January 1986 = 100 base.
3
The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor,
tobacco and contract departments.

DRAFTING INFORMATION Section 882.—Tax on ACTION: Final and temporary regula-


Income of Foreign tions.
The principal author of this revenue Corporations Connected
ruling is Michael Burkom of the Office With United States Business SUMMARY: This document contains re-
of Associate Chief Counsel (Income Tax vised Income Tax Regulations relating to
and Accounting). For further informa- 26 CFR 1.882–5: Determination of interest deduc- the determination of the interest expense
tion regarding this revenue ruling, contact tion. deduction of foreign corporations and
Mr. Burkom at (202) 622–7924 (not a applies to foreign corporations engaged
toll-free call). T.D. 9281 in a trade or business within the United
States. This action is necessary to conform
DEPARTMENT OF the rules to subsequent U.S. Income Tax
THE TREASURY Treaty agreements and to adopt changes
Internal Revenue Service to facilitate improved administrability for
taxpayers and the IRS.
26 CFR Parts 1 and 602
DATES: Effective Date: These regula-
Determination of Interest tions are effective starting the tax year end
Expense Deduction of Foreign for which the original tax return due date
Corporations (including extensions) is after August 17,
2006.
AGENCY: Internal Revenue Service Applicability Date: These regulations
(IRS), Treasury. are applicable starting the tax year end

2006–39 I.R.B. 517 September 25, 2006


for which the original tax return due date States. On March 8, 1996, the Treasury 1. Notice 2005–53
(including extensions) is after August 17, Department and the IRS published final
2006. regulations T.D. 8658, 1996–1 C.B. 161 Notice 2005–53 provided guidance re-
[61 FR 15891 (see §601.601(d)(2) of this garding the interaction of §1.882–5 and
FOR FURTHER INFORMATION chapter)], and new proposed amendments U.S. income tax treaties and explained that
CONTACT: Gregory Spring or INTL–0054–95, 1996–1 C.B. 844 [61 since the recent treaties with the United
Paul Epstein, (202) 622–3870 (not a FR 28118) (see §601.601(d)(2) of this Kingdom and Japan entered into force,
toll-free number). chapter)]. The 1996 amendments imple- §1.882–5 no longer provides the exclusive
mented certain statutory changes enacted rules for determining the interest expense
SUPPLEMENTARY INFORMATION: in the Tax Reform Act of 1986, Public Law attributable to the business profits of a
99–514 (100 Stat. 2085), and took account U.S. permanent establishment. The no-
Paperwork Reduction Act of developments in international financial tice also provided guidance and requested
markets. Comments were received on comments regarding certain potential
These temporary regulations are being both the final and proposed 1996 regula- modifications to certain elements of the
issued without prior notice and public pro- tions. Since then, two new U.S. income tax three-step calculation of interest expense
cedure pursuant to the Administrative Pro- treaties have entered into force that follow under §1.882–5. More specifically, the
cedure Act (5 U.S.C. 553). For this reason, a different approach for determining the notice requested information regarding a
the collection of information contained in limit on profits attributable to a permanent possible increase to the existing 93-per-
these regulations has been reviewed and establishment in a contracting state and cent fixed ratio in Step 2 of the calculation
pending receipt and evaluation of public for determining interest expense allowed and announced the intention to allow the
comments, approved by the Office of Man- in computing such profits. On July 14, use of a safe-harbor interest rate for deter-
agement and Budget under control number 2005, the Treasury Department and the mining excess interest under the “adjusted
1545–2030. Responses to this collection IRS published Notice 2005–53, 2005–2 U.S.-booked liabilities” method in Step
of information are mandatory. C.B. 32, see §601.601(d)(2)), which de- 3. The notice also requested comments
An agency may not conduct or sponsor, scribed those new treaties and announced regarding the effect of intangibles on the
and a person is not required to respond the intention to update the final §1.882–5 Step–1 determination of U.S. assets under
to, a collection of information unless the regulations to take account of changes in the elective fair market value method and
collection of information displays a valid the international banking sector and to the Step–2 determination of U.S. liabilities
control number. promote both ease of administration and using the fixed or actual ratio.
For further information concerning certainty of application.
these collections of information, and These temporary regulations in this 2. Modifications to Three-Step
where to submit comments on the col- document implement Notice 2005–53, Calculation Under §1.882–5
lection of information and the accuracy of make effective one part of the 1996 pro-
the estimated burden, and suggestions for posed regulations, make miscellaneous a. Introduction/background
reducing this burden, please refer to the clarifications to the 1996 final regu-
preamble of the cross-referencing notice of Section 1.882–5 generally requires a
lations, and modify the branch profits
proposed rulemaking (REG–120509–06) foreign corporation to use a three-step cal-
tax liability reduction regulations under
published in this issue of the Bulletin. culation to determine the amount of inter-
§1.884–1(e)(3).
Books and records relating to a collec- est expense that is allocable under section
tion of information must be retained as Explanation of Provisions 882(c) to income effectively connected (or
long as their contents may become mate- treated as effectively connected) with the
rial in the administration of any internal The following discussion is divided foreign corporation’s conduct of a trade or
revenue law. Generally, tax returns and tax into several parts. Section 1 of the fol- business within the United States.
return information are confidential, as re- lowing discussion summarizes Notice Step 1 determines the total value of a
quired by 26 U.S.C. 6103. 2005–53. Section 2 addresses the coordi- foreign corporation’s U.S. assets, which
nation of §1.882–5 with U.S. tax treaties generally are the assets that produce (or
Background and discusses other modifications made would produce) income effectively con-
by these temporary regulations to the nected with the foreign corporation’s con-
On December 30, 1980, the Treasury three-step calculation of interest expense duct of its U.S. trade or business. The
Department and the IRS published final under §1.882–5. Section 3 addresses value of the U.S. assets for this purpose
regulations T.D. 7749, 1981–1 C.B. 390 changes made to the branch profits tax is their adjusted basis, or, if the taxpayer
[46 FR 16100 (see §601.601(d)(2) of this regulations under section 884. Section makes an election, their fair market value.
chapter)] under section 882(c) of the In- 4 then addresses miscellaneous technical Step 2 determines the “U.S.-connected
ternal Revenue Code (Code) regarding modifications made by these temporary liabilities” of a foreign corporation as the
the determination of a foreign corpora- regulations that clarify application of product of the foreign corporation’s U.S.
tion’s interest expense allocable to income the existing final regulations. Section 5 assets multiplied either by the actual ratio
effectively connected with the conduct describes the effective date of these regu- of the foreign corporation’s worldwide li-
of a trade or business within the United lations. abilities to worldwide assets, or by a fixed

September 25, 2006 518 2006–39 I.R.B.


ratio. In the case of a bank, the fixed ratio of a domestic corporation’s fair market must apply either the domestic law or the
is 93 percent. If a taxpayer elects to value value election under section 861, a fair alternative rules expressly provided in
its assets at fair market value for purposes market value election under §1.882–5T the treaty in their entirety, in accordance
of Step 1, then the taxpayer must value may be changed only with consent of the with the consistency principle articulated
worldwide assets at fair market value for Commissioner. in Rev. Rul. 84–17, 1984–1 C.B. 308
purposes of Step 2, as well. (see §601.601(d)(2) of this chapter), and
Step 3 determines the allocable amount b. Treaty coordination — modification of described in the Treasury Department
of interest expense under either the ad- §1.882–5 exclusivity rule Technical Explanation to Article 1(2) of
justed U.S.-booked liabilities (AUSBL) the United States-United Kingdom and
method or the separate currency pools The preamble to the 1996 final regula- United States-Japan income tax treaties.
method. Under the AUSBL method, a tions states that §1.882–5 was fully consis- The Treasury Department and the IRS
foreign bank’s interest expense alloca- tent with all of the United States’ then-ex- are continuing to consider the specific
ble to effectively connected income is isting treaty obligations, including Busi- application of this consistency principle
determined by comparing “U.S.-booked ness Profits articles, and the 1996 final reg- including the application of §1.882–5, the
liabilities” with U.S.-connected liabilities ulations state that §1.882–5 provides the interaction of §1.882–5 with other U.S. in-
and making appropriate adjustments as exclusive rules for determining the interest come tax treaties (particularly those being
necessary. For this purpose, U.S.-booked expense attributable to the business profits renegotiated in whole or in part), and the
liabilities generally include liabilities that of a U.S. permanent establishment under a application of the branch profits tax under
are both entered on books relating to an U.S. income tax treaty. However, the Trea- alternative rules for determining interest
activity that produces effectively con- sury Department Technical Explanation to expense attributable to business profits.
nected income before the close of the Article 7 of the United States-United King-
day on which the liability is incurred and dom income tax treaty which entered into c. Modifications to step one
are directly connected to that activity. force on March 31, 2003, and the Treasury
In consequence, U.S.-booked liabilities Department Technical Explanation to Arti- Consistency Requirement for Fair Market
are not limited to liabilities reflected on cle 7 of the United States-Japan income tax Value Election
books within the United States. If a tax- treaty which entered into force on March
payer’s U.S.-booked liabilities exceed 30, 2004, note that §1.882–5 may pro- Under the 1996 final regulations, a
its U.S.-connected liabilities, then its duce an inappropriate result in some cases. taxpayer that uses the fair market value
U.S-booked interest expense is propor- As a result, the implementing documen- method for Step 1 must also use the fair
tionately disallowed under a “scale down” tation of these treaties provides that the market value method for Step 2. Notice
ratio. If a taxpayer’s U.S.-connected lia- 1995 Organization for Economic Co-Op- 2005–53 clarified that this consistency
bilities exceed its U.S.-booked liabilities, eration and Development (OECD) Trans- rule applies only when the taxpayer has
then interest expense in addition to the fer Pricing Guidelines will apply by anal- elected to use the actual ratio in Step 2,
U.S.-booked interest expense is allocated ogy for the purpose of determining the because assets are not valued when the
in an amount equal to the product of the business profits attributable to a permanent fixed ratio is used. Accordingly, under the
excess U.S.-connected liabilities multi- establishment. Thus, as noted in Notice final regulations, electing the fair market
plied by the borrowing rate on U.S.-dollar 2005–53, the exclusivity provision in the value method under Step 1 does not ob-
liabilities that are not U.S.-booked liabil- 1996 final regulations is no longer accu- ligate a taxpayer to elect the actual ratio
ities. rate. under Step 2.
Under the separate currency pools These temporary regulations modify Notice 2005–53 also stated that the
method, a foreign corporation’s interest the exclusivity provision by recognizing prevalence and significance of intangibles
expense allocable to income effectively that express provision may be made by or in the banking industry warrants reevalu-
connected with the conduct of a trade or pursuant to an income tax treaty or accom- ating the right to elect both the fair market
business within the United States is the panying documents (such as exchange of value method in Step 1 and the fixed ratio
sum of the separate interest deductions for notes) that alternative principles will ap- in Step 2. The Treasury Department and
each of the currencies in which the foreign ply by analogy to determine the business the IRS are concerned that applying the
corporation has U.S. assets. The separate profits attributable to a permanent estab- fixed ratio to intangibles when a Step 1 fair
interest deductions generally are deter- lishment. Such treaty provisions may be market value election is in place would
mined using a three-step calculation that used to determine the limit on the business have the effect of treating existing intan-
multiplies the worldwide borrowing rate profits attributable to a U.S. permanent es- gibles as highly leveraged assets when in
by the U.S.-connected liabilities relevant tablishment, but taxpayers remain eligible fact such items often are more properly
to U.S. assets denominated in each foreign to use §1.882–5, as explained in the Trea- reflected in the taxpayer’s equity accounts
currency. sury Department Technical Explanations under U.S. tax principles. Comments were
Elections under §1.882–5T, as under to Article 7(3) of the United States-United requested.
the 1996 final regulations, generally are Kingdom and United States-Japan income The single comment received in re-
binding for a minimum of five years unless tax treaties. The Treasury Department sponse to this request stated that distor-
specifically provided otherwise. For ex- and the IRS believe that these treaties tions could result either by failing to take
ample, consistent with the binding nature and agreements provide that a taxpayer the value of intangibles into account when

2006–39 I.R.B. 519 September 25, 2006


revising the fixed ratio for banks or by ap- from the fair market value method to the Notice 2005–53 indicated that the Trea-
plying the fixed ratio to directly purchased adjusted basis method for Step 1 without sury Department and the IRS were con-
intangibles that are valued at tax basis. granting consent to move from the actual sidering increasing the fixed ratio. In or-
As further discussed in this section in ratio method to the fixed ratio method for der to improve administration by aligning
connection with modifications to Step 2, Step 2. the fixed ratio more closely with an ap-
these temporary regulations adopt a fixed proximation of current average banking in-
ratio that is believed to represent an ap- Average Value of Securities Subject to dustry balance sheet ratios estimated un-
proximation of current average banking- Section 475 or Section 1256 der U.S. tax principles, these temporary
industry balance-sheet ratios estimated un- regulations revise the fixed ratio for for-
der U.S. tax principles. Following due The 1996 proposed regulations provide eign banks upward to 95 percent. The
consideration of the comment, these tem- that financial instruments that are subject new fixed ratio may be adopted by for-
porary regulations require that the fair mar- to mark-to-market valuation under section eign banks for the first year in which the
ket value method may be elected in Step 1 475 or section 1256 must be valued for original tax return due date (including ex-
only if a taxpayer is eligible to elect and purposes of §1.882–5 on each “determina- tensions) is after August 17, 2006, or for
in fact uses the actual ratio in Step 2. The tion date” (as defined) within the taxable any subsequent year. The ratio may be
consistency rule continues to require that year. Taxpayers generally assess funding adopted, for example, for the 2005 calen-
the fair market value method, once elected, needs throughout the year, and this rule is dar year even if the original return was
must be used in both Step 1 and Step 2. intended to reflect such assessments more filed before these regulations were pub-
This consistency rule applies to all foreign accurately than a single year-end valuation lished. Taxpayers that want to try to sup-
corporations that are subject to §1.882–5. would do. port any further revision to the fixed ra-
These temporary regulations adopt this tio would have to submit detailed, specific,
Conforming-Election Requirement rule from the 1996 proposed regulations. compelling evidence to that effect.
The rule applies solely to determine the av-
A taxpayer that has both a valid fair erage values of relevant assets for purposes Branch Profits Tax Consequences of
market value method election for Step of computing the average valuation of U.S. Fixed-Ratio Election
1 and a valid fixed ratio method elec- assets in Step 1 of the formula. The rule
tion for Step 2 in effect on the date these does not determine the actual tax basis of Use of the new 95-percent fixed ratio
temporary regulations are effective must an asset for any other purpose. “Determi- in Step 2 conceivably could give rise to
conform those elections to the new rules. nation dates” for purposes of the rule are branch profits tax consequences. For ex-
Accordingly, such a taxpayer either may defined as the most frequent regular inter- ample, a taxpayer that elects the new fixed
maintain the fixed ratio method for Step vals for which data are reasonably avail- ratio and that had been using either the
2 and elect the adjusted basis method for able. These temporary regulations pro- 93-percent fixed ratio or an actual ratio that
Step 1, or may maintain the fair mar- vide that a taxpayer that has elected the ac- is less than 95 percent could be viewed
ket value method for Step 1 and elect tual ratio in Step 2 must also take interim under the branch profits tax rules as hav-
the actual ratio method for Step 2. Such mark-to-market values into account using ing experienced a decrease in net equity,
conforming elections must be made for the most frequently available data but in no thus giving rise to a dividend equivalent
the first year these temporary regulations event less frequently than actual-ratio tax- amount. One comment received in re-
are effective, on either an original timely payers are required to do. sponse to Notice 2005–53 requested that
filed return (including extensions) or an regulations implementing the notice pro-
amended return within 180 days after d. Modifications to step two vide special immunity from branch profits
the extended due date. If a conforming tax consequences except to the extent that
election is not made by the extended due New Fixed Ratio a taxpayer benefited from the 1996 reduc-
date for filing the amended return, the tion of the fixed ratio from 95 percent to
Director of Field Operations may make a The 1996 final regulations revised the 93 percent.
binding conforming election on the tax- fixed ratio for banks downward to 93 per- Such consequences under the branch
payer’s behalf. Conforming elections are cent. Since then, foreign bank taxpayers profits tax rules should arise only to the
subject to the minimum five-year period have commented that 93 percent is not rep- extent a taxpayer uses a 95-percent ra-
applicable to the adjusted basis method, resentative of regulated banking industry tio that is substantially higher than the ra-
fixed ratio and actual ratio method elec- capital structures. Foreign bank taxpay- tio used in the prior year, and the tax-
tions. Elections with respect to Step 1 ers also have commented that use of the payer’s asset base has not increased suf-
and Step 2, whether made by the taxpayer actual ratio in Step 2 presents the poten- ficiently in the ordinary course of busi-
(either under the terms of the regulations tial for significant tax risk and uncertainty ness to cause current and accumulated ef-
or pursuant to the Commissioner’s grant of results, particularly when adjusting their fectively connected earnings and profits
of consent within what would otherwise books to conform to U.S. tax principles. to be treated as reinvested. The 1996 fi-
be a five-year minimum period) or im- It appears that many foreign banks have nal regulations identify the actual ratio as
posed by the Commissioner, are separate. adopted the 93-percent fixed ratio despite the preferred method, and taxpayers have
Thus, for example, the Commissioner may indications that many operate on a smaller always been entitled to elect their actual
consent to a taxpayer’s request to move equity capital structure. ratio. Accordingly, the Treasury Depart-

September 25, 2006 520 2006–39 I.R.B.


ment and the IRS believe that granting the Eligibility nounced the intention to permit the use
commenter’s request is unnecessary and in of the published 30-day average London
some cases could produce an inappropri- Under the 1996 final regulations, the Interbank Offering Rate (LIBOR) for tax
ate windfall. In addition, considerable ad- 93-percent fixed ratio is available to for- years beginning after the date the notice
ministrative difficulties would complicate eign banks, which are defined for this was published.
efforts to identify and recapture prior tax purpose as banks within the meaning of In response to Notice 2005–53, two
benefits that may have resulted from the section 585(a)(2)(B), without regard to the comments were received. One comment
increase in net equity when the fixed ra- second sentence thereof. This definition stated that the proposal to use published
tio was reduced in the 1996 final regula- excludes foreign banking corporations 30-day LIBOR rates would make sense if
tions and to track the deferred component that are not engaged in a banking business it has been difficult for banks to calculate
of the computation through the intervening within the United States. This has the their actual rate of interest and that con-
years up to and including the effective date effect of excluding a foreign corporation sideration might be given to making such
of the new fixed ratio. Further, a special that is engaged in the banking business a rule available for prior years. The other
rule of the type requested is inconsistent outside the United States but terminates comment stated that a small sample of
with the expectation of reduced effectively its U.S. banking licenses and continues to available information suggested that the
connected income through increased inter- engage in a nonregulated trade or business 90-day LIBOR rate rather than the 30-day
est expense allocations that result from the within the United States. rate may be more representative of the
higher ratio. Finally, any branch profits The Treasury Department and the IRS sampled banks and suggested that the IRS
tax consequences of a new fixed-ratio elec- intend that a taxpayer that meets the re- review tax returns with excess interest.
tion may be mitigated by applicable tax quirements of section 581 when consid- IRS experience in actual cases involv-
treaties and by the expanded availability of ered on a worldwide basis should be eli- ing excess interest supports the adoption of
the liability-reduction election under sec- gible to elect the fixed ratio applicable to a 30-day LIBOR rate rather than a 90-day
tion 884, as further discussed in Section 3. banks under §1.882–5 without regard to LIBOR rate. In view of IRS experience
Accordingly, the comment is not adopted. whether it remains engaged in a banking and the absence of contrary data, these
business within the United States. There- temporary regulations allow an annual
Elections fore, a taxpayer that is regulated as a bank binding election to use a published 30-day
in its home country, takes deposits, and average LIBOR rate beginning with the
Taxpayers that currently have elected makes loans as a substantial part of its first tax year in which an original tax re-
the fixed ratio for Step 2 may use the re- business outside the United States will be turn is due (including extensions) after
vised 95-percent ratio for the first tax year eligible to elect the 95-percent fixed ratio. August 17, 2006. Taxpayers may continue
for which the original tax return due date
to use their actual U.S.-dollar borrowing
(including extensions) is after August 17, e. Modifications to step three
rate in lieu of the 30-day LIBOR rate.
2006. Remaining on the fixed ratio does
not constitute the election of a new five- Excess Interest
Relevant excess U.S.-connected liabilities
year minimum period. For example, a tax-
A foreign bank that uses the AUSBL
payer that used the 93-percent fixed ratio These temporary and proposed regu-
method to determine its allocable inter-
for three years preceding the publication of lations provide that the determination of
est expense may be required to allocate
these regulations and used the 95-percent the actual U.S.-dollar borrowing rate ap-
interest expense in addition to its U.S.-
fixed ratio for three more years would be plicable to excess U.S.-connected liabil-
booked interest expense if U.S.-connected
entitled to elect the actual ratio method in ities is made with regard only to U.S.-
liabilities exceed U.S.-booked liabilities.
the following year. dollar liabilities that are booked outside
The 1996 final regulations provide that
Foreign bank taxpayers that currently the United States and that do not con-
the interest rate required to be applied to
use the actual ratio for Step 2 may make stitute U.S.-booked liabilities as defined.
excess U.S.-connected liabilities is gener-
a binding five-year election to use the new The rate applicable to excess U.S.-con-
ally the foreign bank’s average U.S.-dollar
95-percent fixed ratio for the first year this nected liabilities is intended to reflect the
borrowing rate outside the United States.
amendment is effective, on either an orig- rate applicable to relevant borrowings and
This rule was a change from the 1981
inal return or on an amended return filed book interest expense that has not other-
regulations, which had allowed taxpayers
within 180 days of the extended due date. wise been allocated. Because interest with
to use published rates under certain con-
An amended return election may not be respect to U.S.-booked liabilities is alloca-
ditions. Taxpayers have commented in-
made for any year where the extended due ble under Step 3 of the AUSBL method,
formally that using actual non-U.S. dollar
date for a timely filing is after December including such interest expense in the de-
borrowing costs in all circumstances im-
31, 2006. If a fixed-ratio election is not termination of the rate applicable to excess
poses significant administrative burdens.
made for the first year these regulations are U.S.-connected liabilities could distort the
The Treasury Department and the IRS
effective, a taxpayer using the actual ratio calculation.
agree that the use of published data rather
may make the fixed-ratio election in any
than the actual borrowing rate requirement Elections
subsequent year, but only on a timely filed
would simplify administration of the ex-
return.
cess-interest computation both for taxpay- The 30-day LIBOR election may be
ers and for the IRS. Notice 2005–53 an- adopted on a year-to-year basis. For the

2006–39 I.R.B. 521 September 25, 2006


first tax year in which the original tax-re- debt-funded capital) by reducing U.S. lia- 4. Clarifications of 1996 Final
turn due date (including extensions) is af- bilities as of the determination date. The Regulations
ter August 17, 2006 and not later than De- amount of liabilities eligible for reduction
cember 31, 2006, taxpayers may make the under this election is limited to the ex- Questions have arisen regarding the ap-
30-day LIBOR election on an original re- cess of U.S. liabilities (which is generally plication of certain rules contained in the
turn, or on an amended return within 180 based on U.S.-connected liabilities, as de- 1996 final regulations. These temporary
days of the original extended due date. fined under §1.882–5) over U.S.-booked regulations clarify the application of the
For subsequent years, the election must be liabilities (as defined under §1.882–5) as 1996 final regulations with respect to cer-
made on an original tax return timely filed of the determination date. An election tain direct interest allocations, certain re-
(including extensions). The election is to reduce liabilities under §1.884–1 also quirements applicable to elections gener-
made by attaching a statement to the return reduces the interest deduction available ally under §1.882–5, the definition of U.S.-
identifying the three-steps of the AUSBL under §1.882–5. booked liability, and the treatment of cer-
calculation and the published rate used. Taxpayers have expressed uncertainty tain currency gain and loss for purposes of
An election to use a 30-day LIBOR rate is regarding the policy served by setting §1.882–5.
binding for such taxable year and may not U.S.-booked liabilities as a floor for liabil-
a. Direct interest allocations
be changed on an amended return for any ity reduction and have requested greater
year. Accordingly, a taxpayer is bound by latitude to treat earnings as reinvested. The direct interest allocation rules un-
the published rate used on its original re- For example, taxpayers have noted that der §1.882–5 provide generally that a for-
turn. If a taxpayer does not timely file an the amount of U.S.-booked liabilities is eign taxpayer with both a U.S. asset and
income tax return, then the opportunity to not relevant to the §1.882–5 allocation indebtedness that meet the requirements
make a timely 30-day LIBOR election will under the separate currency pools method. of both §1.861–10T(b) and (c) may treat
be forfeited for the tax year. Consistent They have noted also that the amount of the asset and the indebtedness as an inte-
with the general rules for untimely elec- U.S.-booked liabilities taken into account grated financial transaction and so may al-
tions, in such circumstances, the Director under the AUSBL method is an average locate interest expense with respect to the
of Field Operations may require a taxpayer balance for the year that may differ signif- indebtedness directly to income from the
to use the actual U.S.-dollar borrowing rate icantly from a year-end balance. asset. In general, §1.861–10T(b) provides
or apply a published 30-day LIBOR rate The Treasury Department and the IRS rules for certain nonrecourse indebtedness,
for the year. believe that it is desirable to more nearly and §1.861–10T(c) provides rules for cer-
align the branch profits tax treatment of tain integrated financial transactions. Fi-
3. Liability Reduction Election Under distributed earnings with the tax treatment nancial institutions may allocate interest
Branch Profits Tax of a subsidiary’s distributed earnings while directly only to the extent provided by
retaining integration with the interest al- the nonrecourse indebtedness rules. These
In general, the branch profits tax is location rules provided in §1.882–5. In temporary regulations clarify that a finan-
imposed under section 884(a) in addition view of taxpayer comments, these tempo- cial institution is not disqualified from di-
to the corporate income tax under section rary regulations permit a taxpayer to re- rect allocation treatment by satisfying only
882 and applies only to amounts that are duce U.S. liabilities to the extent neces- the rules provided in §1.861–10T(b) with
treated as repatriated from the branch. sary to prevent recognition of a dividend respect to particular nonrecourse indebted-
These amounts are determined by refer- equivalent amount. However, this elec- ness transactions. These temporary regu-
ence to a foreign corporation’s effectively tion may not reduce U.S. liabilities below lations also clarify that direct allocation is
connected earnings and profits for a year zero. The other liability-reduction rules of mandatory for eligible taxpayers if the re-
and accumulated effectively connected §1.884–1(e)(3) continue to apply in their quirements of either §1.861–10T(b) or (c)
earnings and profits, adjusted upward to entirety. An example in the final regula- are satisfied.
reflect decreases in U.S. net equity and tions is amended in the temporary regula-
adjusted downward to reflect increases in tions to reflect the new limitation rule. The b. General election requirements
U.S. net equity. Adjustments to net equity new liability reduction election is effective
generally are made by comparing U.S. net for the first year for which the original tax The 1996 final regulations specify
equity at the end of a taxable year to U.S. return due date (including extensions) is the time, place, and manner for making
net equity at the beginning of a taxable after August 17, 2006. For tax years for elections under each step of the formula.
year. which the first original tax return due date These temporary regulations clarify that a
The branch profits tax rules impute (including extensions) is not later than De- taxpayer eligible to change an election as
equity capital to a branch according to a cember 31, 2006, a liability reduction elec- of right after the minimum five-year pe-
formula that treats a portion of reinvested tion may be made on an amended return riod may do so only on an original timely
amounts as having been funded by in- within 180 days after the original extended filed return. These temporary regulations
debtedness. This generally reduces U.S. due date for filing the original return. also clarify that the election procedures
net equity and so gives rise to a dividend prohibit relief under §301.9100 for future
equivalent amount. Regulations provide elections as well as the elections in the
that a taxpayer may elect to treat reinvested first year a taxpayer is subject to the rules.
earnings as equity capital (rather than as These temporary regulations also clarify

September 25, 2006 522 2006–39 I.R.B.


that after the minimum five-year period, nominated in non-dollar currencies and Therefore, a regulatory assessment is not
a taxpayer may change an election on a uses the proceeds to make interbranch required. It also has been determined that
timely filed return for any subsequent year. loans. Because interbranch transactions section 553(b) of the Administrative Pro-
For example, leaving an election in place generally are not recognized for U.S. tax cedure Act (5 U.S.C. chapter 5) does not
in the sixth year after the election was purposes, the third-party liability is treated apply to these regulations. For applica-
made does not constitute a new election as unhedged. As noted in the pream- bility of the Regulatory Flexibility Act
subject to a new 5-year minimum period. ble to the 1996 final regulations, foreign (5 U.S.C. chapter 6) please refer to the
The general election provision is updated currency gain or loss from an unhedged cross reference notice of proposed rule-
to provide expressly that the elections to liability remains subject to the rules of sec- making published elsewhere in this issue
use the fair market value method elec- tion 988. As a result, the U.S. branch may of the Bulletin. Pursuant to section 7805(f)
tion and the 30-day LIBOR rate election have currency gain or loss with respect to of the Code, this regulation has been sub-
are subject to their own specific period the third-party borrowing but may not be mitted to the Chief Counsel for Advocacy
requirements instead of the five-year min- entitled to recognize currency gain or loss of the Small Business Administration for
imum period. with respect to the offsetting interbranch comment on its impact on small business.
transaction. In addition, any scaling down
c. U.S.-booked liabilities of interest expense that might otherwise be Drafting Information
required under the AUSBL method does
The definition of U.S.-booked liability The principal authors of these
not apply to foreign currency gain or loss.
has changed over time. The 1981 final regulations are Paul S. Epstein and
Some taxpayers have suggested infor-
regulations defined U.S.-booked liabili- Gregory A. Spring of the Office of As-
mally that, despite the absence of a gen-
ties to include only liabilities shown on sociate Chief Counsel (International).
eral tracing principle in the interest allo-
the books and records of the U.S. trade *****
cation rules, currency gain and loss from
or business. This definition excluded as-
such third-party liabilities should be trace-
sets that produced effectively connected Amendments to the Regulations
able to currency gains and losses with re-
income but were booked and maintained
spect to specific interbranch and noneffec-
in a foreign branch. The 1996 final regu- Accordingly, 26 CFR parts 1 and 602
tively connected assets. The Treasury De-
lations modified the definition to include are amended as follows:
partment and the IRS solicit comments re-
generally, for non banks, liabilities that are
garding the allocation, sourcing, and ap- PART 1—INCOME TAXES
recorded reasonably contemporaneously
portionment of currency gain or loss from
with their acquisition on a set of books
unhedged third-party borrowings between Paragraph 1. The authority citation for
that has a direct relationship to an activity
effectively connected and non-effectively part 1 is amended by adding entries in nu-
that gives rise to effectively connected in-
connected income. Comments are specif- merical order to read in part as follows:
come. For banks, liabilities generally must
ically requested regarding the viability of Authority: 26 U.S.C. 7805 * * *
be recorded contemporaneously with their
a tracing principle for this purpose and Section 1.882–5 also issued un-
acquisition. These rules do not require
the extent to which current booking prac- der 26 U.S.C. 882, 26 U.S.C. 864(e),
tracing of specific borrowings to specific
tices may provide an administrable basis 26 U.S.C. 988(d), and 26 U.S.C. 7701(l).
effectively connected uses. Whether there
for such rules in accordance with existing ***
is a direct connection between the liability
authority. Section 1.884–1 is also issued under
and an activity that produces effectively
26 U.S.C. 884. * * *
connected income is determined under all 5. Effective Date Par. 2. Section 1.882–0 is amended by:
the facts and circumstances.
1. Revising the entries for §1.882–
These temporary regulations amend the The temporary regulations are applica-
5(a)(1), (a)(1)(i), (a)(1)(ii), (a)(1)(ii)(A),
definition of U.S.-booked liability and pro- ble for the first tax year end for which
(a)(1)(ii)(B), (a)(2), (a)(7), (a)(7)(i),
vide an example to clarify that in the case the original tax return due date (includ-
(a)(7)(ii), (b)(2)(ii)(A), (b)(3), (c)(2)(iv),
of a bank, the liability must be recorded on ing extensions) is after August 17, 2006.
(c)(4), (d)(2)(iii)(A), and (d)(5)(ii).
a set of books before the end of the day Accordingly, for calendar-year taxpayers,
2. Removing the entry for §1.882–
on which it is incurred, and the liability the applicability date is for the tax year
5(b)(2)(iv).
relates to an activity that produces effec- ended December 31, 2005. The rules pro-
3. Adding entries for §1.882–5T. The
tively connected income. The reasonably vide an additional 180 days to make certain
revisions and additions read as follows:
contemporaneous booking rule is retained one-time special elections on an amended
for non banks and the language clarified return for tax years for which the original §1.882–0 Table of contents.
to reassert that the liability must relate to tax return due date is not later than Decem-
an activity that produces effectively con- ber 31, 2006. *****
nected income.
Special Analyses §1.882–5 Determination of interest
d. Currency gain and loss deduction.
It has been determined that this Treasury
A foreign bank’s U.S. branch com- decision is not a significant regulatory ac- *****
monly books third-party liabilities de- tion as defined in Executive Order 12866. (a)(1) through (a)(2) [Reserved].

2006–39 I.R.B. 523 September 25, 2006


***** Par. 3. Section 1.882–5 is amended by: (1) Overview—(i) In general. The
(a)(7) through (a)(7)(iii) [Reserved]. 1. Revising paragraphs (a)(1) amount of interest expense of a foreign
through (a)(2), (a)(7) through (a)(7)(ii), corporation that is allocable under section
***** (b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4), 882(c) to income which is (or is treated
(b)(2)(ii)(A) [Reserved]. (d)(2)(ii)(A)(2), (d)(2)(ii)(A)(3), as) effectively connected with the conduct
***** (d)(2)(iii)(A), and (d)(5)(ii). of a trade or business within the United
(b)(3) [Reserved]. 2. Removing paragraph (b)(2)(iv). States (ECI) is the sum of the interest al-
3. Adding paragraph (d)(6) Example 5. locable by the foreign corporation under
***** The revisions and additions read as fol- the three-step process set forth in para-
(c)(2)(iv) [Reserved]. lows: graphs (b), (c), and (d) of this section and
the specially allocated interest expense
***** §1.882–5 Determination of interest determined under paragraph (a)(1)(ii) of
(c)(4) [Reserved]. deduction. this section. The provisions of this section
***** provide the exclusive rules for allocating
(a)(1) through (a)(2) [Reserved]. interest expense to the ECI of a foreign
(d)(2)(iii)(A) [Reserved].
For further guidance, see entry in corporation under section 882(c). Un-
***** §1.882–5T(a)(1) through (a)(2). der the three-step process, the total value
(d)(5)(ii) [Reserved]. ***** of the U.S. assets of a foreign corpora-
***** (a)(7)(ii) [Reserved]. For further tion is first determined under paragraph
guidance, see §1.882–5T(a)(7) through (b) of this section (Step 1). Next, the
§1.882–5T Determination of interest (a)(7)(ii). amount of U.S.-connected liabilities is
deduction (temporary). determined under paragraph (c) of this
*****
section (Step 2). Finally, the amount of
(b)(2)(ii)(A) [Reserved]. For further
(a) [Reserved]. interest paid or accrued on U.S.-booked
guidance, see §1.882–5T(b)(2)(ii)(A).
(1) Overview. liabilities, as determined under paragraph
(i) In general. ***** (d)(2) of this section, is adjusted for inter-
(ii) Direct allocations. (b)(3) [Reserved]. For further guid- est expense attributable to the difference
(A) In general. ance, see §1.882–5T(b)(3). between U.S.-connected liabilities and
(B) Partnership interests. ***** U.S.-booked liabilities (Step 3). Alterna-
(2) Coordination with tax treaties. (c)(2)(iv) [Reserved]. For further guid- tively, a foreign corporation may elect to
(3) through (6) [Reserved]. ance, see §1.882–5T(c)(2)(iv). determine its interest rate on U.S.-con-
(7) Elections under §1.882–5. nected liabilities by reference to its U.S.
(i) In general. ***** assets, using the separate currency pools
(ii) Failure to make the proper election. (c)(4) [Reserved]. For further guid- method described in paragraph (e) of this
(iii) Step 2 special election for banks. ance, see §1.882–5T(c)(4). section.
(8) through (b)(2)(ii) [Reserved]. ***** (ii) Direct allocations—(A) In gen-
(A) In general. (d)(2)(ii)(A)(2) through (3) [Re- eral. A foreign corporation that has a
(b)(2)(ii)(B) through (b)(2)(iii)(B) [Re- served]. For further guidance, see U.S. asset and indebtedness that meet the
served]. §1.882–5T(d)(2)(ii)(A)(2) through (3). requirements of §1.861–10T(b) or (c), as
(3) Computation of total value of U.S. limited by §1.861–10T(d)(1), shall di-
*****
assets. rectly allocate interest expense from such
(d)(2)(iii)(A) [Reserved]. For further
(i) General rule. indebtedness to income from such asset
guidance, see §1.882–5T(d)(2)(iii)(A).
(ii) Adjustment to basis of financial in- in the manner and to the extent provided
struments. ***** in §1.861–10T. For purposes of paragraph
(c) through (c)(2)(iii) [Reserved]. (d)(5)(ii) [Reserved]. For further guid- (b)(1) or (c)(2) of this section, a foreign
(iv) Determination of value of world- ance, see §1.882–5T(d)(5)(ii). corporation that allocates its interest ex-
wide assets. ***** pense under the direct allocation rule of
(c)(2)(v) through (c)(3) [Reserved]. (d)(6) Example 5 [Reserved]. For fur- this paragraph (a)(1)(ii)(A) shall reduce
(4) Elective fixed ratio method of deter- ther guidance, see §1.882–5T(d)(6) Exam- the basis of the asset that meets the re-
mining U.S. liabilities. ple 5. quirements of §1.861–10T(b) or (c) by the
(c)(5) through (d)(2)(iii) [Reserved]. Par. 4. Section 1.882–5T is added to principal amount of the indebtedness that
(A) In general. read as follows: meets the requirements of §1.861–10T(b)
(B) through (d)(5)(i) [Reserved]. or (c). The foreign corporation shall also
(ii) Interest rate on excess U.S.-con- §1.882–5T Determination of interest disregard any indebtedness that meets the
nected liabilities. deduction (temporary). requirements of §1.861–10T(b) or (c) in
(A) General rule. determining the amount of the foreign
(B) Annual published rate election. (a) [Reserved]. For further guidance, corporation’s liabilities under paragraphs
(6) through (f)(2) [Reserved]. see §1.882–5(a). (c)(2) and (d)(2) of this section and shall

September 25, 2006 524 2006–39 I.R.B.


not take into account any interest expense tion. An amended return does not qualify conforming election requirements of para-
paid or accrued with respect to such a lia- for this purpose, nor shall the provisions graph (b)(2)(ii)(A)(2) of this section and
bility for purposes of paragraph (d) or (e) of §301.9100–1 of this chapter and any may not be made if a taxpayer elects or
of this section. guidance promulgated thereunder apply. maintains a fair market value election for
(B) Partnership interest. A foreign cor- Except as provided elsewhere in this sec- purposes of §1.882–5(b). Taxpayers that
poration that is a partner in a partnership tion, each election under this section, already use the fixed ratio method under
that has a U.S. asset and indebtedness that whether an election for the first taxable an existing election may continue to use
meet the requirements of §1.861–10T(b) year or a subsequent change of election, the new fixed ratio at the higher percentage
or (c), as limited by §1.861–10T(d)(1), shall be made by the corporation calcu- without having to make a new five-year
shall directly allocate its distributive share lating its interest expense deduction in election in the first year that the higher per-
of interest expense from that indebtedness accordance with the methods elected. An centage is effective.
to its distributive share of income from elected method (other than the fair market (8) through (b)(2)(ii) [Reserved]. For
that asset in the manner and to the extent value method under §1.882–5(b)(2)(ii), or further guidance, see §1.882–5(a)(8)
provided in §1.861–10T. A foreign corpo- the annual 30-day London Interbank Of- through (b)(2)(ii) .
ration that allocates its distributive share fered Rate (LIBOR) election in paragraph (A) In general—(1) Fair market value
of interest expense under the direct allo- (d)(5)(ii) of this section) must be used for conformity requirement. A taxpayer may
cation rule of this paragraph (a)(1)(ii)(B) a minimum period of five years before the elect to value all of its U.S. assets on
shall disregard any partnership indebt- taxpayer may elect a different method. To the basis of fair market value, subject to
edness that meets the requirements of change an election before the end of the the requirements of §1.861–9T(g)(1)(iii),
§1.861–10T(b) or (c) in determining the requisite five-year period, a taxpayer must and provided the taxpayer is eligible
amount of its distributive share of part- obtain the consent of the Commissioner and uses the actual ratio method under
nership liabilities for purposes of para- or his delegate. The Commissioner or §1.882–5(c)(2) and the methodology pre-
graphs (b)(1), (c)(2)(vi), and (d)(2)(vii) his delegate will generally consent to a scribed in §1.861–9T(h). Once elected,
or (e)(1)(ii) of this section, and shall not taxpayer’s request to change its election the fair market value must be used by the
take into account any partnership interest only in rare and unusual circumstances. taxpayer for both Step 1 and Step 2 de-
expense paid or accrued with respect to After the five-year minimum period, an scribed in §§1.882–5(b) and (c), and must
such a liability for purposes of paragraph elected method may be changed for any be used in all subsequent taxable years
(d) or (e) of this section. For purposes of subsequent year on the foreign corpora- unless the Commissioner or his delegate
paragraph (b)(1) of this section, a foreign tion’s original timely filed tax return for consents to a change.
corporation that directly allocates its dis- the first year to which the changed election (2) Conforming election requirement.
tributive share of interest expense under applies. Taxpayers that as of the effective date
this paragraph (a)(1)(ii)(B) shall— (ii) Failure to make the proper election. of this paragraph (b)(2)(ii)(A)(2) have
(1) Reduce the partnership’s basis in If a taxpayer, for any reason, fails to make elected and currently use both the fair
such asset by the amount of such indebt- an election provided in this section in a market value method for purposes of
edness in allocating its basis in the partner- timely fashion, the Director of Field Oper- §1.882–5(b) and a fixed ratio for purposes
ship under §1.884–1(d)(3)(ii); or ations may make any or all of the elections of paragraph (c)(4) of this section must
(2) Reduce the partnership’s income provided in this section on behalf of the conform either the adjusted basis or fair
from such asset by the partnership’s inter- taxpayer, and such elections shall be bind- market value methods in Step 1 and Step
est expense from such indebtedness under ing as if made by the taxpayer. 2 of the allocation formula by making an
§1.884–1(d)(3)(iii). (iii) Step 2 special election for banks. adjusted basis election for §1.882–5(b)
(2) Coordination with tax treaties. Ex- For the first tax year for which an origi- purposes while continuing the fixed ratio
cept as expressly provided by or pursuant nal income tax return is due (including ex- for Step 2, or by making an actual ratio
to a U.S. income tax treaty or accompa- tensions) after August 17, 2006 and not election under §1.882–5(c)(2) while re-
nying documents (such as an exchange later than December 31, 2006, in which maining on the fair market value method
of notes), the provisions of this section a taxpayer that is a bank as described in under §1.882–5(b). Taxpayers who elect
provide the exclusive rules for determin- §1.882–5(c)(4) is subject to the require- to conform Step 1 and Step 2 of the for-
ing the interest expense attributable to the ments of this section, a taxpayer may make mula to the adjusted basis method must
business profits of a permanent establish- a new election to use the fixed ratio on ei- remain on both methods for the minimum
ment under a U.S. income tax treaty. ther an original timely filed return, or on five-year period in accordance with the
(3) through (a)(6) [Reserved]. For fur- an amended return filed within 180 days provisions of paragraph (a)(7) of this sec-
ther guidance, see §1.882–5(a)(3) through after the original due date (including ex- tion. Taxpayers that elect to conform Step
(a)(6). tensions). A new fixed ratio election may 1 and Step 2 of the formula to the fair
(7) Elections under §1.882–5—(i) In be made in any subsequent year subject to market value method must remain on the
general. A corporation must make each the timely filing and five-year minimum actual ratio method until the consent of the
election provided in this section on the period requirements of paragraph (a)(7)(i) Commissioner or his delegate is obtained
corporation’s original timely filed Fed- of this section. A new fixed ratio election to switch to the adjusted basis method. If
eral income tax return for the first taxable under this paragraph (a)(7)(iii) is subject consent to use the adjusted basis method
year it is subject to the rules of this sec- to the adjusted basis or fair market value in Step 1 is granted in a later year, the

2006–39 I.R.B. 525 September 25, 2006


taxpayer must remain on the actual ratio (iv) Determination of value of world- (d)(2)(ii)(B) through (d)(2)(iii) [Re-
method for the minimum five-year period wide assets. The value of an asset must be served]. For further guidance, see
unless consent to use the fixed ratio is determined consistently from year to year §1.882–5(d)(2)(ii)(B) through (d)(2)(iii).
independently obtained under the require- and must be substantially in accordance (A) In general. A liability, whether
ments of paragraph (a)(7) of this section. with U.S. tax principles. To be substan- interest bearing or non-interest bearing,
For the first tax year for which an original tially in accordance with U.S. tax princi- is properly reflected on the books of the
income tax return is due (including exten- ples, the principles used to determine the U.S. trade or business of a foreign corpo-
sions) after August 17, 2006 and not later value of an asset must not differ from U.S. ration that is a bank as described in section
than December 31, 2006, taxpayers that tax principles to a degree that will ma- 585(a)(2)(B) (without regard to the second
are required to make a conforming elec- terially affect the value of the taxpayer’s sentence thereof) if—
tion under this paragraph (b)(2)(ii)(A)(2), worldwide assets or the taxpayer’s actual (1) The bank enters the liability on a
may do so either on a timely filed original ratio. The value of an asset is the adjusted set of books before the close of the day
return or on an amended return within 180 basis of that asset for determining the gain on which the liability is incurred, and the
days after the original due date (including or loss from the sale or other disposition of liability relates to an activity that produces
extensions). If a conforming election is that asset, adjusted in the same manner as ECI; and
not made within the timeframe provided the basis of U.S. assets are adjusted under (2) There is a direct connection or rela-
in this paragraph, the Director of Field paragraphs (b)(2)(ii) through (iv) of this tionship between the liability and that ac-
Operations or his delegate may make the section. The rules of §1.882–5(b)(3)(ii) tivity. Whether there is a direct connection
conforming elections in accordance with apply in determining the total value of between the liability and an activity that
the provisions of paragraph (a)(7)(ii) of applicable worldwide assets for the tax- produces ECI depends on the facts and cir-
this section. able year, except that the minimum num- cumstances of each case. For example, a
(B) through (b)(2)(iii)(B) [Re- ber of determination dates are those stated liability that is used to fund an interbranch
served]. For further guidance, in §1.882–5(c)(2)(i). or other asset that produces non-ECI may
see §1.882–5(b)(2)(ii)(B) through (c)(2)(v) through (c)(3) [Reserved]. For have a direct connection to an ECI pro-
(b)(2)(iii)(B). further guidance, see §1.882–5(c)(2)(v) ducing activity and may constitute a U.S.-
(3) Computation of total value of U.S. through (c)(3). booked liability if both the interbranch or
assets—(i) General rule. The total value (4) Elective fixed ratio method of deter- non-ECI activity is the same type of activ-
of U.S. assets for the taxable year is the mining U.S. liabilities. A taxpayer that is ity in which ECI assets are also reflected
average of the sums of the values (deter- a bank as defined in section 585(a)(2)(B) on the set of books (for example, lending
mined under paragraph (b)(2) of this sec- (without regard to the second sentence or money market interbank placements),
tion) of U.S. assets. For each U.S. asset, thereof or whether any such activities are and such ECI activities are not de minimis.
value shall be computed at the most fre- effectively connected with a trade or busi- Such U.S. booked liabilities may still be
quent regular intervals for which data are ness within the United States) may elect to subject to §1.882–5(d)(2)(v).
reasonably available. In no event shall use a fixed ratio of 95 percent in lieu of the (B) through (d)(5)(i) [Re-
the value of any U.S. asset be computed actual ratio. A taxpayer that is neither a served]. For further guidance, see
less frequently than monthly (beginning of bank nor an insurance company may elect §1.882–5(d)(2)(iii)(B) through (d)(5)(i).
taxable year and monthly thereafter) by a to use a fixed ratio of 50 percent in lieu of (ii) Interest rate on excess U.S.-con-
large bank (as defined in section 585(c)(2)) the actual ratio. nected liabilities—(A) General rule.
or a dealer in securities (within the mean- (5) through (d)(2)(ii)(A)(1) [Reserved]. The applicable interest rate on excess
ing of section 475) and semi-annually (be- For further guidance, see §1.882–5(c)(5) U.S.-connected liabilities is determined by
ginning, middle and end of taxable year) through (d)(2)(ii)(A)(1). dividing the total interest expense paid or
by any other taxpayer. (2) The foreign corporation enters the accrued for the taxable year on U.S.-dol-
(ii) Adjustment to basis of financial in- liability on a set of books reasonably con- lar liabilities that are not U.S.-booked
struments. For purposes of determining temporaneous with the time at which the liabilities (as defined in §1.882–5(d)(2))
the total average value of U.S. assets in liability is incurred and the liability relates and that are shown on the books of the
this paragraph (b)(3), the value of a se- to an activity that produces ECI. offices or branches of the foreign corpo-
curity or contract that is marked to mar- (3) The foreign corporation maintains a ration outside the United States by the
ket pursuant to section 475 or section 1256 set of books and records relating to an ac- average U.S.-dollar denominated liabili-
will be determined as if each determina- tivity that produces ECI and the Director of ties (whether interest-bearing or not) that
tion date is the most frequent regular inter- Field Operations determines that there is a are not U.S.-booked liabilities and that
val for which data are reasonably available direct connection or relationship between are shown on the books of the offices or
that reflects the taxpayer’s consistent busi- the liability and that activity. Whether branches of the foreign corporation out-
ness practices for reflecting mark-to-mar- there is a direct connection between the li- side the United States for the taxable year.
ket valuations on its books and records. ability and an activity that produces ECI (B) Annual published rate election.
(c) through (c)(2)(iii) [Reserved]. For depends on the facts and circumstances of For each taxable year beginning with the
further guidance, see §1.882–5(c) through each case. first year end for which the original tax
(c)(2)(iii). return due date (including extensions) is
after August 17, 2006, in which a tax-

September 25, 2006 526 2006–39 I.R.B.


payer is a bank within the meaning of and non-ECI activities on those two books. The con- (e)(3)(iv) [Reserved]. For further guid-
section 585(a)(2)(B) (without regard to solidated books of State A branch and IBF indicate ance, see entry in §1.884–1T(e)(3)(iv).
the second sentence thereof or whether that a substantial amount of the total book assets

any such activities are effectively con-


constitute U.S. assets under §1.882–5(b). Some of *****
the third-party borrowings on the books of the State (e)(5) Example 2 [Reserved].
nected with a trade or business within the A branch are used to lend directly to Bank A’s home
United States), such taxpayer may elect to office in Country X. These borrowings reflect the
For further guidance, see entry in
compute its excess interest by reference average borrowing rate of the State A branch, IBF §1.884–1T(e)(5) Example 2.
to a published average 30-day London and Country C branches as a whole. All third-party
borrowings reflected on the books of State A branch, *****
Interbank Offering Rate (LIBOR) for the the IBF and Country C branch were recorded on such Par. 6. Section 1.884–1T is added to
year. The election may be made for any books before the close of business on the day the read as follows:
eligible year by attaching a statement to liabilities were acquired by Bank A.
a timely filed tax return (including exten- (ii) U.S. booked liabilities. The facts demonstrate §1.884–1T Branch profits tax (temporary).
sions) that shows the 3-step components of that the separate State A branch, IBF and Country C
branch books taken together, constitute a set of books
the taxpayer’s interest expense allocation within the meaning of (d)(2)(iii)(A)(1) of this sec-
(a) through (e)(3)(i) [Reserved]. For
under the adjusted U.S.-booked liabilities tion. Such set of books as a whole has a direct rela- further guidance, see §1.884–1(a) through
method and identifies the provider (for tionship to an ECI activity under (d)(2)(iii)(A)(2) of (e)(3)(i).
example, International Monetary Fund this section even though the Country C branch books (ii) Limitation. For any taxable year,
statistics) of the 30-day LIBOR rate se- standing alone would not. The third-party liabilities a foreign corporation may elect to reduce
recorded on the books of Country C constitute U.S.
lected. Once selected, the provider and the booked liabilities because they were timely recorded
the amount of its liabilities determined un-
rate may not be changed by the taxpayer. and the overall set of books on which they were re- der paragraph §1.884–1(e)(1) of this sec-
If a taxpayer that is eligible to make the flected has a direct relationship to a bank lending tion by an amount that does not exceed the
30-day LIBOR election either does not and interbank placement ECI producing activity. The lesser of the amount of U.S. liabilities as
file a timely return or files a calculation third-party liabilities that were recorded on the books of the determination date, or the amount of
of State A branch that were used to lend funds to Bank
that allocates interest expense under the A’s home office also constitute U.S. booked liabili-
U.S. liability reduction needed to reduce a
scaling ratio in §1.882–5(d)(4) and it is ties because the interbranch activity the funds were dividend equivalent amount as of the de-
determined by the Director of Field Oper- used for is a lending activity of a type that also gives termination date to zero.
ations that the taxpayer’s U.S.-connected rise to a substantial amount of ECI that is properly (iii) [Reserved]. For further guidance,
liabilities exceed its U.S.-booked liabili- reflected on the same set of books as the interbranch see §1.884–1(e)(3)(iii).
loans. Accordingly, the liabilities are not traced to
ties, then the Director of Field Operations, their specific interbranch use but to the overall activ-
(iv) Method of election. A foreign cor-
and not the taxpayer, may choose whether ity of bank lending and interbank placements which poration that elects the benefits of this
to determine the taxpayer’s excess interest gives rise to substantial ECI. The facts show that the paragraph (e)(3) for a taxable year shall
rate under paragraph (d)(5)(ii)(A) or (B) of liabilities were not acquired to increase artificially the state on its return for the taxable year (or
this section and may select the published interest expense of Bank A’s U.S. booked liabilities as on a statement attached to the return) that
a whole under §1.882–5(d)(2)(v). The third-party lia-
30-day LIBOR rate. For the first taxable bilities also constitute U.S. booked liabilities for pur-
it has elected to reduce its liabilities for the
year for which an original tax return due poses of determining Bank A’s branch interest under taxable year under this paragraph (e)(3)
date (including extensions) is after August §1.884–4(b)(1)(i)(A) regardless of whether Bank A and that it has reduced the amount of its
17, 2006 and not later than December 31, uses the Adjusted U.S. booked liability method, or U.S.-connected liabilities as provided in
2006, an eligible taxpayer may make the the Separate Currency Pool method to allocate its in- §1.884–1(e)(3)(iii), and shall indicate the
terest expense under §1.882–5(e).
30-day LIBOR election one time for the amount of such reductions on the return or
(e) through (f)(2) [Reserved]. For fur-
taxable year on an amended return within attachment. An election under this para-
ther guidance, see §1.882–5(e) through
180 days after the original due date (in- graph (e)(3) must be made before the due
(f)(2).
cluding extensions). date (including extensions) for the foreign
(g) Effective date. (1) This section is
(d)(6) through (d)(6) Example 4 corporation’s income tax return for the
applicable for the first tax year in which
[Reserved]. For further guidance, see taxable year, except that for the first tax
an original tax return due date (including
§1.882–5(d)(6) through (d)(6) Example 4. year for which the original tax return due
Example 5. U.S. booked liabilities— direct rela-
extensions) is after August 17, 2006.
date (including extensions) is after August
tionship. (i) Facts. Bank A, a resident of Country X (2) The applicability of this section ex-
17, 2006 and not later than December 31,
maintains a banking office in the U.S. that records pires on or before August 14, 2009.
transactions on three sets of books for State A, an
2006, an election under this paragraph
Par. 5. Section 1.884–1 is amended
International Banking Facility (IBF) for its bank (e)(3) may be made on an amended return
by revising the entries for paragraphs
regulatory approved international transactions, and a within 180 days after the original due date
shell branch licensed operation in Country C. Bank A
(e)(3)(ii), (e)(3)(iv) and (e)(5) Example 2.
(including extensions).
records substantial ECI assets from its bank lending (v) through (e)(5) Example 1 [Re-
and placement activities and a mix of interbranch §1.884–1 Branch profits tax.
and non-ECI producing assets from the same or
served]. For further guidance, see
similar activities on the books of State A branch ***** §1.884–1(e)(3)(v) through (e)(5) Example
and on its IBF. Bank A’s Country C branch borrows (e)(3)(ii) [Reserved]. For further guid- 1.
substantially from third parties, as well as from its ance, see entry in §1.884–1T(e)(3)(ii). Example 2. Election made to reduce liabilities.
home office, and lends all of its funding to its State A (i) As of the close of 2007, foreign corporation A, a
branch and IBF to fund the mix of ECI, interbranch ***** real estate company, owns U.S. assets with an E&P

2006–39 I.R.B. 527 September 25, 2006


basis of $1000. A has $800 of liabilities under para- tion to reduce its liabilities by $120 to reduce to zero the $60 of ECEP that it earned in 2008 that became
graph (e)(1) of this section. A has accumulated ECEP its ECEP in 2009 and to continue to retain for expan- accumulated ECEP because of an election to reduce
of $500 and in 2008, A has $60 of ECEP that it in- sion (without the payment of the branch profits tax) liabilities.
tends to retain for future expansion of its U.S. trade the $60 of ECEP earned in 2008. Without an election (f) through (j)(2)(ii) [Reserved]. For
or business. A elects under paragraph (e)(3) of this to reduce liabilities, A’s dividend equivalent amount
further guidance, see §1.884–1(f) through
section to reduce its liabilities by $60 from $800 to for 2009 would be $120 ($60 of ECEP plus the $60
$740. As a result of the election, assuming A’s U.S. reduction in U.S. net equity from $260 to $200). If A
(j)(2)(ii).
assets and U.S. liabilities would otherwise have re- makes the election to reduce liabilities by $120 (from
mained constant, A’s U.S. net equity as of the close $800 to $680), A’s U.S. net equity will increase by PART 602—OMB CONTROL
of 1994 will increase by the amount of the decrease $60 (from $260 at the end of the previous year to NUMBER UNDER THE PAPERWORK
in liabilities ($60) from $200 to $260 and its ECEP $320), the amount necessary to reduce its ECEP to $0.
REDUCTION ACT
will be reduced to zero. Under §1.884–1(e)(3)(iii), However, the reduction of liabilities will itself create
A’s interest expense for the taxable year is reduced additional ECEP subject to section 884 because of the
by the amount of interest attributable to $60 of liabil- reduction in interest expense attributable to the $120 Par. 7. The authority citation for part
ities and A’s excess interest is reduced by the same of liabilities. A can make the election to reduce liabil- 602 continues to read as follows:
amount. A’s taxable income and ECEP are increased ities by $120 without exceeding the limitation on the Authority: 26 U.S.C. 7805.
by the amount of the reduction in interest expense at- election provided in paragraph (e)(3)(ii) of this sec-
Par. 8. In §602.101, paragraph
tributable to the liabilities, and A may make an elec- tion because the $120 reduction does not exceed the
tion under paragraph (e)(3) of this section to further amount needed to treat the 2009 and 2008 ECEP as
(b) is amended by adding an entry for
reduce its liabilities, thus increasing its U.S. net eq- reinvested in the net equity of the trade or business “§1.882–5T” to the table to read as fol-
uity and reducing the amount of additional ECEP cre- within the United States. lows:
ated for the election. (iii) If A terminates its U.S. trade or business in
(ii) In 2009, assuming A again has $60 of ECEP, 2009 in accordance with the rules in §1.884–2T(a), A
§601.101 OMB Control numbers.
A may again make the election under paragraph (e)(3) would not be subject to the branch profits tax on the
to reduce its liabilities. However, assuming A’s U.S. $60 of ECEP earned in that year. Under paragraph
assets and liabilities under paragraph (e)(1) of this §1.884–1(e)(3)(v) of this section, however, it would *****
section remain constant, A will need to make an elec- be subject to the branch profits tax on the portion of (b) * * *

CFR part or section where Current OMB


identified and described Control No.
*****
1.882–5T ........................................................... 1545–2030
*****

Mark E. Matthews, Eric Solomon, (Filed by the Office of the Federal Register on August 15,
2006, 8:45 a.m., and published in the issue of the Federal
Deputy Commissioner Acting Deputy Assistant Secretary Register for August 17, 2006, 71 F.R. 47443)
for Services and Enforcement. of the Treasury (Tax Policy).

Approved August 2, 2006.

September 25, 2006 528 2006–39 I.R.B.


Part III. Administrative, Procedural, and Miscellaneous
Extension of Replacement years. Section 1033(e)(2) is effective for (2) Publication of List of Drought
Period for Livestock Sold on any taxable year with respect to which the Counties. Taxpayers can generally deter-
Account of Drought due date (without regard to extensions) for mine on the basis of a visual inspection
a taxpayer’s return is after December 31, of U.S. Drought Monitor maps whether
2002. exceptional, extreme, or severe drought
Notice 2006–82
is reported for all or part of a county. In
SECTION 3. EXTENSION OF some cases, however, on the borders of
SECTION 1. PURPOSE
REPLACEMENT PERIOD FOR a drought zone, it may not be clear on
This notice provides guidance regard- PERSISTENT DROUGHT the basis of a visual inspection whether a
ing the replacement period under § 1033(e) county is within or partly within the zone.
.01 In General. If a sale or exchange
of the Internal Revenue Code for livestock Accordingly, the Internal Revenue Ser-
of livestock is treated as an involun-
sold on account of drought. vice, after consultation with the National
tary conversion on account of drought
Drought Mitigation Center, will publish in
and the taxpayer’s replacement period is
SECTION 2. BACKGROUND September of each year a list of counties
determined under § 1033(e)(2)(A), the
for which exceptional, extreme, or severe
.01 Nonrecognition of Gain on Invol- replacement period will be extended un-
drought was reported during the preceding
untary Conversion of Livestock. Section der § 1033(e)(2)(B) until the end of the
12 months. Taxpayers may use this list
1033(a) generally provides for nonrecog- taxpayer’s first taxable year ending after
instead of U.S. Drought Monitor Maps
nition of gain when property is involun- the first drought-free year for the appli-
to determine whether a 12-month period
tarily converted and replaced with prop- cable region. For this purpose, the first
ending on August 31 of a calendar year
erty that is similar or related in service or drought-free year for the applicable region
includes any period for which exceptional,
use. Section 1033(e)(1) provides that a is the first 12-month period that—
extreme, or severe drought is reported for
sale or exchange of livestock (other than (1) Ends on August 31;
a location in the applicable region.
poultry) held by a taxpayer for draft, breed- (2) Ends in or after the last year of the
ing, or dairy purposes in excess of the num- taxpayer’s 4-year replacement period de- SECTION 4. EXAMPLE
ber that would be sold following the tax- termined under § 1033(e)(2)(A); and
payer’s usual business practices is treated (3) Does not include any weekly period The following example illustrates the
as an involuntary conversion if the live- for which exceptional, extreme, or severe application of the rules in this notice.
stock is sold or exchanged solely on ac- drought is reported for any location in the Drought conditions and designations of
count of drought, flood, or other weather- applicable region. eligibility for federal assistance are de-
related conditions. .02 Applicable Region. The applicable scribed in this example solely for illus-
.02 Replacement Period. Section region with respect to a sale or exchange of trative purposes and are not intended to
1033(a)(2)(A) generally provides that livestock on account of drought conditions reflect actual conditions and designations.
is the county that experienced the drought Example. (i) Taxpayer A, a calendar year tax-
gain from an involuntary conversion is payer, raises cattle in Keith County, Nebraska. In
recognized only to the extent the amount conditions on account of which the live-
2002, all of A’s cattle held for breeding purposes are
realized on the conversion exceeds the stock was sold or exchanged and all coun- sold solely on account of drought conditions in Keith
cost of replacement property purchased ties that are contiguous to that county. County. Under A’s normal business practices, only
during the replacement period. If a sale .03 Exceptional, Extreme, or Severe 25 percent of A’s cattle held for breeding purposes
Drought. (1) U.S. Drought Monitor Maps. would have been sold in 2002. In 2003, the Secre-
or exchange of livestock is treated as an tary of Agriculture designates Keith County as eligi-
involuntary conversion under § 1033(e)(1) A taxpayer may determine whether ex-
ble for federal assistance on account of the drought
and is solely on account of drought, flood, ceptional, extreme, or severe drought is conditions.
or other weather-related conditions that re- reported for any location in the applica- (ii) Under § 1033(e)(1), the sale of 75 percent
sult in the area being designated as eligible ble region by reference to U.S. Drought of the cattle held for breeding purposes is treated as
Monitor maps produced by the National an involuntary conversion. Section 1033(a) provides
for assistance by the federal government, that the gain from this portion of A’s sale is not rec-
§ 1033(e)(2)(A) provides that the replace- Drought Mitigation Center. In determin-
ognized except to the extent it exceeds the cost of
ment period ends four years after the close ing whether a 12-month period ending on replacement property (property that is related in ser-
of the first taxable year in which any part August 31 of a calendar year includes any vice or use) purchased during the replacement period.
of the gain from the conversion is realized. period for which exceptional, extreme, Because the Secretary of Agriculture has designated
or severe drought is reported, all maps Keith County as being eligible for federal assistance
Section 1033(e)(2)(B) provides that the on account of the drought conditions, A’s replace-
Secretary may extend this replacement pe- with dates before September 8 of that
ment period is determined under § 1033(e)(2)(A) and
riod on a regional basis for such additional year and after August 31 of the preced- ends on December 31, 2006.
time as the Secretary determines appro- ing calendar year are taken into account. (iii) Under § 1033(e)(2) and this notice, A’s re-
priate if the weather-related conditions U.S. Drought Monitor maps are archived placement period is extended until the end of A’s
at http://www.drought.unl.edu/dm/ first taxable year ending after the first drought-free
that resulted in the area being designated year for the applicable region. For this purpose, the
as eligible for assistance by the federal archive.html.
applicable region is the county that experienced the
government continue for more than three drought conditions on account of which the livestock

2006–39 I.R.B. 529 September 25, 2006


was sold (Keith County) and all counties contiguous period is extended through December 31, 2008 (the overs allocated to qualified states under
to Keith County (Deuel, Garden, Arthur, McPher- last day of A’s first taxable year ending after the first § 42(h)(3)(D) of the Internal Revenue
son, Lincoln, and Perkins Counties, Nebraska, and drought-free year for the applicable region). Code for calendar year 2006.
Sedgwick County, Colorado). Sedgwick County is
contiguous even though it is in a different state and SECTION 5. EFFECTIVE DATE SECTION 2. BACKGROUND
touches Keith County only at Keith County’s south-
west corner. This notice applies to taxable years end-
(iv) For the 12-month period ending on August Rev. Proc. 92–31, 1992–1 C.B. 775,
ing after September 25, 2006.
31, 2006, severe drought conditions are reported on provides guidance to state housing credit
U.S. Drought Monitor maps for all counties in the ap- agencies of qualified states on the pro-
plicable region, and all of those counties are included
SECTION 6. DRAFTING
INFORMATION cedure for requesting an allocation of
on the list published by the IRS. For the 12-month
period ending on August 31, 2007, the only drought
unused housing credit carryovers under
conditions reported for the applicable region on U.S. The principal author of this notice is § 42(h)(3)(D). Section 4.06 of Rev. Proc.
Drought Monitor maps are severe drought conditions Jeffrey Marshall of the Office of Associate 92–31 provides that the Internal Rev-
for Sedgwick County for the first week in Septem- Chief Counsel (Income Tax and Account- enue Service will publish in the Internal
ber 2006. A is unable to determine from the maps
ing). For further information regarding Revenue Bulletin the amount of unused
whether drought conditions have been reported for
the applicable region, but the list published by the IRS this notice, contact Mr. Marshall at (202) housing credit carryovers allocated to
for the 12-month period ending on August 31, 2007, 622–7287 (not a toll-free call). qualified states for a calendar year from
includes Sedgwick County. For the 12-month period a national pool of unused credit authority
ending August 31, 2008, U.S. Drought Monitor maps (the National Pool). This revenue proce-
do not report drought conditions for any county in 26 CFR 601.105: Examination of returns and claims dure publishes these amounts for calendar
the applicable region and none of the counties are in- for refund, credit, or abatement; determination of
cluded on the list published by the IRS. correct tax liability. year 2006.
(v) Neither the 12-month period ending on Au- (Also Part I, § 42; 1.42–14.)
gust 31, 2006, nor the 12-month period ending on SECTION 3. PROCEDURE
August 31, 2007, is a drought-free year for the ap- Rev. Proc. 2006–38
plicable region because, in each of the 12-month The unused housing credit carryover
periods, severe drought conditions have been re- amount allocated from the National Pool
ported for at least one county in the applicable region
SECTION 1. PURPOSE by the Secretary to each qualified state for
for a part of the 12-month period. Accordingly,
the 12-month period ending on August 31, 2008, is
calendar year 2006 is as follows:
the first drought-free year for the applicable region. This revenue procedure publishes the
Under § 1033(e)(2) and this notice, A’s replacement amounts of unused housing credit carry-

Qualified State Amount Allocated


Alabama $119,717
Arizona 156,003
California 949,059
Connecticut 92,203
Delaware 22,156
Florida 467,274
Georgia 238,303
Illinois 335,247
Indiana 164,742
Kansas 72,093
Kentucky 109,620
Maine 34,711
Maryland 147,102
Massachusetts 168,072
Michigan 265,838
Minnesota 134,820
Missouri 152,353
Nebraska 46,197
New Jersey 228,988
New York 505,748
North Dakota 16,723
Oregon 95,637
Pennsylvania 326,480
Rhode Island 28,268

September 25, 2006 530 2006–39 I.R.B.


Qualified State Amount Allocated
Tennessee 156,625
Texas 600,447
Utah 64,867
Vermont 16,365
Virginia 198,770
Washington 165,156
Wisconsin 145,416

SECTION 4. EFFECTIVE DATE DRAFTING INFORMATION procedure, contact Mr. Wilson at (202)
622–3040 (not a toll-free call).
This revenue procedure is effective The principal author of this revenue
for allocations of housing credit dollar procedure is Christopher J. Wilson of
amounts attributable to the National Pool the Office of Associate Chief Counsel
component of a qualified state’s housing (Passthroughs and Special Industries). For
credit ceiling for calendar year 2006. further information regarding this revenue

2006–39 I.R.B. 531 September 25, 2006


Part IV. Items of General Interest
Notice of Proposed FOR FURTHER INFORMATION final regulations, would replace current
Rulemaking and Notice of CONTACT: Concerning the proposed §§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3
Public Hearing regulations, Kimberly L. Koch, (202) of the Income Tax Regulations. The treat-
622–7739; concerning submission of ment of amounts paid to acquire or create
comments, the hearing, and/or to be intangibles was addressed with the pub-
Guidance Regarding placed on the building access list to at- lication of §§1.263(a)–4 and 1.263(a)–5
Deduction and Capitalization tend the hearing, Richard A. Hurst at in the Federal Register on January 5,
of Expenditures Related to Richard.A.Hurst@irscounsel.treas.gov or 2004 (T.D. 9107, 2004–1 C.B. 447 [69 FR
Tangible Property at (202) 622–7180 (not toll-free numbers). 436]).
Certain sections of the current regula-
REG–168745–03 SUPPLEMENTARY INFORMATION: tions under section 263(a) are proposed
to be removed entirely and are not re-
AGENCY: Internal Revenue Service Background stated in the proposed regulations. Section
(IRS), Treasury. 1.263(a)–1(c) of the current regulations
In recent years, much debate has fo-
lists several Code and regulation sections
ACTION: Notice of proposed rulemaking cused on the extent to which section 263(a)
to which the capitalization provisions do
and notice of public hearing. of the Code requires taxpayers to capital-
not apply. Section 1.263(a)–3 (election to
ize as an improvement amounts paid to re-
SUMMARY: This document contains deduct or capitalize certain expenditures)
store property to its former working con-
proposed regulations that explain how lists several Code sections under which
dition; that is, whether, or the extent to
section 263(a) of the Internal Revenue a taxpayer may elect to treat certain cap-
which, the amounts paid to restore or im-
Code (Code) applies to amounts paid to ital expenditures as either deductible or
prove the property are capital expenditures
acquire, produce, or improve tangible deferred expenses, or to treat deductible
or deductible ordinary and necessary re-
property. The proposed regulations clarify expenses as capital expenditures. These
pair and maintenance expenses. There
and expand the standards in the current two sections have not been carried over
has been controversy, for example, regard-
regulations under section 263(a), as well to the proposed regulations because the
ing what tests to apply for determining
as provide some bright-line tests (for ex- lists of items in these sections are outdated.
capitalization or expensing, how to ap-
ample, a 12-month rule for acquisitions This language is intended to have the same
ply the tests, and the appropriate unit of
and a repair allowance for improvements). general effect as current §§1.263(a)–1(c)
property with respect to which to apply
The proposed regulations will affect all and 1.263(a)–3, without citing to specific
the tests. On January 20, 2004, the IRS
taxpayers that acquire, produce, or im- Code and regulation sections that may
and Treasury Department published No-
prove tangible property. This document have been repealed and without omitting
tice 2004–6, 2004–1 C.B. 308, announc-
also provides a notice of public hearing on specific Code and regulation sections that
ing an intention to propose regulations pro-
the proposed regulations. may have been added.
viding guidance in this area. The notice
Certain portions of §1.263(a)–2 of the
identified issues under consideration by
DATES: Written or electronic comments current regulations (examples of capital
the IRS and Treasury Department and in-
must be received by November 20, 2006. expenditures) also are not restated in the
vited public comment on whether these or
Requests to speak and outlines of topics to proposed regulations, or are incorporated
other issues should be addressed in the reg-
be discussed at the public hearing sched- into other sections of the proposed regu-
ulations and, if so, what specific rules and
uled for Tuesday, December 19, 2006, at lations. Section 1.263(a)–2(a) of the cur-
principles should be provided. To respond
10:00 a.m., must be received by Novem- rent regulations (the cost of acquisition of
to various comments and provide a more
ber 28, 2006. property with a useful life substantially be-
comprehensive set of rules regarding tan-
yond the taxable year) is incorporated into
gible property, the proposed regulations in-
ADDRESSES: Send submissions to: and expanded upon in §1.263(a)–2 of the
clude the treatment of amounts paid to ac-
CC:PA:LPD:PR (REG–168745–03), proposed regulations (amounts paid to ac-
quire or produce tangible property.
room 5203, Internal Revenue Ser- quire or produce tangible property). Sec-
vice, POB 7604, Ben Franklin Sta- Explanation of Provisions tion 1.263(a)–2(b) of the current regula-
tion, Washington, DC 20044. Alter- tions (amounts expended for securing a
natively, comments may be sent elec- I. Introduction copyright and plates) is proposed to be
tronically, via the IRS Internet site at removed because these amounts are now
www.irs.gov/regs or via the Federal eRule- The proposed regulations under section addressed by §1.263(a)–4(d)(5) and sec-
making Portal at www.regulations.gov 263(a) of the Code set forth the general tion 263A. The rules in §1.263(a)–2(c) of
(IRS–REG–168745–03). The public hear- statutory principles of capitalization and the current regulations (the cost of defend-
ing will be held in the auditorium of the provide that capital expenditures generally ing or perfecting title to property) are ad-
New Carrollton Federal Building, 5000 include amounts paid to sell, acquire, pro- dressed in §1.263(a)–4(d)(9) of the current
Ellin Road, Lanham, MD 20706 at 10:00 duce, or improve tangible property. The regulations with regard to intangibles and
a.m. proposed regulations, if promulgated as

September 25, 2006 532 2006–39 I.R.B.


in §1.263(a)–2(d)(2) of the proposed reg- II. General Principle of Capitalization maintenance to tangible property are de-
ulations with regard to tangible property. ductible if the amounts paid are not re-
Section 1.263(a)–2(d) of the current regu- A. Overview quired to be capitalized under §1.263(a)–3
lations (amounts expended for architect’s of the proposed regulations. The proposed
The proposed regulations require capi-
services) is proposed to be removed be- regulations, however, do not amend or re-
talization of amounts paid to acquire, pro-
cause those amounts are now included in move any other provisions of the current
duce, or improve tangible real and personal
section 263A. The rules in §1.263(a)–2(f) regulations under section 162(a), includ-
property, including amounts paid to facil-
and (g) of the current regulations (relating ing §§1.162–6 (regarding professional ex-
itate the acquisition of tangible property.
to certain capital contributions) essentially penses) and 1.162–12 (regarding certain
The proposed regulations do not address
are restated in §1.263(a)–1(b) of the pro- expenses of farmers). Section 1.162–6
amounts paid to facilitate an acquisition of
posed regulations. Finally, §1.263(a)–2(h) permits a deduction for amounts paid for
a trade or business because those amounts
of the current regulations (the cost of good- books, furniture, and professional instru-
are addressed in §1.263(a)–5 of the current
will in connection with the acquisition of ments and equipment, the useful life of
regulations.
the assets of a going concern) is proposed which is short, while §1.162–12 permits a
The proposed regulations clarify that
to be removed because this cost is now ad- deduction for the cost of ordinary tools of
they do not change the treatment of any
dressed by §1.263(a)–4(c)(1)(x). short life or small cost. The rules in cur-
amount that is specifically provided for
Taking into account the provisions that rent §§1.162–6 and 1.162–12 are consis-
under any provision of the Code or regula-
are proposed to be removed and other tent with the rules in the proposed regula-
tions other than section 162(a) or section
modifications to the current regulations tions and are not revised.
212 and the regulations under those sec-
noted above, the remaining guidance in
tions. This rule applies regardless of B. Amounts paid to sell property
the current regulations is contained in
whether that specific provision is more
§1.263(a)–1(a) and (b) of the proposed
or less favorable to the taxpayer than The proposed regulations provide that,
regulations. Section 1.263(a)–1(a) of the
the treatment in the proposed regula- except in the case of dealers in property,
current regulations restates the statutory
tions. Thus, where another section of the commissions and other transaction costs
rules from section 263(a), which are car-
Code or regulations prescribes a specific paid to facilitate the sale of property gen-
ried over in §1.263(a)–1(a) of the proposed
treatment of an amount, the provisions erally must be capitalized and treated as a
regulations. The rules in §1.263(a)–1(b)
of that section apply and not the rules reduction in the amount realized. Dealers
of the current regulations address amounts
contained in the proposed regulations. in property include taxpayers that main-
paid to add to the value, or substantially
This rule is the same as that contained tain and sell inventories and taxpayers that
prolong the useful life, of property owned
in §§1.263(a)–4(b)(4) and 1.263(a)–5(j) produce property for sale in the ordinary
by the taxpayer, and amounts paid to adapt
of the current regulations. The proposed course of business, for example, the home
property to a new or different use. They
regulations, for example, do not preclude construction business. The language in
also address the treatment of those cap-
taxpayers from deducting the cost of cer- this section is slightly broader than the
italized expenditures, for example, as a
tain depreciable business assets under sec- current language of §1.263(a)–2(e), which
charge to capital account or basis. These
tion 179. On the other hand, the proposed refers only to commissions paid in sell-
rules are incorporated into and expanded
regulations do not exempt taxpayers from ing securities. However, the language in
upon in §1.263(a)–3 of the proposed reg-
applying the uniform capitalization rules the proposed regulations is consistent with
ulations. The proposed regulations also
under section 263A when applicable, nor case law that generally treats all trans-
revise §1.162–4 of the current regulations
do they exempt taxpayers from complying action costs paid in connection with the
(allowing a deduction for the cost of inci-
with the timing rules regarding incurring sale of any property as capitalized and
dental repairs) to provide rules consistent
a liability under section 461 (including offset against the amount realized. See,
with §1.263(a)–3 of the proposed regula-
economic performance). Wilson v. Commissioner, 49 T.C. 406, 414
tions (requiring capitalization of amounts
The rule clarifying that the proposed (1968); rev’d on other grounds, 412 F.2d
paid to improve property).
regulations do not change the treatment of 314 (6th Cir. 1969) (“The rule is thor-
The proposed regulations do not ad-
any other amount that is specifically pro- oughly engrained that commissions and
dress amounts paid to acquire or cre-
vided for under any other provision of the similar charges must be treated as capi-
ate intangible interests in land, such as
Code or regulations provides an excep- tal expenditures which reduce the selling
easements, life estates, mineral interests,
tion for the treatment of any amount that price when gain or loss is computed on
timber rights, zoning variances, or other
is specifically provided for under section the transaction”); Frick v. Commissioner,
intangible interests in land. The IRS and
162(a) or section 212 or the regulations T.C. Memo 1983–733, aff’d without opin-
Treasury Department request comments
under those sections. Thus, the proposed ion, 774 F.2d 1168 (7th Cir. 1985) (“Fees
on whether these and similar amounts, or
regulations override any conflicting pro- paid in connection with the disposition of
certain of these amounts, should be ad-
visions in the regulations under sections real property are capital expenditures and
dressed in the final regulations and, if so,
162(a) and 212. For this reason, the pro- are deductible from the selling price in de-
what rules should be provided. The pro-
posed regulations amend the current rule termining gain or loss on the ultimate dis-
posed regulations also do not address the
for deductible repairs under §1.162–4 to position”); Hindes v. United States, 246
treatment of software development costs.
provide that amounts paid for repairs and F. Supp. 147, 150 (W.D. Tex. 1965); affd.

2006–39 I.R.B. 533 September 25, 2006


in part, revd. in part on other grounds, Therefore, §1.263(a)–2 of the proposed ulations at §1.263(a)–2(c) and parallels the
371 F.2d 650 (5th Cir. 1967) (“Fees and regulations also requires capitalization of rule in §1.263(a)–4(d)(9) with regard to in-
expenses paid in connection with the ac- amounts paid to acquire real or personal tangible property. The proposed regula-
quisition or disposition of property, real property for resale and to produce real or tions also require capitalization of amounts
or personal, are capital expenditures, and, personal property for sale. paid to facilitate the acquisition of real or
in the case of a taxpayer not engaged in The proposed regulations provide that personal property. The IRS and Treasury
the business of buying and selling real es- the terms amounts paid and payment Department request comments on whether
tate, are deductible from the selling price mean, in the case of a taxpayer using any specific guidance is needed with re-
in determining gain or loss on the ulti- an accrual method of accounting, a li- gard to employee compensation and over-
mate disposition”). The sales cost rule in ability incurred (within the meaning of head costs that facilitate the acquisition of
the proposed regulations, however, applies §1.446–1(c)(1)(ii)). The definitions of tangible property and, if so, what that guid-
only to transaction costs and does not in- real and tangible personal property are ance should provide. The proposed reg-
clude other amounts that might be paid intended to be the same as the defini- ulations do not address transaction costs
for the purpose of selling property, such tions used for depreciation purposes as related to the production or improvement
as amounts paid to repair or improve the derived from the language in the regula- of tangible property because those costs
property in preparation for a sale. The tions at §1.48–1. Thus, for purposes of the are subject to capitalization under section
treatment of those amounts is governed by proposed regulations, tangible personal 263A.
the general rules under §1.263(a)–3 of the property means any tangible property
proposed regulations relating to improve- except land and improvements thereto, B. Materials and supplies
ments. such as buildings or other inherently per-
As noted in section II.A. above, the
manent structures (including items that
proposed regulations generally do not
III. Amounts Paid to Acquire or Produce are structural components of buildings or
change the treatment of any amount that is
Tangible Property structures). See, Whiteco Indus., Inc. v.
specifically provided for under any provi-
Commissioner, 65 T.C. 664 (1975) (ap-
sion of the Code or regulations other than
A. In general plying six factors in determining whether
section 162(a) or section 212 and the reg-
property is an inherently permanent struc-
ulations under those sections. However,
The current regulations under section ture). Under the proposed regulations,
with regard to section 162(a), the pro-
263(a) require capitalization of amounts the definitions of building and structural
posed regulations provide an exception for
paid for the acquisition, construction, components are the definitions provided
amounts paid for materials and supplies
or erection of buildings, machinery and in §1.48–1(e). The IRS and Treasury De-
that are properly treated as deductions or
equipment, furniture and fixtures, and partment considered other definitions of
deferred expenses, as appropriate, under
similar property having a useful life sub- real and tangible personal property, in-
§1.162–3. Thus, the proposed regulations
stantially beyond the taxable year. See cluding the definitions in the regulations
do not change the treatment of materials
§1.263(a)–2(a) of the current regulations. under section 263A(f), but believe that the
and supplies under §1.162–3, including
The proposed regulations are consistent definitions used for depreciation purposes
property that is treated as a material and
with this rule, but treat amounts paid to are the definitions most consistent with
supply that is not incidental under Rev.
construct or erect property as production the purposes of the proposed regulations.
Proc. 2002–28, 2002–1 C.B. 815 (regard-
costs. Specifically, the proposed regu- The definition of produce in
ing the use of the cash method by certain
lations require capitalization of amounts §1.263(a)–2(b)(4) of the proposed reg-
qualifying small business taxpayers), Rev.
paid for property having a useful life sub- ulations is intended to be the same as
Proc. 2002–12, 2002–1 C.B. 374 (regard-
stantially beyond the taxable year, includ- the definition used for purposes of sec-
ing smallwares), and Rev. Proc. 2001–10,
ing land and land improvements, build- tion 263A(g)(1) and §1.263A–2(a)(1)(i),
2001–1 C.B 272 (regarding inventory of
ings, machinery and equipment, and fur- except that improvements are separately
certain qualifying taxpayers).
niture and fixtures, and a unit of property defined in §1.263(a)–3 of the proposed
(as determined under §1.263(a)–3(d)(2)), regulations. The costs that are required C. 12-month rule
having a useful life substantially beyond to be capitalized to property produced
the taxable year. See §1.263(a)–2(d) of the or to any improvement are the costs that The current regulations under sec-
proposed regulations. Thus, §1.263(a)–2 must be capitalized under section 263A. tions 263(a), 446, and 461 require tax-
of the proposed regulations requires cap- Thus, for example, all direct materials payers to capitalize amounts paid to ac-
italization of amounts paid for property and direct labor, and all indirect costs that quire property having a useful life sub-
that is not itself a unit of property, such directly benefit or are incurred by reason stantially beyond the taxable year. See
as property (not treated as a material or of production/improvement activities are §§1.263(a)–2(a), 1.446–1(c)(1)(ii), and
supply under §1.162–3) that is intended required to be capitalized to the property 1.461–1(a)(2)(i) of the current regulations.
to be used as a component in the repair being produced or improved. Section 1.263(a)–2(d) of the proposed reg-
or improvement of a unit of property. The proposed regulations require tax- ulations retains this general rule. Some
Additionally, the current regulations at payers to capitalize an amount paid to de- courts have adopted a 12-month rule for
§1.263(a)–1(b) list inventory costs as cap- fend or perfect title to tangible property. determining whether property has a use-
ital expenditures under §1.263(a)–1(a). This rule is consistent with the current reg- ful life substantially beyond the taxable

September 25, 2006 534 2006–39 I.R.B.


year. See Mennuto v. Commissioner, 56 ity generally is not incurred until the tax- The IRS and Treasury Department rec-
T.C. 910 (1971), acq. (1973–2 C.B. 2); able year in which all the events have oc- ognize that for regulatory or financial ac-
Zelco, Inc. v. Commissioner, 331 F.2d 418 curred that establish the fact of the liabil- counting purposes, taxpayers often have a
(1st Cir. 1964); International Shoe Co. ity, the amount of the liability can be deter- policy for deducting an amount paid below
v. Commissioner, 38 B.T.A. 81 (1938). mined with reasonable accuracy, and eco- a certain dollar threshold for the acquisi-
Under the 12-month rule adopted by some nomic performance has occurred with re- tion of tangible property (de minimis rule).
courts, a taxpayer may deduct currently spect to the liability. Thus, the 12-month For Federal income tax purposes, the tax-
an amount paid for a benefit or paid for rule provided by the proposed regulations payer generally would be required to capi-
property having a useful life that does does not permit an accrual method tax- talize the amount paid if the property has a
not extend beyond one year. This rule payer to deduct an amount paid for tan- useful life substantially beyond the taxable
was adopted in the regulations relating gible property if the amount has not been year. However, in this context some courts
to intangibles. See §1.263(a)–4(f). The incurred under section 461 (for example, have permitted the use of a de minimis
proposed regulations provide a similar if the taxpayer does not have a fixed lia- rule for Federal income tax purposes. See
12-month rule for amounts paid to acquire bility to acquire the property). The pro- Union Pacific R.R. Co. v. United States,
or produce certain tangible property. posed regulations contain examples illus- 524 F.2d 1343 (Ct. Cl. 1975) (permitting
The proposed regulations generally trating the interaction of the 12-month rule the use of the taxpayer’s $500 de minimis
provide that an amount (including trans- with section 461. rule, which was in accordance with the
action costs) paid for the acquisition or The proposed regulations provide that, Interstate Commerce Commission (ICC)
production of a unit of property with an upon a sale or other disposition, property to minimum rule and generally accepted ac-
economic useful life of 12 months or less which a taxpayer applies the 12-month rule counting principles); Cincinnati, N.O. &
is not a capital expenditure. The unit of is not treated as a capital asset under sec- Tex. Pac. Ry. v. United States, 424
property and economic useful life determi- tion 1221 or as property used in the trade F.2d 563 (Ct. Cl. 1970) (same). But
nations are made under the rules described or business under section 1231. Thus, see Alacare Home Health Services, Inc. v.
in §1.263(a)–3 for improved property. 12-month property is not of a character Commissioner, T.C. Memo 2001–149 (dis-
The 12-month rule generally applies un- subject to depreciation and any amount re- allowing the taxpayer’s use of a $500 de
less the taxpayer elects not to apply the alized upon disposition of 12-month prop- minimis rule because it distorted income).
12-month rule, which election may be erty is ordinary income to the taxpayer. The proposed regulations do not in-
made with regard to each unit of property The IRS and Treasury Department do clude a de minimis rule for acquisition
that the taxpayer acquires or produces. An not believe that it is appropriate to apply costs. However, the IRS and Treasury
election not to apply the 12-month rule the 12-month rule to certain types of prop- Department recognize that taxpayers often
may not be revoked. Taxpayers that have erty. Thus, the proposed regulations pro- reach an agreement with IRS examining
elected to use the original tire capitaliza- vide that the 12-month rule does not apply agents that, as an administrative matter,
tion method of accounting for the cost of to property that is or will be included in based on risk analysis and/or materiality,
certain tires under Rev. Proc. 2002–27, property produced for sale or property ac- the IRS examining agents do not select
2002–1 C.B. 802, must use that method quired for resale, improvements to a unit certain items for review such as the ac-
for the original and replacement tires of of property, land, or a component of a unit quisition of tangible assets with a small
all their qualifying vehicles. See section of property. cost. This often is referred to by taxpayers
5.01 of Rev. Proc. 2002–27. Therefore, and IRS examining agents as a de minimis
taxpayers that use that method cannot use D. De minimis rule rule. The absence of a de minimis rule in
the 12-month rule provided under the pro- the proposed regulations is not intended to
In Notice 2004–6, the IRS and Trea-
posed regulations to deduct amounts paid change this practice.
sury Department requested comments on
to acquire original or replacement tires. The IRS and Treasury Department con-
whether the regulations should provide
The proposed regulations clarify the in- sidered including a de minimis rule in the
a de minimis rule. Because the notice
teraction of the 12-month rule with the tim- proposed regulations. The de minimis rule
refers to the application of section 263(a)
ing rules contained in section 461 of the considered would have provided that tax-
to amounts paid to repair, improve, or
Code. Nothing in the proposed regula- payers are not required to capitalize cer-
rehabilitate tangible property, most com-
tions is intended to change the application tain de minimis amounts paid for the acqui-
mentators focused on a de minimis rule
of section 461, including the application sition or production of a unit of property.
for the cost of repairs rather than the cost
of the economic performance rules in sec- Under the rule considered, if a taxpayer
to acquire property. However, one com-
tion 461(h). This coordination rule is the had written accounting procedures in place
mentator requested that the regulations
same as that provided in the regulations treating as an expense on its applicable fi-
specifically provide a de minimis rule for
under section 263(a) relating to intangi- nancial statement (AFS) amounts paid for
acquisition costs, but allow taxpayers to
bles. See §1.263(a)–4(f). In the case of property costing less than a certain dollar
continue to use their current method if
a taxpayer using an accrual method of ac- amount, and treated the amounts paid dur-
they have reached a working agreement
counting, section 461 requires that an item ing the taxable year as an expense on its
with their IRS examining agent regarding
be incurred before it is taken into account AFS in accordance with those written ac-
a de minimis rule.
through capitalization or deduction. For counting procedures, the taxpayer would
example, under §1.461–1(a)(2), a liabil- not have been required to capitalize those

2006–39 I.R.B. 535 September 25, 2006


amounts if they did not exceed a certain aggregate of amounts paid for the acquisi- determined whether the amount paid for
dollar threshold. A taxpayer that did not tion or production (including any amounts the component property is required to be
meet these criteria (for example, a taxpayer paid to facilitate the acquisition or produc- capitalized under section 263A as an indi-
that did not have an AFS) would not have tion) of a unit of property and including rect cost that directly benefits or is incurred
been required to capitalize amounts paid amounts paid for improvements prior to by reason of property produced or acquired
for a unit of property that did not exceed the unit of property being placed in service. for resale. The proposed regulations illus-
the established dollar threshold. Because If a de minimis rule should be provided in trate this concept in an example of a man-
taxpayers without an AFS generally are the final regulations, the IRS and Treasury ufacturer that replaces one window in a
smaller than taxpayers with an AFS, the Department request comments on what, if building. The taxpayer initially must cap-
dollar threshold for the de minimis rule that any, type of rule should be provided to pre- italize under §1.263(a)–2(d) amounts paid
would have applied to them would have vent a distortion of income when taxpay- to acquire the window. The replacement
been lower than the threshold for taxpay- ers acquire a large number of assets, each of the window subsequently is determined
ers with an AFS (although the de minimis of which individually is within the de min- to be a repair to the building rather than
rule for taxpayers with an AFS also would imis rule (for example, the purchase by a an improvement. Amounts paid for the re-
have been limited to the amount treated as taxpayer of 2,000 personal computers). pair (or an allocable portion thereof) must
an expense on their AFS). The de minimis If a de minimis rule for acquisition costs then be capitalized under section 263A to
rule considered by the IRS and Treasury should be provided in the final regulations, the inventory that the taxpayer produces to
Department would not have applied to in- the IRS and Treasury Department request the extent that the repair directly benefits
ventory property, improvements, land, or a comments on whether the rule should per- or is incurred by reason of the taxpayer’s
component of a unit of property. mit IRS examining agents and taxpayers production activities.
The de minimis rule considered also to agree to the use of higher de minimis
would have provided that property to thresholds on the basis of materiality and IV. Amounts Paid to Improve Tangible
which a taxpayer applies the de minimis risk analysis and, if so, under what circum- Property
rule is treated upon sale or disposition stances a higher threshold should be al-
similar to section 179 property. Thus, de lowed. The IRS and Treasury Department A. In general
minimis property would have been prop- also request comments on whether, if a de
In response to Notice 2004–6, the IRS
erty of a character subject to depreciation minimis rule should be provided in the fi-
and Treasury Department received several
and amounts paid that were not capital- nal regulations, changes to begin using a de
comments on the issues that should be ad-
ized under the de minimis rule would have minimis rule or changes to a higher dollar
dressed in the proposed regulations to pro-
been treated as amortization subject to amount within a de minimis rule should be
vide guidance on amounts paid to repair,
recapture under section 1245. Thus, gain treated as changes in a method of account-
improve, and rehabilitate tangible prop-
on disposition of the property would have ing.
erty. These comments have been taken
been ordinary income to the taxpayer to
into account in drafting §1.263(a)–3 of the
the extent of the amount treated as amorti- E. Recovery of costs when property is
proposed regulations. That section ad-
zation for purposes of section 1245. used in a repair
dresses amounts paid to improve tangible
The IRS and Treasury Department de-
property and includes the following pro-
cided to not include a de minimis rule As noted in section III.A. of this pre-
visions: (1) rules for determining the ap-
in the proposed regulations but instead amble, §1.263(a)–2 of the proposed regu-
propriate unit of property to which the im-
to request comments on whether such a lations generally requires capitalization of
provement provisions apply; (2) general
rule should be included in the final regu- amounts paid for the acquisition or produc-
rules for improvements; (3) rules for de-
lations or whether to continue to rely on tion of property having a useful life sub-
termining whether an amount paid mate-
the current administrative practice of IRS stantially beyond the taxable year. Thus,
rially increases the value of the unit of
examining agents. Therefore, the IRS and §1.263(a)–2(d) of the proposed regulations
property; (4) rules for determining whether
Treasury Department request comments applies to property that is not itself a unit
an amount paid restores the unit of prop-
on whether a de minimis rule for acquisi- of property, such as property (not treated
erty; and (5) an optional repair allowance
tion costs should be included in the final as a material or supply under §1.162–3)
method.
regulations, and, if so, whether the de that is intended to be used as a component
minimis rule should be the rule described in the repair or improvement of a unit of B. Unit of property rules
above and what dollar thresholds are ap- property. It must be determined whether
propriate. the subsequent use of the component prop- 1. In general
The IRS and Treasury Department also erty results in an improvement to the unit
request comments on the scope of costs of property under §1.263(a)–3 or an oth- A threshold issue in applying the im-
that should be included in a de minimis erwise deductible repair or maintenance provement rules under §1.263(a)–3 of the
rule if one is provided in the final regula- cost under §1.162–4. Even if the subse- proposed regulations is determining the
tions and on the character of de minimis quent use of the component is an otherwise appropriate unit of property to which the
rule property. For example, the de min- deductible expense under §1.162–4, the rules should be applied. For example, to
imis rule considered by the IRS and Trea- amount paid nonetheless may be required determine whether an amount paid ma-
sury Department would have applied to the to be capitalized. For example, it must be terially increases the value of property, it

September 25, 2006 536 2006–39 I.R.B.


is necessary to know what property is at visits (ESVs) must be treated as capital However, the IRS and Treasury Depart-
issue. The smaller the unit of property, expenditures. Relying on the opinions in ment determined that some factors were
the more likely it is that amounts paid Ingram and Smith, the court concluded that not relevant for certain types of property.
in connection with that unit of property the following four factors were relevant in For example, the factors listed in Notice
will materially increase the value of, or determining the appropriate unit of prop- 2004–6 primarily derive from case law
restore, the property. Taxpayers and the erty: (1) whether the taxpayer and the in- that addresses tangible personal property;
IRS frequently disagree on the unit of dustry treat the component part as a part therefore, the factors were not as help-
property to which the capitalization rules of a larger unit of property for regulatory, ful in determining the appropriate unit of
should be applied. Thus, the unit of prop- market, management, or accounting pur- property for real property, such as land.
erty rules in the proposed regulations are poses; (2) whether the economic useful life Further, some types of property lend them-
intended to provide guidance in deter- of the component part is coextensive with selves to specific unit of property rules,
mining whether an amount paid improves the economic useful life of the larger unit such as buildings and property owned by
the unit of property under §1.263(a)–3. of property; (3) whether the larger unit of taxpayers in a regulated industry. The
The unit of property rules also apply for property and the smaller unit of property IRS and Treasury Department believe
purposes of §1.263(a)–1 of the proposed can function without each other; and (4) that the administrative burden associated
regulations (which references the rules in whether the component part can be and is with determining the appropriate unit of
§§1.263(a)–2 and 1.263(a)–3 of the pro- maintained while affixed to the larger unit property can be reduced for both the IRS
posed regulations) and §1.263(a)–2 of the of property. Applying these factors to air- and taxpayers by identifying specific rules
proposed regulations (for example, with craft engines, the court concluded that the reflecting an approach appropriate for
regard to the 12-month rule). The unit engines should not be considered a unit of the taxpayer’s industry and the type of
of property rules in the proposed regula- property separate and apart from the air- property at issue. Therefore, the proposed
tions apply only for purposes of section plane. regulations provide different unit of prop-
263(a) and §§1.263(a)–1, 1.263(a)–2, and In Notice 2004–6, the IRS and Trea- erty rules for four categories of property,
1.263(a)–3 of the proposed regulations, sury Department requested comments on rather than prescribing one rule for all
and not any other Code or regulation sec- the relevance of various unit of property types of property.
tion. For example, no inference is intended factors derived from FedEx and other cases The unit of property rules in the pro-
that these unit of property rules have any that addressed the unit of property issue. posed regulations apply to all real and
application for section 263A(f) interest The factors listed in Notice 2004–6 in- personal property other than network
capitalization purposes. cluded: (1) whether the property is man- assets. For purposes of the unit of prop-
The current regulations under section ufactured, marketed, or purchased sepa- erty rules, network assets means railroad
263(a) do not provide any guidance on de- rately; (2) whether the property is treated track, oil and gas pipelines, water and
termining the appropriate unit of property. as a separate unit by a regulatory agency, sewage pipelines, power transmission
Some courts have addressed the unit of in industry practice, or by the taxpayer and distribution lines, and telephone and
property issue under section 263(a), but in its books and records; (3) whether the cable lines that are owned or leased by
their holdings are based on the particu- property is designed to be easily removed taxpayers in each of those respective in-
lar facts of each case and do not contain from a larger assembly, is regularly or pe- dustries. Network assets include, for
rules that are generally applicable for pur- riodically replaced, or is one of a fungi- example, trunk and feeder lines, pole
poses of section 263(a). See, FedEx Corp. ble set of interchangeable or rotable assets; lines, and buried conduit. They do not
v. United States, 291 F. Supp. 2d 699 (4) whether the property must be removed include property that would be included as
(W.D. Tenn. 2003), aff’d, 412 F.3d 617 from a larger assembly to be fixed or im- a structural component of a building un-
(6th Cir. 2005) (concluding that an aircraft, proved; (5) whether the property has a dif- der §1.263(a)–3(d)(2)(iv) of the proposed
and not the aircraft engine, was the appro- ferent economic life than the larger assem- regulations, nor do they include separate
priate unit of property); Smith v. Commis- bly; (6) whether the property is subject to property that is adjacent to, but not part of
sioner, 300 F.3d 1023 (9th Cir. 2002) (con- a separate warranty; (7) whether the prop- a network asset, such as bridges, culverts,
cluding that an aluminum reduction cell, erty serves a discrete purpose or functions or tunnels. The proposed regulations do
rather than entire cell line, was the ap- independently from a larger assembly; or not affect current guidance that addresses
propriate unit of property); Ingram Indus- (8) whether the property serves a dual pur- the unit of property or capitalization rules
tries, Inc. v. Commissioner, T.C. Memo pose function. for network assets, such as Rev. Proc.
2000–323 (concluding that a towboat, and The IRS and Treasury Department 2001–46, 2001–2 C.B. 263 (track main-
not the towboat engine, was the appropri- received nine comments on the unit of tenance allowance method for Class I
ate unit of property); LaSalle Trucking Co. property issue, four of which specifically railroads); Rev. Proc. 2002–65, 2002–2
v. Commissioner, T.C. Memo 1963–274 recommended that the proposed regula- C.B. 700 (track maintenance allowance
(concluding that truck engines, tanks, and tions adopt the factors used by the court method for Class II and III railroads); and
cabs were each separate units of property). in FedEx. These factors essentially are Rev. Proc. 2003–63, 2003–2 C.B. 304
In FedEx, the court ruled on whether contained in factors 1, 2, 4, 5, and 7 of (safe harbor unit of property rule for ca-
an aircraft engine or the entire aircraft was Notice 2004–6. Several of the factors ble television distribution systems). The
the appropriate unit of property for deter- listed in Notice 2004–6 have been in- IRS and Treasury Department request
mining whether the costs of engine shop corporated into the proposed regulations. comments on the relevant rules for deter-

2006–39 I.R.B. 537 September 25, 2006


mining the appropriate unit of property for T.D. 8584, 1995–1 C.B. 20, 25; [59 FR FedEx for determining the appropriate unit
network assets. Additionally, the IRS and 67, 187] Dec. 29, 1994). of property — whether the taxpayer and
Treasury Department request comments In contrast to the unit of property rules the industry treat the component part as
on whether to include rules for network in §1.263A–10(a)(2), the purpose of the part of the larger unit of property for regu-
assets in final regulations, or whether to unit of property rules under section 263(a) latory, market, management, or accounting
develop for network assets industry-spe- is to provide a starting point for determin- purposes. Thus, this rule ties into the reg-
cific guidance that is similar to the above ing whether an amount paid materially in- ulatory accounting element of the FedEx
referenced revenue procedures. creases the value of, or restores, the unit factor, as well as the general concept of in-
With the exception of network assets, of property. Thus, §1.263A–10(a)(2) has dustry practice. The IRS and Treasury De-
the four categories of property in the pro- a different purpose than the proposed reg- partment are aware of three Federal regula-
posed regulations are intended to cover all ulations under section 263(a). Further, in tors that provide a USOA: (1) the Federal
real and personal property. In addition to determining the appropriate unit of prop- Energy Regulatory Commission (FERC);
the four categories of property, the unit of erty for purposes of section 263(a), the (2) the Federal Communications Commis-
property rules provide for an initial unit functional interdependence test does not sion (FCC); and (3) the Surface Trans-
of property determination, which, except always produce appropriate results. For portation Board (STB). Accordingly, this
with regard to buildings and structural example, a taxpayer might argue that ap- unit of property category applies to taxpay-
components, is made prior to categorizing plication of that test results in an entire ers such as power companies, telecommu-
the property. The initial unit of property complex of structures and machinery, such nications companies, and railroads.
determination is based on the functional as an entire power plant, being treated as a The IRS and Treasury Department de-
interdependence test in §1.263A–10(a)(2), single unit of property. The IRS and Trea- termined that the regulatory accounting
relating to the capitalization of interest. sury Department do not believe that result rule should be applied similarly to all tax-
The initial unit of property determina- is correct for purposes of section 263(a). payers in industries for which a Federal
tion is intended to be a common-sense After the initial unit of property deter- regulator provides a USOA, regardless
approach to defining the largest possible mination is made, the unit of property anal- of whether the taxpayer is subject to the
unit of property as a starting point for ysis continues with determining the ap- regulatory accounting rules of the Federal
analyzing the rules under one of the four propriate category of property and apply- regulator. This rule is consistent with the
relevant unit of property categories. After ing the rules in that category. The pro- general standard of using industry prac-
the initial unit of property is determined, posed regulations provide specific rules tice to determine the appropriate unit of
the additional unit of property rules are for four categories of property: (1) prop- property. Further, it results in all taxpayers
intended to result in a determination that erty owned by taxpayers in a regulated in- within a specific industry being treated
either confirms the initial unit of property dustry; (2) buildings and structural com- the same for Federal income tax purposes,
as the unit of property, or that separates ponents; (3) other personal property; and without regard to whether a particular tax-
one or more components of the initial unit (4) other real property. The unit of prop- payer is subject to the accounting rules of
of property into separate units of property. erty determination made under the appli- the Federal regulator. The rule is limited
Some commentators suggested that cable category is then subject to an ad- to the regulator’s USOA and does not ap-
the functional interdependence test un- ditional rule in §1.263(a)–3(d)(2)(vii) re- ply to other Federal regulatory rules, such
der §1.263A–10(a)(2) regarding interest garding treatment for other Federal income as rules concerning safety or health. The
capitalization should be the sole test for tax purposes. The rules for each of the four proposed regulations apply only to USOA
determining the appropriate unit of prop- categories are explained below. provided by Federal regulators and do not
erty. The IRS and Treasury Department apply to USOA issued by any state or local
believe that the functional interdepen- 2. Category I: Taxpayers in regulated agencies. Rules of state and local agencies
dence test is a relevant, but not dispositive industries may be different than Federal regulatory
factor. The purpose of that test under rules and can vary widely within an indus-
§1.263A–10(a)(2) is to calculate the ap- The first unit of property category in the try depending on the taxpayer’s location.
propriate unit of property for determining proposed regulations is property owned by Four of the commentators on this aspect
the accumulated production expenditures taxpayers in a regulated industry. The pro- of Notice 2004–6 recommended adopting
at the beginning and end of the production posed regulations provide that if the tax- the four factors cited in FedEx, from which
period. The preamble that accompanied payer is in an industry for which a Federal the regulated industry rule was derived.
the promulgation of §1.263A–10 discusses regulator has a uniform system of accounts None of the commentators specifically ob-
the reasoning for adopting a broad formu- (USOA) identifying a particular unit of jected to a regulatory accounting rule, al-
lation of the unit of property definition property, the taxpayer must use the same though one commentator suggested that
and states that “this concept of single unit of property for Federal income tax where cost recovery is determined for non-
property may differ from the concept of purposes, regardless of whether the tax- tax purposes by a Federal or state agency,
single or separate property that taxpayers payer is subject to the regulatory account- the regulations should provide a special
use for other purposes (e.g., for comput- ing rules of the Federal regulator and re- election that may be made on an annual ba-
ing amounts of depreciation deductions or gardless of whether the property is par- sis under which the taxpayer may use the
separately tracking the bases of assets).” ticular to that industry. This rule derives same unit of property for tax purposes as it
from one of the factors cited by the court in must use for regulatory purposes. The IRS

September 25, 2006 538 2006–39 I.R.B.


and Treasury Department believe the unit unit in a condominium building, whether aircraft were initially acquired. The IRS
of property inquiry should result in one the unit is used for personal or investment and Treasury Department believe that the
clear determination that will be used con- purposes, should not treat the entire build- acquisition of a component from a differ-
sistently by the taxpayer unless the under- ing as the unit of property. Therefore, ent seller at the time the larger property
lying facts change and, therefore, do not the IRS and Treasury request comments is acquired should be a relevant factor,
believe an annual election is appropriate. on how the unit of property rules should and that the same rule should apply if
apply to condominiums, cooperatives, and the taxpayer leases the component from a
3. Category II: Buildings and structural similar types of property. different party than the seller of the larger
components property.
4. Category III: Other personal property The IRS and Treasury Department rec-
In general, a building and its struc- ognize that this factor may produce differ-
The unit of property determination for
tural components must be treated as one ent results depending on whether the prop-
personal property not included in Category
unit of property. This rule is based on erty is new or used. When a taxpayer ac-
I (taxpayers in a regulated industry) is a
the definitions of building and structural quires or leases used property, it is possible
facts and circumstances test, based on four
component in the regulations under sec- that items that were separate units of prop-
exclusive factors, none of which is dispos-
tion 48. The repair allowance regulations erty when purchased new will be treated
itive or weighs more heavily than the oth-
under the Class Life Asset Depreciation as one unit of property because the ini-
ers.
Range (CLADR) system also provide that tial purchaser has assembled the units into
a building and its structural components a. Factor 1: Marketplace treatment factor one functional item that it sells or leases.
generally are a single unit of property. The IRS and Treasury Department consid-
See §1.167(a)–11(d)(2)(vi). The IRS and The first exclusive factor is whether ered whether it was appropriate to have a
Treasury Department believe that these the component is (1) marketed separately factor that could treat new and used prop-
definitions are useful in determining the to or acquired or leased separately by erty differently, and decided that the differ-
appropriate unit of property for buildings the taxpayer (from a party other than the ence reasonably reflects the substance of
and structural components. One com- seller/lessor of the property of which the the transactions — where the taxpayer ac-
mentator specifically requested that the component is a part) at the time it is ini- quires or leases a component from a differ-
proposed regulations use the definition of tially acquired or leased; (2) subject to a ent party from whom it acquires or leases
building under §1.48–1(e) to determine separate warranty contract (from a party the larger property, the taxpayer typically
a unit of property. The proposed regu- other than the seller/lessor of the property is conducting different, but related, trans-
lations rely on the definition of building of which the component is a part); (3) sub- actions with separately negotiated terms.
under §1.48–1(e). Property located inside ject to a separate maintenance manual or Whether the component is subject to a
a building that is not a structural com- written maintenance policy; (4) appraised separate warranty contract, maintenance
ponent of the building must be analyzed separately; or (5) sold or leased separately manual, or written maintenance policy was
under one of the other three unit of prop- by the taxpayer to another party. This cited as a factor in FedEx and is adopted
erty categories; for example, machinery factor contains a number of items intended as part of the marketplace treatment factor
and equipment inside a factory must be to determine the treatment in the market- in the proposed regulations. The warranty
analyzed under Category III (the other place of the component as a separate unit contract factor applies only to a warranty
personal property category). of property. that is provided by a party other than the
This Category II is the only category Whether the component is acquired seller/lessor of the larger property. It is not
to which the initial unit of property de- separately was a factor addressed by the intended to apply to a warranty provided
termination does not apply. Applying courts in FedEx and Ingram, and is also by the sellor/lessor that may contain sepa-
the functional interdependence test to a part of the CLADR repair allowance reg- rate warranties (for example, for different
building would raise issues in cases where ulations under section 167 and the unit of time periods) on various components of
certain floors or portions of a building property determination for interest capi- the larger property. Whether the property
are placed in service independently of an- talization in §1.263A–10. In FedEx, the is manufactured separately was a possi-
other. The IRS and Treasury Department court discussed this issue in the context of ble factor cited in Notice 2004–6. The
believe that, unless the additional rule in whether the taxpayer and the industry treat proposed regulations do not specifically
§1.263(a)–3(d)(2)(vii) of the proposed the component part as part of the larger adopt this factor because components that
regulations (regarding treatment for other unit of property for regulatory, market, are subject to a separate warranty or main-
Federal income tax purposes) applies to management, or accounting purposes. In tenance procedures also are likely to be
require a component of a building to be finding that the aircraft engines were not manufactured separately. The FedEx case
treated as a separate unit of property, the purchased separately, the court relied on used as a factor whether the component
building and its structural components the fact that the engines and aircraft were was appraised or valued separately and
should be the unit of property. The IRS designed to be compatible and were gen- the CLADR repair allowance regulations
and Treasury Department recognize, how- erally acquired by the taxpayer at the same under section 167 addressed whether the
ever, that it is not always appropriate to time. The court disregarded the fact that component was sold separately to another
treat the entire building as the unit of prop- the taxpayer purchased the engines and party. The proposed regulations adopt
erty. For example, a taxpayer who owns a airframes from different sellers when the

2006–39 I.R.B. 539 September 25, 2006


these tests as part of the marketplace fac- of the component in its books and records For example, in the case of a taxpayer that
tor. under this Factor 2 includes any useful does not maintain an inventory of rotable
The IRS and Treasury Department be- life determinations of the component and spare parts, if a major component of the
lieve that it is important that all the crite- the property of which the component is a larger property breaks down, then the en-
ria in this factor be taken into account to- part in the books and records. Therefore, tire larger property must be taken out of
gether when weighing this factor with the the economic useful life factor was not service while the major component is be-
other three factors. Some criteria may be specifically adopted as a separate factor. ing repaired. This is indicative of the larger
stronger indicators warranting treatment of property and the component collectively
the component as a separate unit of prop- c. Factor 3: Rotable part factor being treated as one unit of property. Con-
erty than others. The IRS and Treasury versely, a taxpayer that does maintain an
The third exclusive factor in the other
Department acknowledge that several of inventory of rotable spare parts for a ma-
personal property category is whether the
the criteria within this factor do not work jor component is able to continue to use the
taxpayer treats the component as a rotable
well for property produced by the taxpayer, larger property without regard to the time
part. A rotable part is defined as a part
and request comments regarding how and required to repair the broken down compo-
that is removeable from property, repaired
whether a marketplace factor should apply nent. In this instance, the IRS and Treasury
or improved, and either immediately rein-
to self-constructed property. Department believe that continued use of
stalled on other property or stored for later
the larger property is indicative of separate
b. Factor 2: Industry practice and installation. This factor was cited by the
unit of property treatment for the rotable
financial accounting factor courts in Smith and LaSalle. The court in
part. In addition, rotables being depre-
FedEx ignored this factor, but considered
ciated as rotable spare parts is indicative
The second exclusive factor in this as a separate concept whether the compo-
of separate treatment because the compo-
Category III is whether the component nent can be and is maintained while affixed
nents are depreciated separately from the
is treated as a separate unit of property to the larger unit. The IRS and Treasury
larger property.
in industry practice or by the taxpayer in Department considered this separate con-
In the request for comments, Notice
its books and records. This factor was cept as well, but believe that the rotable
2004–6 combined several other factors
cited by the court in FedEx. The IRS part factor incorporates this concept from
with the rotables factor, including whether
and Treasury Department believe that the FedEx. As the examples in the proposed
a component is designed to be easily re-
taxpayer’s treatment of the component regulations illustrate, this factor focuses on
moved from a larger assembly, is regularly
as separate in its books and records is a the particular taxpayer’s treatment of the
or periodically replaced, or is one of a
relevant factor in determining whether the property as a rotable part in determining
fungible set of interchangeable assets.
component should be treated as a separate whether the rotable is a separate unit of
These factors are broader than the rota-
unit of property in the proposed regula- property. Therefore, for example, if the
bles factor in the proposed regulations and
tions. In particular, if the taxpayer’s books rotable part is a separate unit of property
would sweep in many minor components
and records assign different economic use- to the taxpayer and the taxpayer incorpo-
that rarely, if ever, would be appropriately
ful lives to the component and the larger rates the rotable into other property for re-
considered a separate unit of property.
property, this factor would weigh heavily sale, the rotable part will not necessarily be
Further, these factors are duplicative of
toward treating the component as a sepa- a separate unit of property to the purchaser.
the rotables part factor, because a rotable
rate unit of property. Two commentators stated that the treat-
generally meets all of these factors. The
The IRS and Treasury Department con- ment of a component as a rotable part is of
IRS and Treasury Department believe that
sidered whether to use as a factor whether limited or no relevance. While treatment
these factors are not more helpful in deter-
the component has a different economic of minor parts as rotable would not weigh
mining whether a component is a separate
useful life than the property of which it is heavily toward separate unit of property
unit of property than the rotables factor
a part. This factor was cited by the courts treatment, the IRS and Treasury Depart-
described in the proposed regulations.
in Smith, Ingram, and FedEx. However, ment believe that the treatment of major
Therefore, the proposed regulations do not
for this factor to be useful, the regula- components as rotable is a relevant factor
include these other factors.
tions would need to define economic in determining whether a component is a
useful life. The proposed regulations at separate unit of property, particularly when d. Factor 4: Function factor
§1.263(a)–3(f) (with regard to restoration the economic useful life of the larger prop-
of a unit of property) provide a definition erty is limited by the expected useful life The fourth and final factor in Category
of economic useful life, which has dif- of the rotable part. Many taxpayers do not III is whether the property of which the
ferent meanings depending on whether a maintain an inventory of rotable spares for component is a part generally functions
taxpayer has an AFS. If the unit of property their major components. Although it is un- for its intended use without the compo-
rules adopted this definition, the economic derstood that the purpose for maintaining nent property. This factor was cited by the
useful life test under this factor would an inventory of rotables is to minimize the court in FedEx and is similar to the dis-
produce different results depending on time that the larger property is out of ser- crete purpose test under the CLADR re-
whether the taxpayer has an AFS. These vice, treatment of a major component as a pair allowance regulations. It is also simi-
different results are not justified in this rotable has consequences that tend to be lar to the functional interdependence test
context. Further, a taxpayer’s treatment indicative of a separate unit of property. under §1.263A–10(a)(2) and the rules in

September 25, 2006 540 2006–39 I.R.B.


these proposed regulations regarding the that it is not a separate unit of property for The IRS and Treasury Department recog-
initial unit of property determination. As capitalization purposes. For example, if a nize that the language of this consistency
noted in the discussion of the initial unit of taxpayer does a cost segregation study on rule is very broad, and request comments
property determination, the IRS and Trea- a building and properly identifies separate regarding circumstances in which this rule
sury Department agree with commentators section 1245 property, the taxpayer must should not apply.
that the functional interdependence test is treat that separate property as the unit of
a relevant, although not dispositive, factor property for capitalization purposes. V. Improvements in General
in the unit of property analysis. Although As a further example, if a taxpayer
the proposed regulations use the functional properly recognizes a loss under section Section 1.263(a)–1(b) of the current
interdependence test to determine the ini- 165, or under another applicable provi- regulations provides that an amount must
tial unit of property, the functional inter- sion, from a retirement of a component be capitalized if it (1) adds to the value,
dependence test in that context is merely of property or from the worthlessness or or substantially prolongs the useful life,
a starting point in determining the appro- abandonment of a component of property, of property owned by the taxpayer, or (2)
priate unit of property, rather than a spe- the taxpayer must treat the component as adapts the property to a new or different
cific factor to be considered. Providing a separate unit of property. A loss arising use. Notice 2004–6 requested comments
this version of the functional interdepen- under another applicable provision in this on what general principles of capitaliza-
dence test as a specific factor gives appro- context includes a loss arising under (1) tion should apply to amounts paid to repair
priate weight to that test in the unit of prop- §1.167(a)–8 or 1.167(a)–11, as applica- or improve tangible property. Commenta-
erty analysis for other personal property. ble, from a retirement of a component tors were almost unanimous in their sug-
of property if the component is not sub- gestion that the current principles of value,
5. Category IV: Other real property ject to section 168 (MACRS property) useful life, and new or different use be re-
or former section 168 (ACRS property); tained. The IRS and Treasury Department
The unit of property determination for
(2) §1.167(a)–8(a) from a retirement of a agree with the commentators that the cur-
real property not included in Category I or
component of property if the component rent guidelines generally are appropriate.
II is based on a facts and circumstances
is MACRS or ACRS property (applying However, the current regulations require a
test. The property subject to this category
§1.167(a)–8(a) as though the retirement subjective inquiry into the application of
is primarily land and land improvements
is a normal retirement from a single as- the particular facts at issue, which often
owned or leased by taxpayers not in a reg-
set account) unless the component is a results in disagreements between taxpay-
ulated industry. This category does not
structural component or the component ers and the IRS. Accordingly, the proposed
list specific factors because land and land
is in a mass asset account (ACRS prop- regulations attempt to clarify and expand
improvements are such unique assets that
erty) or a general asset account (MACRS the standards in the current regulations by
specific factors cannot uniformly provide
property); or (3) §1.168(i)–1(e) from the setting forth rules to determine whether
appropriate results. Thus, the unit of prop-
disposition of a component of property if there has been a material increase in value
erty determination for property in this cat-
the component is MACRS property and in (including adapting property to a new or
egory may be based on some, all, or none
a general asset account. No inference is different use) and to determine whether
of the factors listed in Category III for per-
intended that this rule in the proposed reg- there has been a restoration of property
sonal property, or may be based on other
ulations requires or allows taxpayers that (the useful life rules). In addition, the pro-
factors. The IRS and Treasury Depart-
are using a unit of property for purposes of posed regulations provide objective rules
ment request comments on whether addi-
the proposed regulations to use the same for improvements in an optional repair
tional guidance is needed for this category
unit of property for purposes of any Code allowance method.
of property and, if so, what unit of property
or regulation section other than section The proposed regulations generally
guidance would be appropriate.
263(a) and §§1.263(a)–1, 1.263(a)–2, and provide that a taxpayer must capitalize
6. Additional rule for unit of property 1.263(a)–3 of the proposed regulations. the aggregate of related amounts paid that
This rule is intended to prevent tax- improve a unit of property, whether the
After determining the initial unit of payers from taking a loss deduction on a improvements are made by the taxpayer
property and applying the unit of property component of a unit of property, and then or a third party. The aggregate of related
rules under the appropriate category, the deducting the cost of the replaced com- amounts does not encompass otherwise
additional rule in §1.263(a)–3(d)(2)(vii) ponent as a repair. The application of deductible repair costs unless those costs
must be applied. Under this rule, if a this rule results in the replacement com- directly benefit or are incurred by reason
taxpayer properly treats a component as a ponent being treated as a separate unit of of a capital improvement. Instead, the
separate unit of property for any Federal property, thus requiring capitalization un- aggregation language is intended to in-
income tax purpose, the taxpayer must der §1.263(a)–2 of amounts paid to acquire clude amounts paid for an entire project,
treat the component as a separate unit of or produce the replacement component. including removal costs and other project
property for purposes of §1.263(a)–3. The The IRS and Treasury Department believe costs, regardless of whether amounts are
purpose of this rule is to prevent taxpay- that taxpayers must be consistent in the paid to more than one party or whether the
ers from taking inconsistent positions by treatment of a unit of property for capital- work spans more than one taxable year.
arguing that a component of property is a ization (other than interest capitalization), The proposed regulations do not affect the
unit of property for one tax purpose and depreciation, and loss deduction purposes. treatment of amounts paid to retire and

2006–39 I.R.B. 541 September 25, 2006


remove a unit of property in connection proposed regulations provide that a Fed- tion and to replace certain waste storage
with the installation or production of a eral, state, or local regulator’s requirement tanks to comply with applicable state and
replacement asset. See Rev. Rul. 2000–7, that a taxpayer perform certain repairs or Federal regulations. See Rev. Rul. 94–38,
2000–1 C.B. 712. maintenance is not relevant in determin- 1994–1 C.B. 35; Rev. Rul. 98–25, 1998–1
Several commentators suggested that ing whether the amount paid improves C.B. 998. The IRS specifically recognized
the proposed regulations provide that the unit of property. Several courts have in Rev. Rul. 2001–4, 2001–1 C.B. 295 that
the relevant distinction between capital held that amounts paid to bring property the requirement of a regulatory authority to
improvements and deductible repairs is into compliance with government regu- make certain repairs or to perform certain
whether the amounts were paid to put the lations were capital expenditures, in part maintenance on an asset to continue oper-
property in ordinarily efficient operating because they made the taxpayer’s prop- ating the asset does not mean that the work
condition or to keep the property in ordi- erty more valuable for use in its trade or performed must be capitalized. Thus, the
narily efficient operating condition. See business. See, Swig Investment Co. v. proposed regulations reiterate that state-
Estate of Walling v. Commissioner, 373 United States, 98 F.3d 1359 (Fed. Cir. ment in Rev. Rul. 2001–4 and provide
F.2d 190 (3d Cir. 1967); Illinois Mer- 1996) (replacing cornices and parapets that a legal compulsion to repair or main-
chants Trust Co. v. Commissioner, 4 on hotel to comply with city earthquake tain tangible property is not a relevant fac-
B.T.A. 103 (1926), acq. (V–2 C.B. 2); ordinance); Teitelbaum v. Commissioner, tor in the repair versus improvement anal-
Rev. Rul. 2001–4, 2001–1 C.B. 295. The 294 F.2d 541 (7th Cir. 1961) (converting ysis. The IRS and Treasury Department
improvement rules in the proposed regu- electrical system from direct current to further believe that a new government re-
lations are consistent with the put versus alternating current to comply with city quirement for existing property that man-
keep standard, to the extent that standard ordinance); RKO Theatres, Inc. v. United dates certain expenditures with respect to
is relevant. An amount paid may be a States, 163 F. Supp. 598 (Ct. Cl. 1958) the property does not create an inherent de-
capital expenditure even if it does not put (installing fire-proof doors and fire es- fect in the property.
the property in ordinarily efficient oper- capes to comply with city code); Hotel In response to several comments, the
ating condition because not all repair or Sulgrave, Inc. v. Commissioner, 21 T.C. proposed regulations provide that if a
improvement costs affect the functional- 619 (1954) (installing sprinkler system taxpayer needs to replace part of a unit
ity of the property. Thus, amounts paid to comply with city code). In each case, of property that cannot practicably be
that keep property in ordinarily efficient however, the court did not rely entirely replaced with the same type of part, the
operating condition are not necessarily on regulatory compliance as a basis for replacement of the part with an improved
deductible repair costs, particularly if the requiring capitalization. For example, in but comparable part does not, by itself,
useful life is extended. On the other hand, Hotel Sulgrave and RKO Theatres, both result in an improvement to the unit of
amounts that put property in ordinarily involving the installation of certain equip- property. This rule is intended to apply
efficient operating condition are likely to ment to comply with city fire codes, the in cases where the same replacement part
be amounts paid prior to the property’s courts emphasized that the work involved is no longer available, generally because
being placed in service or to ameliorate a the addition of property with a useful of technological advancements or product
pre-existing condition or defect. Amounts life extending beyond the taxable year. enhancements. This rule, however, is not
paid in these later situations would be Moreover, both Swig and Teitelbaum in- intended to apply if, instead of replacing
capital expenditures under either the value volved expenditures for the replacement an obsolete part with the most similar
rule or the restoration rule in the proposed of major structural components of a build- comparable part available, the taxpayer
regulations. ing (parapets and cornices in Swig and replaces the part with one of a better qual-
Some commentators suggested that the an electrical system in Teitelbaum) with ity than what would have sufficed.
frequency of the expenditure should be upgraded components. Thus, in all these The proposed regulations do not pre-
considered, noting that an expenditure be- cases, even without the legal compulsion scribe a plan of rehabilitation doctrine as
ing regularly incurred on a cyclical basis to make these changes, the taxpayers’ traditionally described in the case law.
should be a strong indication of deductible amounts paid would have constituted cap- That judicially-created doctrine provides
maintenance. The IRS and Treasury De- ital expenditures. that a taxpayer must capitalize otherwise
partment considered this comment but In contrast to the cases discussed above, deductible repair costs if they are incurred
concluded that the frequency of the ex- both the courts and the IRS have permitted as part of a general plan of rehabilitation
penditure was too vague a standard to be a current deduction for some government to the property. See, Norwest Corp. v.
administrable. Further, the IRS and Trea- mandated expenditures. For example, in Commissioner, 108 T.C. 265 (1997); Moss
sury Department believe that the proposed Midland Empire Packing Co. v. Commis- v. Commissioner, 831 F.2d 833 (9th Cir.
regulations provide appropriate guidance sioner, 14 T.C. 635 (1950), acq. (1950–2 1987); United States v. Wehrli, 400 F.2d
on cyclical maintenance by clarifying C.B. 3), the court allowed the taxpayer 686 (10th Cir. 1968). Specifically, if an
other rules, such as the appropriate com- to deduct the costs of applying a concrete expenditure is made as part of a general
parison rule for adding value and the rules liner to its basement walls to satisfy Fed- plan of rehabilitation, modernization, and
relating to prolonging economic useful eral meat inspectors. Similarly, the IRS improvement of the property, the expen-
life. has permitted taxpayers to treat as other- diture must be capitalized, even though,
In accordance with several comments wise deductible repairs amounts paid to re- standing alone, the item may be classified
received in response to Notice 2004–6, the mediate certain environmental contamina- as one of repair or maintenance. Wehrli,

September 25, 2006 542 2006–39 I.R.B.


400 F.2d at 689. Whether a general plan Bank of Houston v. Commissioner, T.C.M. erating condition must be capitalized. This
of rehabilitation exists, and whether a par- 1960–110. pre-existing defect rule applies regardless
ticular repair or maintenance item is part The IRS and Treasury Department do of whether the taxpayer was aware of the
of it, are questions of fact to be determined not believe it is appropriate to capitalize as condition or defect at the time of acqui-
based upon all the surrounding facts and an improvement otherwise deductible re- sition or production. The IRS and Trea-
circumstances, including, but not limited pair costs solely because the taxpayer has sury Department considered but rejected
to, the purpose, nature, extent, and value a plan (written or otherwise) to perform as too subjective the idea of providing dif-
of the work done. Id. at 690. periodic repairs or maintenance or solely ferent treatment based on the taxpayer’s
The issue of whether an amount paid because the taxpayer performs several re- prior knowledge of the condition or defect.
must be capitalized under the plan of re- pairs to the same property at one time. The The IRS and Treasury Department request
habilitation doctrine has been the subject IRS and Treasury Department believe that comments on whether, and in what circum-
of much litigation, with varying results. it is appropriate to capitalize otherwise de- stances, the pre-existing defect rule should
For example, some cases have limited ap- ductible repair costs as part of an improve- take into account the condition of the prop-
plication of the plan of rehabilitation doc- ment only if the taxpayer improves a unit erty in the hands of a transferor. For ex-
trine to buildings that are not suitable for of property and the otherwise deductible ample, if an individual transfers property
their intended use in the taxpayer’s trade or repair costs directly benefit or are incurred to a corporation in exchange for stock in
business. See Schroeder v. Commissioner, by reason of the improvement to the prop- a transaction under section 351, should
T.C. Memo 1996–336; Koanis v. Commis- erty. Section 263A applies to these expen- the pre-existing defect rule take into ac-
sioner, T.C. Memo 1978–184, aff’d mem., ditures. Section 263A requires that all di- count the condition of the property when
639 F.2d 788 (9th Cir. 1981); Keller Street rect costs of an improvement and all in- acquired by the individual, rather than the
Dev. Co. v. Commissioner, 37 T.C. 559 direct costs that directly benefit or are in- condition of the property when received by
(1961); acq., 1962–2 C.B. 5, aff’d in part, curred by reason of the improvement must the corporation?
rev’d in part on other grounds, 323 F.2d be capitalized. This application of section The second test for materially increas-
166 (9th Cir. 1963). Other courts, as well 263A to otherwise deductible repair costs ing value is whether the work was per-
as the IRS, have viewed the plan of rehabil- in this context is consistent with the appli- formed prior to the date the property is
itation doctrine more broadly, emphasiz- cation of the plan of rehabilitation doctrine placed in service by the taxpayer. This
ing the planned aspect of the work done by described in Rev. Rul. 2001–4. The pro- test essentially restates the concept that
the taxpayer, rather than the condition of posed regulations provide that repairs that amounts paid to put property into ordinar-
the property. See Mountain Fuel Supply are made at the same time as an improve- ily efficient operating condition must be
Co. v. United States, 449 F.2d 816 (10th ment, but that do not directly benefit or capitalized. The IRS and Treasury Depart-
Cir. 1971); Wolfsen Land & Cattle Co. v. are not incurred by reason of the improve- ment believe that if the property cannot be
Commissioner, 72 T.C. 1 (1979); Rev. Rul. ment, are not required to be capitalized un- placed in service prior to work being per-
88–57, 1988–2 C.B. 36. der section 263(a). formed, that work necessarily increases the
In Rev. Rul. 2001–4, 2001–1 C.B. 295, value of the property.
the IRS clarified its view of the plan of re- VI. Value The third value test is whether the
habilitation doctrine. In applying the plan amounts paid adapt the property to a new
of rehabilitation doctrine to the facts in Sit- A. In general or different use. The commentators agreed
uation 3 of that ruling, the IRS noted that that this factor should remain a standard
(1) the taxpayer planned to perform sub- The proposed regulations provide that for capitalization. The new or different
stantial capital improvements to upgrade a taxpayer must capitalize amounts paid use standard is unchanged from the current
the unit of property; (2) the repairs were in- that materially increase the value of a unit regulations, but it is included in the value
cidental to the taxpayer’s plan to upgrade of property and provide an exclusive list section of the proposed regulations, rather
the unit of property; and (3) the effect of of five tests for determining whether an than as its own standard. The new or dif-
all the work performed on the unit of prop- amount paid materially increases value. ferent use test is not intended to apply to
erty, including the repairs and maintenance An amount paid must be capitalized if it amounts paid to prepare a unit of property
work, was to materially increase the value meets any of the five tests. The first test for sale (for example, painting a house).
or prolong the useful life of the unit of is whether the amount paid ameliorates a The fourth value test is whether the
property. The ruling also notes that the ex- condition or defect that either existed prior amount paid results in a betterment or
istence of a written plan, by itself, is not to the taxpayer’s acquisition of the unit material addition to the unit of property.
sufficient to trigger the plan of rehabilita- of property or arose during the production The betterment language is consistent
tion doctrine. The ruling’s interpretation of the unit of property. See United Dairy with the statutory language of section
of the plan of rehabilitation doctrine is con- Farmers, Inc. v. United States, 267 F.3d 263(a)(1) as well as the current regulations
sistent with the majority of cases apply- 510 (6th Cir. 2001); Dominion Resources, at §1.263(a)–1(a)(1). A betterment is an
ing that doctrine. See California Casket Inc. v. United States, 219 F.3d 359 (4th improvement that does more than restore
Co. v. Commissioner, 19 T.C. 32 (1952), Cir. 2000); Jones v. Commissioner, 242 to a former good condition. The better-
acq., 1953–1 C.B. 3; Stoeltzing v. Com- F.2d 616 (5th Cir. 1957). This rule is con- ment test is intended to capture amounts
missioner, 266 F.2d 374 (3d Cir. 1959); sistent with the concept that amounts paid paid that are qualitative improvements to
to put property into ordinarily efficient op- the property that make the property bet-

2006–39 I.R.B. 543 September 25, 2006


ter and more valuable than mere repairs erty (see Ingram Industries, Inc. v. Com- in capacity. The IRS and Treasury De-
would do, such as using upgraded mate- missioner, T.C. Memo 2000–323). Courts partment do not believe that providing a
rials when materials comparable to the have considered fair market value only fixed percentage as a presumption of what
original were available and would have in a few cases when property has been is a material increase would be an ap-
sufficed. However, the betterment test is appraised for some other purpose (see propriate safe harbor. Although perhaps
not intended to be a fair market value test. Jones v. United States, 279 F. Supp. 772, measurable, the same fixed percentage in-
The fifth test in the value section of 774 (D. Del. 1968)), or when property crease in capacity would not work well as
the proposed regulations is whether the has been appraised in the course of the a rule applicable to all types of property.
amount paid results in a material increase litigation (see FedEx, 291 F. Supp. 2d at A twenty-five percent increase in capacity
in capacity, productivity, efficiency, or 706–707). may be a reasonable litmus test for deter-
quality of output of the unit of property. Additionally, the fair market value of mining whether there has been a material
These standards are consistent with case property may change over time without re- increase in value for certain types of prop-
law under the current regulations. gard to the use, upkeep, or improvements erty. However, for many types of property,
The proposed regulations provide an made by the taxpayer, due to other factors a much smaller increase in capacity may
exception to the value tests if the original such as supply and demand or changes in be an extraordinary, or in some cases im-
economic useful life of the unit of property style, trends, technologies, etc. For ex- possible, improvement. For example, an
is 12 months or less and the taxpayer does ample, land may increase in fair market increase in the square footage of a 50,000
not elect to capitalize amounts paid for the value over time without the taxpayer per- square foot building by 5 percent would be
property. The purpose of this rule is to not forming any activities to improve it. Con- a rather large improvement that should be
require capitalization under the value rules versely, amounts paid to make substantial capitalized. Therefore, the determination
for improvements made to 12-month prop- improvements to a unit of property may of whether an increase in capacity, produc-
erty. This exception, however, does not ap- not always increase fair market value, or tivity, efficiency, or quality is a material in-
ply to the restoration rule for determining may not increase the fair market value by crease in value should be based on all the
whether an amount paid improves prop- the full amount paid for the improvements. facts and circumstances.
erty. Thus, for example, if a taxpayer per- See, Harrah’s Club v. United States, 661
forms work on 12-month property that pro- F.2d 203 (Ct. Cl. 1981) (amount paid to B. Appropriate comparison
longs the economic useful life of the prop- restore antique automobiles must be capi-
erty, the amount paid must be capitalized. talized even though restoration did not in- Notice 2004–6 requested comments
The proposed regulations do not adopt crease fair market value by the amount on the proper starting point for compar-
an increase in fair market value as a stan- paid for the restoration). Attempting to ad- ing whether an expenditure materially
dard for capitalization. In response to just fair market value for factors like these increases the value of property. Almost all
Notice 2004–6, most commentators stated further complicates any possible compar- the commentators suggested that the pro-
that value means fair market value. How- ison. The IRS and Treasury Department posed regulations adopt the test set forth
ever, in practice, taxpayers generally do believe that the fair market value standard in Plainfield-Union Water Co. v. Commis-
not measure, and would have no reason to is too subjective and impractical, particu- sioner, 39 T.C. 333 (1962), nonacq. on
measure, the fair market value of a unit of larly because most repairs also increase the other grounds (1964–2 C.B. 8) (the Plain-
property prior to some condition necessi- fair market value of property if the value is field-Union test). In that case, the court
tating the expenditure. Further, taxpayers compared immediately before and after the noted that almost any properly performed
generally have no reason to measure the work is performed. Therefore, the IRS and repair adds value as compared with the
fair market value of a unit of property Treasury Department do not believe that situation existing immediately prior to
after the work is performed. The IRS fair market value is an appropriate stan- that repair. The proper test, the court
and Treasury Department did not want dard. The value factors in the proposed said, is whether the expenditure materially
to propose regulations with a standard regulations are intended to be objective in- enhances the value of the property as com-
that required taxpayers to have property dications of work performed that generally pared with the status of the property prior
appraised solely for the purpose of apply- would increase the fair market value of the to the condition necessitating the expen-
ing a capitalization standard. In fact, the unit of property. Whether amounts paid diture. The court also noted that the test
courts rarely have applied a strict increase materially increase the value of a unit of is appropriate even when the expenditure
in fair market value standard. Usually, property requires an analysis of the pur- does not arise from a sudden, unexpected,
the courts rely on some surrogate for fair pose, the physical nature, and the effect of or unusual external circumstance.
market value to determine whether value the work for which the amounts were paid, The IRS and Treasury Department
is increased. For example, courts have and not an analysis of the fair market value agree with this application of the Plain-
looked to the amount of the expenditure of the property or the level of monetary ex- field-Union test and believe that the test is
versus (1) the cost of the property (see penditures. appropriately applied to cases of normal
Stoeltzing v. Commissioner, 266 F.2d 374 Some commentators requested that the wear and tear as well as cases when the
(3d Cir. 1959)); (2) the cost of comparable regulations provide a bright line rule defin- expenditure arises from a sudden, unex-
new property (see LaSalle Trucking Co. ing a material increase in value with re- pected, or unusual external circumstance.
v. Commissioner, T.C. Memo 1963–274); spect to a specified percentage increase, The proposed regulations adopt the Plain-
and (3) the cost of comparable used prop- for example a twenty-five percent increase field-Union test for cases in which a partic-

September 25, 2006 544 2006–39 I.R.B.


ular event necessitates the expenditure and restore property. The restoration lan- nomic useful life definition that applies to
clarify that when the event necessitating guage is from section 263(a)(2) and taxpayers without an AFS.
the expenditure is normal wear and tear, §1.263(a)–1(a)(2) of the current regu- One commentator stated that the useful
the condition of the property immediately lations and generally has been viewed life used for book depreciation purposes is
prior to the event necessitating the ex- as a rule requiring the capitalization not appropriate for tax purposes because
penditure is the condition of the property of amounts paid that substantially pro- the book useful life takes into account fac-
after the last time the taxpayer corrected long the useful life of the property. See tors that do not measure the inherent useful
the effects of normal wear and tear or, if §1.263(a)–1(b). This section of the pro- life, but rather the period over which the
the taxpayer has not previously corrected posed regulations defines economic useful property is expected to be useful (on av-
the effects of normal wear and tear, the life and what it means to substantially erage) to the taxpayer. The IRS and Trea-
condition of the property when placed in prolong economic useful life. sury Department believe it is appropriate
service by the taxpayer. This comparison The comments received in response to take into account the period over which
rule for wear and tear is intended to apply to Notice 2004–6 varied greatly with re- the property may reasonably be expected
when a taxpayer engages in regular, cycli- gard to useful life, with two commentators to be useful to the taxpayer, as required by
cal maintenance of a unit of property to specifically suggesting that the concept of taxpayers without an AFS, rather than the
correct the effects of normal wear and tear. useful life be eliminated from the regula- inherent useful life of the property.
Although wear and tear begins affecting tions. The other commentators suggested The proposed regulations also provide
the condition of property as soon as it is that economic useful life be defined as the four rules for determining when an amount
placed in service, the proposed regulations period of time over which the property paid substantially prolongs economic use-
do not adopt the placed-in-service date is expected to be useful to the taxpayer, ful life. The first rule requires capitaliza-
as the appropriate comparison point. Al- taking into account the various factors tion when the amount paid extends the pe-
though the placed-in-service date would listed in §1.167(a)–1(b). The proposed riod over which the property may reason-
be the appropriate comparison point when regulations adopt this definition of eco- ably be expected to be useful to the tax-
the taxpayer first corrects the effects of nomic useful life for taxpayers that do not payer beyond the end of the taxable year
normal wear and tear, the IRS and Trea- have an AFS. Economic useful life is not immediately succeeding the taxable year
sury Department believe that the condition determined by reference to the recovery in which the economic useful life of the
of the property after the previous mainte- period under section 168 for the property. property was originally expected to cease.
nance cycle is the appropriate comparison For a taxpayer that has an AFS, the eco- One commentator suggested that the reg-
point for each subsequent maintenance nomic useful life of the property is pre- ulations provide a safe harbor bright line
cycle. sumed to be the same as the useful life rule to define whether an amount substan-
The Plainfield-Union test works well used by the taxpayer for purposes of deter- tially prolongs the useful life. The IRS
when the amount paid is necessitated by a mining depreciation in its AFS. The IRS and Treasury Department believe that a
specific event (like amounts paid to repair and Treasury Department believe that the one year rule is an appropriate bright line.
damage or amounts paid to maintain prop- economic useful life definition is subjec- Therefore, the regulations require capital-
erty by correcting the effects of wear and tive and difficult to apply; therefore, this ization when the amount paid extends the
tear). However, the test does not work in rule provides certainty for taxpayers with original useful life of the property by more
a pure improvement setting; that is, when an AFS. The regulations provide an excep- than one taxable year. The IRS and Trea-
a taxpayer decides to improve property tion to this rule for situations in which a sury Department believe that a one year
without any event causing the taxpayer taxpayer does not assign a useful life to rule is a more appropriate bright line than
to perform the work to restore the prop- certain property in its AFS, even though a rule based on a percentage of the useful
erty to a former good condition. There- the property has a useful life of more than life, because the one-year rule corresponds
fore, the proposed regulations do not ap- one year. For example, a taxpayer may with the 12-month safe harbor rule for the
ply the Plainfield-Union test to the first treat amounts paid for a unit of property acquisition or production of property.
three value factors (pre-existing defects, as an expense in its AFS if the property is The second rule requires capitalization
work performed prior to the property being used in a specific research project and has if a major component or a substantial struc-
placed in service, and adapting the prop- no alternative future uses. Additionally, tural part of the unit of property is replaced
erty to a new or different use). These fac- many taxpayers have a policy of treating and notes that the replacement of a rela-
tors are more appropriately analyzed on an as an expense in their AFS an amount paid tively minor portion of the physical struc-
absolute, rather than relative basis. Sim- for tangible property below a certain dol- ture of the unit of property or a relatively
ilarly, the test does not work well for bet- lar threshold, despite the fact that the prop- minor portion of any of its major parts does
terments, which by definition are improve- erty has a useful life of more than one year. not constitute the replacement of a major
ments that do more than restore property to This type of property does not have a use- component or substantial structural part of
a former good condition. ful life for purposes of determining depre- the unit of property. It is possible, how-
ciation in the taxpayer’s AFS, even though ever, for amounts paid to replace a rela-
VII. Restoration it may have a useful life of more than one tively minor portion of the physical struc-
year. Therefore, the IRS and Treasury De- ture of the unit of property or a relatively
The proposed regulations provide that partment believe that in these situations it minor portion of any of its major parts
a taxpayer must capitalize amounts paid to is appropriate for taxpayers to use the eco- to substantially prolong the economic use-

2006–39 I.R.B. 545 September 25, 2006


ful life of the property if the property is The courts have distinguished between sualty loss. As another example, work
near the end of its economic useful life, losses that are deductible as casualties performed at the end of the economic use-
in which case the amounts paid neverthe- under section 165(a) and incidental repair ful life of the unit of property may extend
less must be capitalized. The rule is not in- costs that are deductible under section the property’s useful life. Additionally,
tended to require capitalization if a major 162(a) as ordinary and necessary business replacement of a major component or a
component is replaced with a similar, used expenses. In general, if property is lost, substantial structural part of a unit of prop-
component that has not been rebuilt, for destroyed, or abandoned as a result of a erty extends the useful life, particularly
example, if the engine in a car is replaced casualty, a loss deduction under section when the expected life of the component is
with a used engine with similar mileage 165(a) is appropriate; however, if property coterminous with the economic useful life
obtained from a junkyard, or a component is simply damaged in a casualty and ex- of the unit of property, and the economic
of property subject to a warranty or main- penditures are made to repair the property useful life of the unit of property is in
tenance agreement is replaced with a used in a manner that does not permanently im- fact limited by the period over which the
part that has been repaired. prove or better it or prolong its useful life, component is expected to be useful. Thus,
Although the replacement of minor those expenditures are business expenses the proposed regulations do not adopt the
parts does not usually prolong the eco- deductible under section 162(a). Hensler commentators’ suggestion.
nomic useful life of most property, the v. Commissioner, 73 T.C. 168, 179 (1979);
replacement of most or all minor parts for see also Hubinger v. Commissioner, 36 VIII. Repair Allowance Method
some types of property may be the equiva- F.2d 724, 726 (2d Cir. 1929) (expenses
lent of rebuilding the property, particularly resulting from “trifling accidental causes” A. In general
in cases in which the property consists al- are deductible only under section 162(a)
most entirely of minor parts. Therefore, and not under section 165(a)); Atlantic The primary focus of the proposed
the third rule provides that amounts paid Greyhound Corp. v. United States, 111 regulations is to provide guidance that dis-
that restore a unit of property (or a major F. Supp. 953 (1953) (“the provisions for tinguishes deductible repair expenses from
component or substantial structural part of deductions of ‘ordinary and necessary ex- capital expenditures. However, because
the unit of property) to a like-new condi- penses’ and ‘casualty losses’ would seem this remains inherently a facts-and-cir-
tion substantially prolong the useful life. to be mutually exclusive, for the normal cumstances based determination, the IRS
The IRS and Treasury Department intend connotation of one negates, at least by and Treasury Department requested com-
that this test be applied to situations in implication, the idea of the other”). Thus, ments in Notice 2004–6 on whether the
which the property undergoes the equiva- the mere fact that the damage results from regulations should provide a repair al-
lent of being rebuilt. Merely recondition- a casualty is not controlling; instead, the lowance. Six commentators suggested
ing a property by dismantling the property, nature of the damage resulting from the ca- the regulations should provide a repair
and cleaning and inspecting components, sualty is relevant in determining whether allowance or other de minimis rules for
is not the equivalent of rebuilding. All or the expenditure should be treated as a loss repair expenditures. Two commentators
almost all major and minor parts of the or deduction. specifically proposed a repair allowance
unit of property (or the major component The IRS and Treasury Department system modeled on the former CLADR re-
or substantial structural part of the unit of believe that when a taxpayer properly pair allowance system. The proposed reg-
property) must be returned to the original deducts a casualty loss, the nature of the ulations adopt these suggestions and pro-
manufacturers’ specifications. damage resulting from the casualty is vide an optional repair allowance method,
The fourth rule relates to the restoration such that any repairs done to restore the similar to the CLADR repair allowance,
of a unit of property after the taxpayer has property after the casualty should not be to create objective rules in this area. Al-
properly deducted a casualty loss under treated as ordinary and necessary repair though some commentators additionally
section 165 with respect to the property. costs. Thus, the proposed regulations requested other de minimis rules for re-
Section 165(a) allows a taxpayer to deduct provide that any amounts paid to repair pair expenditures as well, the IRS and
any loss sustained during the taxable year property after a casualty loss must be cap- Treasury Department believe that a repair
and not compensated for by insurance italized. allowance is an appropriate safe harbor
or otherwise. Generally, any loss arising Commentators stated that amounts paid for repair expenditures. Therefore, the
from a fire, storm, shipwreck, or other at any point during the property’s eco- proposed regulations do not provide a safe
casualty is allowable as a deduction under nomic useful life that do not change the harbor other than the repair allowance.
section 165(a). Section 1.165–7(a)(1). function, design, etc., but enable prop- Under the repair allowance in the pro-
The amount of the deduction is the dif- erty to be used for its expected useful life posed regulations, the taxpayer compares
ference between the fair market value of should not be determined to extend the the amounts paid for materials and labor
the property before and after the casualty, useful life. The IRS and Treasury Depart- during the taxable year to repair, maintain,
to the extent the amount does not exceed ment believe that there are circumstances or improve repair allowance property to
the property’s adjusted basis. Section in which amounts paid that merely restore the repair allowance amount. The amounts
1.165–7(b)(1). A casualty loss deduction property to a former good condition may paid are deductible under section 162 to
under section 165(a) results in a decrease properly be capitalized as substantially the extent of the repair allowance amount,
in the taxpayer’s basis in the property. prolonging useful life, for example, when and any excess amounts paid are capital-
repairs are made to property after a ca- ized. Under the proposed repair allowance

September 25, 2006 546 2006–39 I.R.B.


method, a repair allowance amount is payer would be treated as placed in service uing to use the CLADR repair allowance
determined separately for each MACRS on June 30 of the taxable year. for other property.
class. The repair allowance amount for Because the single asset treatment does
a particular class is determined by multi- not permit taxpayers to recognize a gain or D. Excluded additions
plying the repair allowance percentage in loss on the disposition of repair allowance
Repair allowance property also does
effect for that class by the average unad- property, the IRS and Treasury Depart-
not include excluded additions, the cost of
justed basis of repair allowance property ment request comments on whether, in the
which must be capitalized. The CLADR
in that class. For buildings that are repair final regulations, taxpayers should be per-
repair allowance system has a similar rule.
allowance property, the repair allowance mitted to change to the allocation treat-
Under the CLADR repair allowance sys-
method is applied separately to each build- ment for the taxable year of disposition and
tem, excluded additions are defined as
ing. This rule is consistent with the rule if so, what record keeping rules or other
any expenditures (1) that increase by 25%
for buildings under the CLADR repair rules should be required for taxpayers to
or more the productivity or capacity of
allowance system. make that change. With regard to the allo-
an existing identifiable unit of property
cation treatment, the IRS and Treasury De-
B. Capitalized amount over its productivity or capacity when first
partment request comments on whether the
acquired; (2) that modify an existing iden-
allocation should be based on an amount
The excess of amounts paid to re- tifiable unit of property for a substantially
other than the unadjusted basis as of the
pair, maintain, or improve all the repair different use; (3) for an additional iden-
beginning of the taxable year, such as the
allowance property in a MACRS class tifiable unit of property or a replacement
unadjusted basis at the end of the taxable
over the repair allowance amount for the of an identifiable unit of property that was
year or the average unadjusted basis.
class must be capitalized (the capital- retired; (4) for a replacement of a part in
ized amount). The capitalized amount C. Repair allowance property or a component or portion of an existing
includes the taxpayer’s direct costs of re- identifiable unit of property if such part,
pairing, maintaining, or improving repair Repair allowance property is defined component, or portion is for replacement
allowance property in a particular MACRS in the proposed regulations as real or per- of a part, component or portion which was
class. In addition, the taxpayer must add sonal property subject to MACRS that retired in a retirement upon which gain or
to the capitalized amount any allocable is used in the taxpayer’s trade or busi- loss was recognized; (5) in the case of a
indirect costs of producing the repair al- ness or for the production of income. It building or other structure, for additional
lowance property in the MACRS class, also includes certain tangible property cubic or linear space; and (6) in the case of
which must be capitalized in accordance not otherwise subject to MACRS if the those units of property of pipelines, elec-
with the taxpayer’s method of accounting taxpayer, solely for purposes of the repair tric utilities, telephone companies, and
for section 263A costs. Except with re- allowance method, classifies the property telegraph companies consisting of lines,
gard to repair allowance property that is in the appropriate MACRS class in which cables, and poles, for replacement of 5%
depreciated under section 168(g) or repair the property would be included if the prop- or more of the unit of property with respect
allowance property that is public utility erty were subject to MACRS. Taxpayers to which the replacement is made.
property (for which separate rules are pro- are not required to classify non-MACRS One commentator suggested that the
vided), the proposed regulations permit property (property placed in service be- proposed regulations should not have
taxpayers to choose one of two methods of fore the effective date of section 168 and excluded additions similar to those in the
treating the capitalized amount. The first property for which the taxpayer properly CLADR repair allowance because they are
method is to treat the capitalized amount elected out of section 168). Non-classi- too qualitative and difficult to administer.
as a separate single asset and to depreciate fied property will not be repair allowance The IRS and Treasury Department agree
the asset in accordance with that MACRS property eligible for the repair allowance that some of the items listed as excluded
class. The second method is to allocate method. Certain types of property are additions under the CLADR system are
the capitalized amount for a particular not included in repair allowance prop- too subjective and do not provide the kind
MACRS class to all repair allowance erty, including any property for which the of objective determination the proposed
property in the particular MACRS class taxpayer has elected to use the CLADR repair allowance is intended to provide.
in proportion to the unadjusted basis of repair allowance method and property for For this reason, the proposed regulations
the property in that MACRS class as of which the taxpayer uses the method of ac- limit the excluded additions to amounts
the beginning of the taxable year. Under counting provided in Rev. Proc. 2001–46, paid (1) for the acquisition or produc-
either the single asset method or the allo- 2001–2 C.B. 263, or Rev. Proc. 2002–65, tion of a specific unit of property; (2)
cation method, the capitalized amount is 2002–2 C.B. 700 (both with regard to rail- for work that ameliorates a condition or
treated as a section 168(i)(6) improvement road track). Thus, the repair allowance in defect that either existed prior to the tax-
and is treated as placed in service by the the proposed regulations does not repeal payer’s acquisition of the unit of property
taxpayer on the last day of the first half the CLADR repair allowance, nor does it or arose during the production of the unit
of the taxable year in which the amount is prohibit taxpayers from using the repair of property, whether or not the taxpayer
paid, before application of the convention allowance method in these regulations for was aware of the condition or defect at
under section 168(d). For example, the repair allowance property, while contin- the time of acquisition or production; (3)
capitalized amount for a calendar year tax- for work performed prior to the date the

2006–39 I.R.B. 547 September 25, 2006


unit of property is placed in service by the payer from another party. One commen- of property determination with regard to
taxpayer (without regard to any applicable tator suggested that the repair allowance network assets is not addressed in the pro-
convention under section 168(d)); (4) that apply to leased property. The IRS and posed regulations and is an issue on which
adapts the unit of property to a new or dif- Treasury Department recognize that tax- the IRS and Treasury Department have re-
ferent use; or (5) that increases the cubic payers that lease property confront the quested comments. Therefore, the IRS and
or square space of a building. same issues as owners in distinguishing Treasury Department anticipate that final
Thus, the proposed regulations adopt deductible repairs from capital improve- regulations specifically will include net-
excluded additions 2, 3, and 5 in the ments. However, the application of the re- work assets as repair allowance property
CLADR repair allowance. These ex- pair allowance method to leased property if appropriate unit of property rules can be
cluded additions are also listed in raises several difficult issues. The IRS and determined. If appropriate unit of property
§1.263(a)–3(e)(1) of the proposed reg- Treasury Department request comments rules cannot be determined for network as-
ulations as factors that indicate a material on whether the repair allowance method sets, the IRS and Treasury Department re-
increase in value. The regulations do not should be extended to leased property and, quest comments on whether to develop in-
adopt excluded addition 1 in the CLADR if so, how the following issues should be dustry-specific guidance on how the repair
repair allowance because an increase in resolved: (1) How should the unadjusted allowance method should apply (in partic-
productivity or capacity of 25% or more basis of leased property be determined? ular, how excluded additions should be de-
may be too difficult to measure. The reg- Should fair market value be used instead termined) with regard to network assets in
ulations do not specifically cite excluded of unadjusted basis and, if so, how and a particular industry.
addition 4 from the CLADR repair al- when should fair market value be deter-
lowance; however, if a part, component, mined? (2) How should the regulations be G. Repair allowance percentages
or portion of a unit of property is retired drafted to prevent abuse between related
The repair allowance percentages un-
in a retirement upon which gain or loss lessors and lessees? (3) How should the
der the CLADR repair allowance were
properly was recognized, the replacement regulations be drafted to prevent both the
determined by the Treasury Department’s
of that component is a separate unit of lessor and lessee from using the repair
Office of Industrial Economics, which
property under §1.263(a)–3(d)(2) of the allowance method for the same property?
is no longer in existence. The percent-
proposed regulations and thus is addressed (4) How should the regulations address
ages were published in various revenue
by excluded addition 1 of the proposed qualified lessee construction allowances
procedures (most recently in Rev. Proc.
regulations. Excluded addition 6 in the for short-term leases under section 110?
83–35, 1983–1 C.B. 745), made obsolete
CLADR repair allowance addresses net- (5) What is the proper treatment of the
by Rev. Proc. 87–56, 1987–2 C.B. 674,
work assets and was not adopted in the capitalized amount for leased property
with regard to property subject to section
proposed regulations pending comments under the repair allowance? (6) Should
168, and were revised and supplemented
on how the final regulations should ad- lessees be permitted to classify the leased
periodically. The proposed regulations
dress the unit of property rules relating to property to a MACRS class and use one of
create a new repair allowance percent-
network assets. the treatments of the capitalized amount
age for each MACRS class. These rates
In addition to the three excluded addi- in the proposed regulations? (7) Should
are based on the principle that a taxpayer
tions that the proposed regulations carry the capitalized amount be allocated to
will spend 50% of the property’s unad-
over from the CLADR repair allowance, individual leases and amortized over the
justed basis on repairs over the property’s
the excluded additions in the proposed reg- remaining term of each lease and, if so,
MACRS recovery period. Thus, the re-
ulations include amounts paid for work how should that allocation be made? (8) If
pair allowance percentages for a particular
that ameliorates a pre-existing condition the taxpayer has a number of leases with
MACRS class in the proposed regulations
or defect and for work performed prior to varying lease terms, should the capitalized
were computed by: (1) dividing 100% by
the date the unit of property is placed in amount be allocated to certain groups of
the number of years in the recovery period
service by the taxpayer. These two ex- leases and amortized over the average re-
for the MACRS class, which represents
cluded additions also are listed as factors maining term of the leases and if so, how
the portion of the property’s unadjusted
in §1.263(a)–3(e)(1) of the proposed reg- should the leases be grouped? (9) Are
basis that is allocable to each year of the
ulations that indicate a material increase there any other issues with regard to the
recovery period, and; (2) multiplying the
value. The IRS and Treasury Department application of a repair allowance to leased
result by 50%. For example, if a tax-
believe that the excluded additions pro- property that need to be addressed?
payer has repair allowance property in
vided in the repair allowance in the pro-
F. Network assets a MACRS class with a 5 year recovery
posed regulations are more objective than
period, 100% divided by 5 is 20%, which
those in the CLADR regulations and are
The definition of repair allowance prop- represents the portion of the property’s
easier to verify.
erty in the proposed regulations does not unadjusted basis that is allocable to each
E. Leased property specifically exclude network assets. How- year of the recovery period. Multiplying
ever, application of the repair allowance the 20% amount by 50% results in a re-
Like the repair allowance under requires a determination of the appropriate pair allowance percentage of 10% for that
CLADR, repair allowance property does unit of property, in particular with regard MACRS class.
not include property leased by the tax- to identifying excluded additions. The unit

September 25, 2006 548 2006–39 I.R.B.


The IRS and Treasury Department re- or in published guidance in the Internal Proposed Effective Date
quest comments on whether the repair Revenue Bulletin.
allowance percentages should be different The proposed regulations provide that These regulations are proposed to ap-
than those provided in the proposed reg- the repair allowance method, if elected, ply to taxable years beginning on or af-
ulations, whether the rates in Rev. Proc. must be elected for all repair allowance ter the date the final regulations are pub-
83–35 should be used, and whether the property. A taxpayer may revoke an elec- lished in the Federal Register. The final
final regulations should permit taxpay- tion made under the repair allowance regulations will provide rules applicable to
ers to choose between repair allowance method only by obtaining the Commis- taxpayers that seek to change a method of
percentages in Rev. Proc. 83–35 and sioner’s consent. Procedures for obtaining accounting to comply with the rules con-
the final regulations. The IRS and Trea- the Commissioner’s consent to revoke an tained in the final regulations. Taxpay-
sury Department also request comments election will be provided either in the final ers may not change a method of account-
on whether a separate repair allowance regulations or in published guidance in the ing in reliance upon the rules contained in
percentage should be provided for certain Internal Revenue Bulletin. The IRS and the proposed regulations until the rules are
types of property, such as repair allowance Treasury Department expect to provide published as final regulations in the Fed-
property subject to section 168(g) (for that a taxpayer that revokes an election eral Register.
example, a percentage that reflects the may not re-elect the repair allowance The IRS and Treasury Department an-
recovery period under the alternative de- method for a period of at least five tax- ticipate that, except as otherwise provided
preciation system in section 168(g) rather able years, beginning with the year of the (for example, in the repair allowance sec-
than the MACRS recovery period under revocation unless, based on a showing of tion), the final regulations will provide
section 168). Finally, the IRS and Trea- unusual and compelling circumstances, that a taxpayer seeking to change to a
sury Department request comments on consent is specifically granted by the method of accounting provided in the fi-
whether industries should be permitted Commissioner to re-elect the repair al- nal regulations must follow the applicable
to request guidance through the Industry lowance at an earlier time. The IRS and procedures for obtaining the Commis-
Issue Resolution program to establish dif- Treasury Department request comments sioner’s automatic consent to a change in
ferent repair allowance percentages for on the appropriateness of the five year accounting method. Generally, a change in
their particular industry. waiting period, as well as on the circum- method of accounting is made using an ad-
stances that should be considered unusual justment under section 481(a). However,
H. Manner of electing and manner of and compelling so that the Commissioner the IRS and Treasury Department are con-
revoking election would grant consent to re-elect the repair cerned about the potential administrative
allowance prior to expiration of the five burden on taxpayers and the IRS that may
The proposed regulations reserve the is- result from section 481(a) adjustments that
year waiting period.
sue of how a taxpayer will elect the re- originate many years prior to the effective
pair allowance method. Two commenta- I. Record keeping date of the final regulations. The IRS and
tors suggested that taxpayers be permitted Treasury Department request comments
to elect the repair allowance on a year by The proposed regulations do not impose on whether there are circumstances in
year basis. The IRS and Treasury Depart- any specific record keeping requirements. which it is appropriate to permit a change
ment disagree with this suggestion. The However, under section 6001, taxpayers in method of accounting to be made using
repair allowance method is a method of ac- are required to keep books and records suf- a cut-off basis instead of a section 481(a)
counting under section 446(e) and should ficient to establish the amounts used to adjustment. Finally, the IRS and Treasury
be used consistently by taxpayers. Allow- compute a deduction under the repair al- Department request comments on any ad-
ing a year by year election would com- lowance method. For example, taxpayers ditional terms and conditions for changes
plicate a taxpayer’s record keeping and must maintain books and records reason- in methods of accounting that would be
would create a burden on IRS examining ably sufficient to determine (1) the total helpful to taxpayers in adopting the rules
agents when auditing a taxpayer’s com- amounts paid (other than amounts paid for contained in these proposed regulations.
pliance with the repair allowance method. excluded additions) during the taxpayer
Therefore, the IRS and Treasury Depart- year for the repair, maintenance, or im- Special Analyses
ment do not expect to permit a year by provement of repair allowance property in
year election. However, even though the the specific MACRS class; (2) the unad- It has been determined that this notice
repair allowance method is a method of justed basis of all repair allowance prop- of proposed rulemaking is not a signifi-
accounting under section 446(e), the IRS erty in the specific MACRS class at the cant regulatory action as defined in Exec-
and Treasury Department expect to pro- beginning and the end of the taxable year; utive Order 12866. Therefore, a regula-
vide that taxpayers may elect the repair (3) the repair allowance percentages used tory assessment is not required. It also has
allowance method prospectively without for the specific MACRS class for the tax- been determined that section 553(b) of the
having to file an application for change in able year; and (4) the treatment of the cap- Administrative Procedure Act (5 U.S.C.
accounting method and that the election italized amounts (whether capitalized as a chapter 5) does not apply to these regu-
be done on a cutoff basis. Procedures for single asset or allocated to all repair al- lations, and, because the regulation does
electing the repair allowance method will lowance property in the specific MACRS not impose a collection of information on
be provided either in the final regulations class). small entities, the Regulatory Flexibility

2006–39 I.R.B. 549 September 25, 2006


Act (5 U.S.C. chapter 6) does not apply. Associate Chief Counsel (Income Tax and (d) Acquired or produced tangible prop-
Pursuant to section 7805(f) of the Code, Accounting), IRS. However, other person- erty.
this notice of proposed rulemaking will be nel from the IRS and Treasury Department (1) In general.
submitted to the Chief Counsel for Advo- participated in their development. (i) Requirement of capitalization.
cacy of the Small Business Administration (ii) Examples.
*****
for comment on its impact on small busi- (2) Defense or perfection of title to tan-
ness. Proposed Amendments to the gible property.
Regulations (i) In general.
Comments and Public Hearing (ii) Examples.
Accordingly, 26 CFR part 1 is proposed (3) Transaction costs.
Before the proposed regulations are
to be amended as follows: (i) In general.
adopted as final regulations, consideration
(ii) Examples.
will be given to any written comments
PART 1—INCOME TAXES (4) 12-month rule.
(a signed original and eight (8) copies)
(i) In general.
or electronic comments that are submitted
Paragraph 1. The authority citation for (ii) Coordination with section 461.
timely to the IRS. Comments are requested
part 1 continues to read in part as follows: (iii) Exceptions to 12-month rule.
on all aspects of the proposed regulations.
Authority: 26 U.S.C. 7805 * * * (iv) Character of property subject to
In addition, the IRS and Treasury Depart-
Par. 2. Section 1.162–4 is revised to 12-month rule.
ment specifically request comments on
read as follows: (v) Election to capitalize.
the clarity of the proposed rules and how
(vi) Examples.
they may be made easier to understand. §1.162–4 Repairs. (e) Treatment of capital expenditures.
All comments will be available for public
(f) Recovery of capitalized amounts.
inspection and copying. Amounts paid for repairs and mainte- (1) In general.
A public hearing has been scheduled nance to tangible property are deductible (2) Examples.
for Tuesday, December 19, 2006, at 10:00 if the amounts paid are not required to be (g) Effective date.
a.m., in the auditorium of the New Car- capitalized under §1.263(a)–3. (h) Accounting method changes.
rollton Federal Building, 5000 Ellin Road, Par. 3. Section 1.263(a)–0 is amended
Lanham, MD 20706. Due to building se- by revising the entries for §1.263(a)–1 §1.263(a)–3 Amounts paid to improve
curity procedures, visitors must enter at through §1.263(a)–3 to read as follows: tangible property.
the main front entrance. In addition, all
visitors must present photo identification §1.263(a)–0 Table of contents. * * *
(a) Overview.
to enter the building. Because of access
(b) Definitions.
restrictions, visitors will not be admitted §1.263(a)–1 Capital expenditures; in
(1) Amount paid.
beyond the immediate entrance area more general.
(2) Personal property.
than 30 minutes before the hearing starts.
(a) General rule for capital expendi- (3) Real property.
For information about having your name
tures. (c) Coordination with other provisions
placed on the building access list to attend
(b) Examples of capital expenditures. of the Internal Revenue Code.
the hearing, see the “FOR FURTHER IN-
(c) Amounts paid to sell property. (1) In general.
FORMATION CONTACT” section of this
(1) In general. (2) Example.
preamble.
(2) Treatment of capitalized amount. (d) Improved property.
The rules of 26 CFR 601.601(a)(3) ap-
(3) Examples. (1) Capitalization rule.
ply to the hearing. Persons who wish to
(d) Amount paid. (2) Determining the appropriate unit of
present oral comments at the hearing must
(e) Effective date. property.
submit electronic or written comments and
(f) Accounting method changes. (i) In general.
an outline of the topics to be discussed and
(ii) Initial unit of property determina-
the time to be devoted to each topic (signed
§1.263(a)–2 Amounts paid to acquire or tion.
original and eight (8) copies) by Novem-
produce tangible property. (iii) Category I: Taxpayers in regulated
ber 28, 2006. A period of 10 minutes will
industries.
be allotted to each person for making com-
(a) Overview. (iv) Category II: Buildings and struc-
ments. An agenda showing the scheduling
(b) Definitions. tural components.
of the speakers will be prepared after the
(1) Amount paid. (v) Category III: Other personal prop-
deadline for receiving outlines has passed.
(2) Personal property. erty.
Copies of the agenda will be available free
(3) Real property. (vi) Category IV: Other real property.
of charge at the hearing.
(4) Produce. (vii) Additional rule.
Drafting Information (c) Coordination with other provisions (viii) Examples.
of the Internal Revenue Code. (3) Compliance with regulatory re-
The principal author of these regula- (1) In general. quirements.
tions is Kimberly L. Koch, Office of the (2) Materials and supplies. (4) Unavailability of replacement parts.

September 25, 2006 550 2006–39 I.R.B.


(5) Repairs performed during an im- (11) Examples. of property generally must be capitalized.
provement. (h) Treatment of capital expenditures. However, in the case of dealers in property,
(i) In general. (i) Recovery of capitalized amounts. amounts paid to facilitate the sale of prop-
(ii) Exception for individuals. (j) Effective date. erty are treated as ordinary and necessary
(e) Value. (k) Accounting method changes. business expenses. See §1.263(a)–5(g) for
(1) In general. the treatment of amounts paid to facilitate
*****
(2) Exception. the disposition of assets that constitute a
Par. 4. Sections 1.263(a)–1 through
(3) Appropriate comparison. trade or business.
1.263(a)–3 are revised to read as follows:
(4) Examples. (2) Treatment of capitalized amount.
(f) Restoration. §1.263(a)–1 Capital expenditures; in Amounts capitalized under paragraph
(1) In general. general. (c)(1) of this section are treated as a reduc-
(2) Economic useful life. tion in the amount realized and generally
(i) Taxpayers with an applicable finan- (a) General rule for capital expendi- are taken into account either in the taxable
cial statement. tures. Except as provided in chapter 1 of year in which the sale occurs or in the
(ii) Taxpayers without an applicable fi- the Internal Revenue Code, no deduction taxable year in which the sale is aban-
nancial statement. is allowed for— doned if a loss deduction is permissible.
(iii) Definition of “applicable financial (1) Any amount paid for new buildings The capitalized amount is not added to the
statement.” or for permanent improvements or better- basis of the property and is not treated as
(3) Substantially prolonging economic ments made to increase the value of any an intangible under §1.263(a)–4.
useful life. property or estate, or (3) Examples. The following examples,
(i) In general. (2) Any amount paid in restoring prop- which assume the sale is not an installment
(ii) Replacements. erty or in making good the exhaustion sale under section 453, illustrate the rules
(iii) Restoration to like-new condition. thereof for which an allowance is or has of this paragraph (c):
(iv) Restoration after a casualty loss. been made in the form of a deduction for Example 1. Sales costs of real property. X owns
(4) Examples. depreciation, amortization, or depletion. a parcel of real estate. X sells the real estate and pays
legal fees, recording fees, and sales commissions to
(g) Repair allowance method. (b) Examples of capital expenditures. facilitate the sale. X must capitalize the fees and com-
(1) In general. The following amounts paid are examples missions and, in the taxable year of the sale, offset
(2) Election of repair allowance of capital expenditures: the fees and commissions against the amount realized
method. (1) An amount paid to acquire or from the sale of the real estate.
(3) Application of repair allowance produce real or personal property. See Example 2. Sales costs of dealers. Assume the
same facts as in Example 1, except that X is a dealer
method. §1.263(a)–2. in real estate. The commissions and fees paid to facil-
(4) Repair allowance amount. (2) An amount paid to improve real or itate the sale of the real estate are treated as ordinary
(i) In general. personal property. See §1.263(a)–3. and necessary business expenses under section 162.
(ii) Average unadjusted basis. (3) An amount paid to acquire or create Example 3. Sales costs of personal property used
(iii) Unadjusted basis. intangibles. See §1.263(a)–4. in the trade or business. X is a farmer and owns a
truck for use in X’s trade or business. X decides to
(iv) Buildings. (4) An amount paid or incurred to facil- sell the truck and on November 15, 2008, X pays
(5) Capitalized amount. itate an acquisition of a trade or business, to advertise the sale of the truck in the local news
(i) In general. a change in capital structure of a business media. On February 15, 2009, X sells the truck to Y.
(ii) Single asset treatment of capitalized entity, and certain other transactions. See X is required to capitalize in 2008 the amount paid to
amount. §1.263(a)–5. advertise the sale of the truck and, in 2009, is required
to offset the amount paid against the amount realized
(iii) Allocation treatment of capitalized (5) An amount assessed and paid un- from the sale of the truck.
amount. der an agreement between bondholders or Example 4. Costs of abandoned sale of personal
(iv) Section 168(g) repair allowance shareholders of a corporation to be used in property used in a trade or business. Assume the
property. a reorganization of the corporation or vol- same facts as in Example 3, except that, instead of
(v) Section 168(g) election. untary contributions by shareholders to the selling the truck on February 15, 2009, X decides on
that date not to sell the truck and takes the truck off the
(vi) Public utility property. capital of the corporation for any corporate market. X is required to capitalize in 2008 the amount
(6) Repair allowance property. purpose. See section 118 and §1.118–1. paid to advertise the sale of the truck. However, X
(i) In general. (6) An amount paid by a holding com- may treat the amount paid as a loss under section 165
(ii) Certain property not subject to sec- pany to carry out a guaranty of dividends in 2009 when the sale is abandoned.
tion 168. at a specified rate on the stock of a sub- Example 5. Sales costs of personal property not
used in a trade or business. Assume the same facts as
(iii) Exclusions from repair allowance sidiary corporation for the purpose of se- in Example 3, except that X does not use the truck in
property. curing new capital for the subsidiary and X’s trade or business, but instead uses it for personal
(7) Excluded additions. increasing the value of its stockholdings in purposes. X decides to sell the truck and on Novem-
(i) In general. the subsidiary. This amount must be added ber 15, 2008, X pays to advertise the sale of the truck
(ii) Treatment of excluded additions. to the cost of the stock in the subsidiary. in the local news media. On February 15, 2009, X
sells the truck to Y. X is required to capitalize in 2008
(8) Repair allowance percentage. (c) Amounts paid to sell property—(1) the amount paid to advertise the sale of the truck and,
(9) Manner of election. In general. Commissions and other trans- in 2009, is required to offset the amount paid against
(10) Manner of revoking election. action costs paid to facilitate the sale the amount realized from the sale of the truck.

2006–39 I.R.B. 551 September 25, 2006


Example 6. Costs of abandoned sale of personal tural components of such buildings or by X purchasing new parts. In 2008, X purchases
property not used in a trade or business. Assume the structures) that are not personal prop- expendable flight equipment spare parts. X prop-
same facts as in Example 5, except that, instead of erty as defined in paragraph (b)(2) of this erly treats the amount paid for the expendable flight
selling the truck on February 15, 2009, X decides on equipment spare parts as a deferred expense under
that date not to sell the truck and takes the truck off the
section. Local law is not controlling in §1.162–3. Nothing in this section changes the treat-
market. X is required to capitalize in 2008 the amount determining whether property is real prop- ment of the original acquisition cost as a deferred ex-
paid to advertise the sale of the truck. Although the erty for purposes of this section. pense.
sale is abandoned in 2009, X may not treat the amount (4) Produce. Produce means construct, Example 2. Acquisition of personal property —
paid as a loss under section 165 because the truck was build, install, manufacture, develop, cre- coordination with §1.162–3. X, an industrial laundry
not used in X’s trade or business or in a transaction business, leases many products, including garments,
entered into for profit.
ate, raise, or grow. See §1.263(a)–3 for linens, shop towels, continuous roll towels, and mops
(d) Amount paid. For purposes of this capitalization rules applicable to amounts (rental items). X maintains a supply of rental items on
section, the terms amounts paid and pay- paid to improve property. hand to replace worn or damaged items. The rental
(c) Coordination with other provisions items have useful lives of 12 months or less. In 2008,
ment mean, in the case of a taxpayer us- X purchases a large quantity of rental items. The
ing an accrual method of accounting, a of the Internal Revenue Code—(1) In gen-
amount paid for the rental items is properly treated
liability incurred (within the meaning of eral. Nothing in this section changes the by X as a deferred expense under §1.162–3. Nothing
§1.446–1(c)(1)(ii)). A liability may not be treatment of any amount that is specifically in this section changes the treatment of the original
taken into account under this section prior provided for under any provision of the In- acquisition cost as a deferred expense.
ternal Revenue Code or regulations other Example 3. Acquisition of personal property. In
to the taxable year during which the liabil- 2008, X purchases new cash registers, which have a
ity is incurred. than section 162(a) or section 212 and the
useful life substantially beyond the taxable year, for
(e) Effective date. The rules in this sec- regulations under those sections. use in its retail store located in a leased space in a
tion apply to taxable years beginning on or (2) Materials and supplies. Nothing shopping mall. X must capitalize under this para-
after the date of publication of the Treasury in this section changes the treatment of graph (d)(1) the amount paid to purchase each cash
amounts paid for materials and supplies register.
decision adopting these rules as final reg- Example 4. Relocation and installation of per-
ulations in the Federal Register. that are properly treated as deductions or
sonal property. Assume the same facts as in Example
(f) Accounting method changes. [Re- deferred expenses, as appropriate, under 3, except that X’s lease expires in 2009 and X decides
served] §1.162–3. to relocate its retail store to a different building. In ad-
(d) Acquired or produced tangible dition to various other costs, X pays $5,000 to move
§1.263(a)–2 Amounts paid to acquire or property—(1) In general—(i) Require- the cash registers and $1,000 to reinstall them in the
ment of capitalization. A taxpayer must other store. X is not required to capitalize under this
produce tangible property.
paragraph (d)(1) the $5,000 amount paid for moving
capitalize amounts paid to acquire or the cash registers; however, X must capitalize under
(a) Overview. This section provides produce real or personal property hav- this paragraph (d)(1) the $1,000 amount paid to rein-
rules for applying section 263(a) to ing a useful life substantially beyond the stall the cash registers in its other store because, under
amounts paid to acquire or produce real taxable year, including land and land im- paragraph (b)(4) of this section, installation costs are
or personal property. See §1.263(a)–3 provements, buildings, machinery and production costs.
Example 5. Acquisition of land. X purchases a
for the treatment of amounts paid to im- equipment, and furniture and fixtures, and parcel of undeveloped real estate. X must capitalize
prove tangible property, §1.263(a)–4 for a unit of property (as determined under under this paragraph (d)(1) the amount paid to acquire
the treatment of amounts paid to acquire §1.263(a)–3(d)(2)), having a useful life the real estate. See §1.263(a)–2(d)(3) for the treat-
or create intangibles, and §1.263(a)–5 for substantially beyond the taxable year. A ment of amounts paid to facilitate the acquisition of
the treatment of amounts paid to facilitate taxpayer also must capitalize amounts real property.
Example 6. Acquisition of building. X purchases
an acquisition of a trade or business, a paid to acquire real or personal property a building. X must capitalize under this paragraph
change in capital structure of a business for resale and to produce real or personal (d)(1) the amount paid to acquire the building. See
entity, and certain other transactions. property for sale. See section 263A for the §1.263(a)–2(d)(3) for the treatment of amounts paid
(b) Definitions. For purposes of this scope of costs required to be capitalized to facilitate the acquisition of real property.
section, the following definitions apply: to property produced by the taxpayer or to Example 7. Acquisition of property for resale. X
purchases goods for resale. X must capitalize under
(1) Amount paid. In the case of a tax- property acquired for resale. this paragraph (d)(1) the amounts paid to acquire the
payer using an accrual method of account- (ii) Examples. The following examples goods. See section 263A for the treatment of amounts
ing, the terms amounts paid and payment illustrate the rule of this paragraph (d)(1): paid to acquire property for resale.
mean a liability incurred (within the mean- Example 1. Acquisition of personal property — Example 8. Production of property for sale. X
ing of §1.446–1(c)(1)(ii)). A liability may coordination with §1.162–3. X, an airline, operates a produces goods for sale. X must capitalize under
fleet of aircraft. X purchases and maintains in stock this paragraph (d)(1) the amount paid to produce the
not be taken into account under this section
for repairs to its aircraft a great number of differ- goods. See section 263A for the treatment of amounts
prior to the taxable year during which the ent expendable flight equipment spare parts (includ- paid to produce property.
liability is incurred. ing cartridges, canisters, cylinders, and disks), based Example 9. Production of building. X constructs
(2) Personal property. Personal prop- in part on the manufacturer’s recommendations and a building. X must capitalize under this paragraph
erty means tangible personal property as in part on the airline’s experience. The expendable (d)(1) the amount paid to construct the building. See
flight equipment spare parts are carried on hand by X section 263A for the treatment of amounts paid to
defined in §1.48–1(c).
until they are installed in the particular type of aircraft produce real property.
(3) Real property. Real property means for which purchased. The expendable flight equip- Example 10. Acquisition of assets constituting a
land and improvements thereto, such as ment spare parts are of a type normally not repaired trade or business. Y owns tangible and intangible as-
buildings or other inherently permanent and reused. As these parts are taken from stock and sets that constitute a trade or business. X purchases
structures (including items that are struc- used to repair aircraft, the stock supply is replenished all the assets of Y in a taxable transaction. X must

September 25, 2006 552 2006–39 I.R.B.


capitalize under this paragraph (d)(1) the amount paid 1031. See §1.263(a)–5 for the treatment used in the trade or business under section
for the tangible assets of Y. See §1.263(a)–4 for the of amounts paid to facilitate the acquisi- 1231.
treatment of amounts paid to acquire intangibles and tion of assets that constitute a trade or busi- (v) Election to capitalize. A taxpayer
§1.263(a)–5 for the treatment of amounts paid to fa-
cilitate the acquisition of assets that constitute a trade
ness. See section 263A for the scope of may elect not to apply the 12-month rule
or business. See section 1060 for special allocation costs required to be capitalized to property contained in paragraph (d)(4)(i) of this
rules for certain asset acquisitions. produced by the taxpayer or to property ac- section with regard to a unit of property.
(2) Defense or perfection of title to quired for resale. An election made under this paragraph
property—(i) In general. Amounts paid (ii) Examples. The following examples (d)(4)(v) applies to any unit of property
to defend or perfect title to real or per- illustrate the rule of this paragraph (d)(3): during the taxable year to which para-
sonal property constitute amounts paid to Example 1. Legal fees, taxes, and commissions graph (d)(4)(i) of this section would apply
acquire or produce property within the to facilitate an acquisition. X purchases a building (but for the election under this paragraph
and pays legal fees, sales taxes, and sales commis-
meaning of this section and must be capi- sions to facilitate the acquisition. X must capitalize
(d)(4)(v)). A taxpayer makes the election
talized. See section 263A for the scope of the amounts paid for legal fees, sales taxes, and sales by treating the amount paid as a capital
costs required to be capitalized to property commissions. expenditure in its timely filed original
produced by the taxpayer or to property Example 2. Moving costs to facilitate an acqui- Federal income tax return (including ex-
acquired for resale. sition. X purchases all the assets of Y and, in con- tensions) for the taxable year in which
nection with the purchase, hires a transportation com-
(ii) Examples. The following examples pany to move storage tanks from Y’s plant to X’s
the amount is paid. In the case of a
illustrate the rule of this paragraph (d)(2): plant. X must capitalize the amount paid to move the pass-through entity, the election is made
Example 1. Amounts paid to contest condemna- tanks from Y’s plant to X’s plant because the amount by the pass-through entity, and not by the
tion. X owns real property located in County. County paid facilitates the acquisition of the storage tanks. shareholders, partners, etc. An election
filed an eminent domain complaint condemning a
(4) 12-month rule—(i) In general. may not be made through the filing of
portion of X’s property to use as a roadway. X hired
an attorney to contest the condemnation. Amounts
Except as otherwise provided in this para- an application for change in accounting
paid by X to the attorney must be capitalized because graph (d)(4), an amount paid for the method or by an amended Federal income
they were to defend X’s title to the property. acquisition or production (including any tax return and an election may not be re-
Example 2. Amounts paid to invalidate or- amount paid to facilitate the acquisition voked.
dinance. X is in the business of quarrying and
or production) of a unit of property (as (vi) Examples. The rules of this para-
supplying sand and stone in a certain municipality.
Several years after X established its business, the
determined under §1.263(a)–3(d)(2)) with graph (d)(4) are illustrated by the follow-
municipality in which it was located passed an ordi- an economic useful life (as defined in ing examples, in which it is assumed (un-
nance that prohibited the operation of X’s business. §1.263(a)–3(f)(2)) of 12 months or less is less otherwise stated) that the taxpayer is
X incurred attorney’s fees in a successful prosecution not a capital expenditure under paragraph a calendar year, accrual method taxpayer
of a suit to invalidate the municipal ordinance. X
(d) of this section. that has not elected out of the 12-month
prosecuted the suit to preserve its business activities
and not to defend X’s title in the property. Therefore,
(ii) Coordination with section 461. In rule under paragraph (d)(4)(v) of this sec-
attorney’s fees paid by X are not required to be capi- the case of a taxpayer using an accrual tion with regard to the unit of property, and
talized under this paragraph (d)(2). However, under method of accounting, the rules of this that none of the property is materials and
section 263A, all indirect costs, including otherwise paragraph (d)(4) do not affect the deter- supplies under §1.162–3:
deductible costs, that directly benefit or are incurred
mination of whether a liability is incurred Example 1. Production cost. X corporation
by reason of the taxpayer’s production activities
during the taxable year, including the de- manufactures and sells aluminum storm windows
must be capitalized to the property produced for sale. and doors. To conduct its business, X purchases
Therefore, because the amounts paid to invalidate the termination of whether economic perfor-
strips of aluminum called extrusions and applies
ordinance are incurred by reason of X’s production mance has occurred with respect to the li- paint electrostatically to the extrusions through a
activities, the amounts paid must be capitalized under ability. See §1.461–4 for rules relating to complex process. In 2008, X installs a leaching pit
section 263A to the property produced for sale by X.
economic performance. to provide a draining area for liquid waste produced
Example 3. Amounts paid to challenge building
(iii) Exceptions to 12-month rule. The in the process of painting the extrusions. X previ-
line. The board of public works of a municipality ously had dumped this waste into a creek bed, but
established a building line across X’s business prop- 12-month rule in paragraph (d)(4)(i) of this
the local water department ordered it to cease this
erty, adversely affecting the value of the property. X section does not apply to the following: practice. The economic useful life of the leaching
incurred legal fees in unsuccessfully litigating the es- (A) Amounts paid for property that is or pit is 12 months, after which time the factory will be
tablishment of the building line. Amounts paid by X
will be included in property produced for connected to the local sewer system. Assume that the
to the attorney must be capitalized because they were
sale or property acquired for resale; leaching pit is the unit of property, as determined un-
to defend X’s title to the property. der §1.263(a)–3(d)(2). X is not required to capitalize
(3) Transaction costs—(i) In general. (B) Amounts paid to improve property
under paragraph (d) of this section the amount paid
A taxpayer must capitalize amounts paid to under §1.263(a)–3; to produce the leaching pit because the useful life of
facilitate the acquisition of real or personal (C) Amounts paid for land; and the leaching pit is 12 months or less. However, under
property, including shipping costs, bidding (D) Amounts paid for any component section 263A, all indirect costs, including otherwise
of a unit of property. deductible costs, that directly benefit or are incurred
costs, sales and transfer taxes, legal and ac- by reason of the taxpayer’s manufacturing activities
counting fees, title fees, engineering fees, (iv) Character of property subject to
must be capitalized to the property produced for sale.
survey costs, inspection costs, appraisal 12-month rule. Property to which a tax- Therefore, because the amounts paid for the leaching
fees, recording fees, application fees, com- payer applies the 12-month rule contained pit are incurred by reason of X’s manufacturing op-
missions, and compensation for the ser- in paragraph (d)(4)(i) of this section is not erations, the amounts paid must be capitalized under
treated upon sale or disposition as a capi- section 263A to the property produced for sale by X.
vices of a qualified intermediary or other
facilitator of an exchange under section tal asset under section 1221 or as property

2006–39 I.R.B. 553 September 25, 2006


Example 2. Acquisition or production cost. X Example 8. Election not to capitalize. Assume 1.263(a)–3 determine whether amounts
purchases or produces jigs, dies, molds, and patterns the same facts as in Example 4, except that X elects capitalized under this section §1.263(a)–2
for use in the manufacture of motor vehicles and mo- under paragraph (d)(4)(v) of this section not to apply for property that is used to replace a
tor vehicle parts. The economic useful life of the the 12-month rule contained in paragraph (d)(4)(i) of
jigs, dies, molds, and patterns is 12 months. Assume this section to the tires purchased on December 1,
component of a unit of property are repair
each jig, die, mold, and pattern is a separate unit of 2008. X must capitalize under paragraph (d) of this or maintenance expenses or capitalized as
property, as determined under §1.263(a)–3(d)(2). X section the amount paid for the tires. an improvement to the unit of property.
is not required to capitalize under paragraph (d) of Example 9. Exception to 12-month rule — prop- (2) Examples. The following examples
this section the amounts paid to produce or purchase erty acquired for resale. Assume the same facts as in illustrate the rule of this paragraph (f)(1)
the jigs, dies, molds, and patterns because the eco- Example 4, except that X purchases the tires for re-
nomic useful life is 12 months or less. However, un- sale. The 12-month rule in paragraph (d)(4)(i) of this
and assume that the taxpayer does not treat
der section 263A, all indirect costs, including other- section does not apply because the tires are property the acquired property as materials and sup-
wise deductible costs, that directly benefit or are in- acquired for resale. Thus, X is required under para- plies under §1.162–3:
curred by reason of the taxpayer’s manufacturing ac- graph (d) of this section to capitalize the amount paid Example 1. Recovery when property placed in
tivities must be capitalized to the property produced for the tires. service. X owns a 10-unit apartment building. The
for sale. Therefore, because the amounts paid for the Example 10. Exception to 12-month rule — com- refrigerator in one of the apartments stops function-
jigs, dies, molds, and patterns are incurred by reason ponent of property. Assume the same facts as in ing and X purchases a new refrigerator to replace the
of X’s manufacturing operations, the amounts paid Example 4, except that the tires are the first set of old one. X pays for the acquisition, delivery, and
must be capitalized under section 263A to the prop- tires to be installed on a truck tractor acquired by X installation of the new refrigerator. Assume the re-
erty produced for sale by X. and X uses the original tire capitalization method de- frigerator is the unit of property, as determined under
Example 3. Acquisition or production cost. As- scribed in Rev. Proc. 2002–27 (see §601.601(d)(2) §1.263(a)–3(d)(2). Section 1.263(a)–2(d) requires
sume the same facts as in Example 2, but the eco- of this chapter) so that the truck tractor (including capitalization of amounts paid for the acquisition, de-
nomic useful life of the jigs, dies, molds, and patterns the tires) is the unit of property, as determined under livery, and installation of the refrigerator. Under this
is 3 years. X is required to capitalize under paragraph §1.263(a)–3(d)(2). Also assume that the truck tractor paragraph (f), the capitalized amounts are recovered
(d) of this section the amounts paid to produce or pur- has an economic useful life of more than 12 months through depreciation when the refrigerator is placed
chase the jigs, dies, molds, and patterns because the and that the invoice for the acquisition of the truck in service by X.
economic useful life is more than 12 months. tractor separately states the cost of tires and various Example 2. Recovery when property used in a re-
Example 4. Acquisition cost. X corporation is other components of the truck tractor. X is required pair. Assume the same facts as in Example 1, except
an interstate motor carrier. On December 1, 2008, X under paragraph (d) of this section to capitalize the that a window in one of the apartments needs to be
purchases, pays for, and takes delivery of truck tires amount paid for the truck tractor because the eco- replaced. X pays for the acquisition, delivery, and
with an economic useful life of 12 months. Assume nomic useful life of the truck tractor is more than 12 installation of a new window. Assume the window
X does not use the original tire capitalization method months. Further, X may not use the 12-month rule to is a structural component of the apartment building
described in Rev. Proc. 2002–27, 2002–1 C.B. 802 currently deduct the amount paid for the tires or any and that the apartment building is the unit of prop-
(see §601.601(d)(2) of this chapter). Also assume other component of the truck tractor, regardless that erty, as determined under §1.263(a)–3(d)(2). Section
that each tire is a separate unit of property, as de- some components may have an economic useful life 1.263(a)–2(d) requires capitalization of amounts paid
termined under §1.263(a)–3(d)(2). X is not required of 12 months or less and regardless that the cost of for the acquisition and delivery of the window be-
under paragraph (d) of this section to capitalize the individual components is separately stated in the in- cause the window is property with a useful life sub-
amount paid for the tires because the economic use- voice. stantially beyond the end of the taxable year. As-
ful life of the tires is 12 months or less. (e) Treatment of capital expenditures. sume the replacement of the old window with the new
Example 5. Transaction costs. Assume the same one does not improve the apartment building under
Amounts required to be capitalized un-
facts as in Example 4, but in addition to the amount §1.263(a)–3. Under this paragraph (f), the capital-
paid for the tires, X also pays sales tax and delivery
der this section are capital expenditures ized amounts paid to acquire the window are recov-
charges for the tires. X is not required to capitalize and must be taken into account through ered as ordinary and necessary repair expenses under
under paragraph (d) of this section the sales tax and a charge to capital account or basis, or in §1.162–4 when the window is used in the repair by
delivery charges because they were paid to facilitate the case of property that is inventory in its installation in the apartment building.
the acquisition of property with an economic useful Example 3. Recovery when property used in a
the hands of a taxpayer, through inclusion
life of 12 months or less. repair; coordination with section 263A. Assume the
Example 6. Coordination with section 461 fixed
in inventory costs. See section 263A for same facts as in Example 2, except that the window
liability rule. Assume the same facts as in Example 4, the treatment of amounts referred to in that is replaced is in an office in a plant where X man-
except that instead of purchasing the tires on Decem- this section as well as other amounts paid ufactures widgets for sale. Section 1.263(a)–2(d) re-
ber 1, 2008, X enters into a contract with the tire man- in connection with the production of real quires capitalization of amounts paid to produce in-
ufacturer on that date to purchase tires from the man- ventory. Under section 263A, all indirect costs, in-
property and personal property, includ-
ufacturer in 2009. X purchases, pays for, and takes cluding otherwise deductible repair costs that directly
delivery of the tires on March 31, 2009. X does not
ing films, sound recordings, video tapes, benefit or are incurred by reason of the production of
incur a liability under section 461 for the tires in 2008 books, or similar properties. inventory must be capitalized to the inventory pro-
because X does not have a fixed liability with respect (f) Recovery of capitalized duced. Although the repair cost otherwise would be
to the tires until 2009. When X incurs the amount in amounts—(1) In general. Amounts deductible as an expense under §1.162–4, X must de-
2009, X is not required under paragraph (d) of this termine whether the cost of the repair, or an allocable
that are capitalized under this section
section to capitalize that amount. portion thereof, is required to be capitalized to the in-
Example 7. Coordination with section 461 eco-
are recovered through depreciation, cost ventory produced as an indirect expense that directly
nomic performance rule. Assume the same facts as of goods sold, or by an adjustment to benefits or is incurred by reason of the production ac-
in Example 4, except that the tires are not delivered basis at the time the property is placed in tivities. Any portion of the repair capitalized to in-
to X until March 31, 2009. X does not incur a liability service, sold, used, or otherwise disposed ventory is recovered through cost of goods at the time
under section 461 for the tires in 2008 because eco- the property is sold or otherwise disposed of in accor-
of by the taxpayer. Cost recovery is
nomic performance does not occur with respect to the dance with the taxpayer’s method of accounting for
liability until the property is provided to X in 2009.
determined by the applicable Internal inventories.
See §1.461–4(d)(2). When X incurs the amount in Revenue Code and regulation provisions (g) Effective date. The rules in this sec-
2009, X is not required under paragraph (d) of this relating to the use, sale, or disposition of tion apply to taxable years beginning on or
section to capitalize that amount. property. For example, §§1.162–4 and

September 25, 2006 554 2006–39 I.R.B.


after the date of publication of the Treasury than section 162(a) or section 212 and the nents of the initial unit of property deter-
decision adopting these rules as final reg- regulations under those sections). mination must be treated as separate units
ulations in the Federal Register. (2) Example. The following example of property.
(h) Accounting method changes. [Re- illustrates the rules of this paragraph (c): This paragraph (d)(2) applies to all real
served] Example. Railroad rolling stock. X is a railroad and personal property, other than network
that properly treats amounts paid for the rehabilitation assets. For purposes of this paragraph
of railroad rolling stock as deductible expenses un-
§1.263(a)–3 Amounts paid to improve der section 263(d). X is not required to capitalize the
(d)(2), network assets means railroad
tangible property. amounts paid because nothing in this section changes track, oil and gas pipelines, water and
the treatment of amounts specifically provided for un- sewage pipelines, power transmission and
(a) Overview. This section provides der section 263(d). distribution lines, and telephone and cable
rules for applying section 263(a) to (d) Improved property—(1) Capitaliza- lines that are owned or leased by taxpay-
amounts paid to improve tangible prop- tion rule. Except as provided in the re- ers in each of those respective industries.
erty. Paragraph (b) of this section contains pair allowance method in paragraph (g) The term includes, for example, trunk and
definitions. Paragraph (c) of this section of this section, a taxpayer must capital- feeder lines, pole lines, and buried conduit.
contains rules for coordinating this section ize the aggregate of related amounts paid It does not include property that would be
with other provisions of the Internal Rev- to improve a unit of property (including a included as a structural component of a
enue Code. Paragraph (d) of this section unit of property for which the acquisition building under paragraph (d)(2)(iv), nor
provides rules for determining the treat- or production costs were deducted under does it include separate property that is
ment of amounts paid to improve tangible the 12-month rule in §1.263(a)–2(d)(4)), adjacent to, but not part of a network asset,
property, including rules for determining whether the improvements are made by such as bridges, culverts, or tunnels.
the appropriate unit of property. Paragraph the taxpayer or by a third party. See sec- (ii) Initial unit of property determina-
(e) of this section contains rules for deter- tion 263A for the scope of costs required tion. Except for property described in
mining whether amounts paid materially to be capitalized to property produced by paragraph (d)(2)(iv) of this section (re-
increase the value of the unit of property. the taxpayer or to property acquired for re- garding buildings and structural compo-
Paragraph (f) of this section contains rules sale; section 1016 for adding capitalized nents), the unit of property determination
for determining whether amounts paid amounts to the basis of the unit of prop- under this paragraph (d)(2) begins by
restore the unit of property. Paragraph (g) erty; and section 168(i)(6) for the treat- identifying property that consists entirely
of this section describes an optional repair ment of additions or improvements to a of components that are functionally inter-
allowance method. unit of property. For purposes of this para- dependent. Components of property are
(b) Definitions. For purposes this sec- graph (d), a unit of property is improved if functionally interdependent if the plac-
tion, the following definitions apply: the amounts paid— ing in service of one component by the
(1) Amount paid. In the case of a tax- (i) Materially increase the value of the taxpayer is dependent on the placing in
payer using an accrual method of account- unit of property (see paragraph (e) of this service of the other component by the
ing, the terms amounts paid and payment section); or taxpayer. For purposes of this section,
mean a liability incurred (within the mean- (ii) Restore the unit of property (see property that is aggregated and subject to
ing of §1.446–1(c)(1)(ii)). A liability may paragraph (f) of this section). a general asset account election may not
not be taken into account under this section (2) Determining the appropriate unit of be treated as a single unit of property.
prior to the taxable year during which the property—(i) In general. The unit of prop- (iii) Category I: Taxpayers in regulated
liability is incurred. erty rules in this paragraph (d)(2) apply industries. In the case of a taxpayer en-
(2) Personal property. Personal prop- only for purposes of section 263(a) and gaged in a trade or business in a regulated
erty means tangible personal property as §§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3, industry, the unit of property is the USOA
defined in §1.48–1(c). and not any other Internal Revenue Code (uniform system of accounts) unit of prop-
(3) Real property. Real property means or regulation section. Under this para- erty. For purposes of this section, a reg-
land and improvements thereto, such as graph (d)(2), the appropriate unit of prop- ulated industry is an industry for which a
buildings or other inherently permanent erty is initially determined by applying the Federal regulator (including any Federal
structures (including items that are struc- rules in paragraph (d)(2)(ii) of this section, department, agency, commission, board,
tural components of such buildings or except as provided in paragraph (d)(2)(iv) or similar entity) has a USOA identifying
structures) that are not personal prop- of this section (relating to buildings and a particular unit of property (USOA unit
erty as defined in paragraph (b)(2) of this structural components). The initial unit of property). This rule applies to any tax-
section. Local law is not controlling in of property determination is further ana- payer engaged in a trade or business in the
determining whether property is real prop- lyzed in accordance with the appropriate regulated industry, regardless of whether
erty for purposes of this section. hierarchical category described in one of the taxpayer is subject to the regulatory
(c) Coordination with other provisions paragraphs (d)(2)(iii) through (d)(2)(vi) of accounting rules of the Federal regulator.
of the Internal Revenue Code—(1) In gen- this section and by applying the additional The unit of property determination made
eral. Nothing in this section changes the rule in paragraph (d)(2)(vii) of this section. under this paragraph (d)(2)(iii) is subject to
treatment of any amount that is specifically The specific rules contained in paragraphs paragraph (d)(2)(vii) of this section, which
provided for under any provision of the In- (d)(2)(iii) through (d)(2)(vii) of this sec- may require one or more components to be
ternal Revenue Code or regulations (other tion dictate whether one or more compo- treated as separate units of property.

2006–39 I.R.B. 555 September 25, 2006


(iv) Category II: Buildings and struc- improved, and either immediately rein- graph (d)(2)(vii) of this section does not re-
tural components. In the case of a building stalled on other property or stored for later quire the use of a different unit of property:
(as defined in §1.48–1(e)(1)) other than installation); and Example 1. Category I. X is an electric utility
that described in paragraph (d)(2)(iii) of (D) Whether the property of which the company that operates a power plant to generate elec-
tricity. X’s operation previously was regulated by the
this section, the building and its structural component is a part generally functions Federal Energy Regulatory Commission (FERC) but,
components (as defined in §1.48–1(e)(2)) for its intended use without the component for various reasons, is no longer subject to regulation
are a single unit of property. The unit of property. by FERC. Under FERC’s USOA, each turbine, econ-
property determination made under this (vi) Category IV: Other real property. omizer, generator, and pulverizer is treated as a sepa-
paragraph (d)(2)(iv) is subject to para- In the case of real property other than rate unit of property for regulatory accounting pur-
poses. The initial unit of property determined un-
graph (d)(2)(vii) of this section, which that described in paragraphs (d)(2)(iii) and der paragraph (d)(2)(ii) of this section is the entire
may require one or more components to (d)(2)(iv) of this section, the unit of prop- power plant, which consists entirely of components
be treated as separate units of property. erty determination must be made on the that are functionally interdependent. The power plant
(v) Category III: Other personal prop- basis of all the facts and circumstances. must next be analyzed under paragraph (d)(2)(iii) of
erty. In the case of personal property other The unit of property determination made this section because X is engaged in a trade or busi-
ness in an industry for which a Federal regulator has
than that described in paragraph (d)(2)(iii) under this paragraph (d)(2)(vi) is subject to a USOA. Under the rules in that paragraph, X must
of this section, the unit of property deter- paragraph (d)(2)(vii) of this section, which treat each turbine, economizer, generator, and pul-
mination must be made on the basis of may require one or more components to verizer as a separate unit of property for determining
the four factors listed in this paragraph be treated as separate units of property. whether an amount paid improves the unit of property
(d)(2)(v). These four factors are the exclu- (vii) Additional rule. If the taxpayer for Federal income tax purposes.
Example 2. Category I. X is a Class I railroad. All
sive factors under this paragraph (d)(2)(v). properly treats a component as a sepa- Class I railroads are regulated by the Surface Trans-
No one factor is determinative and it is not rate unit of property for any Federal in- portation Board (STB). Under STB’s USOA, each
intended that a determination be made on come tax purpose, the taxpayer must treat locomotive and each freight car is treated as a sep-
the basis of the number of factors indicat- the component as a separate unit of prop- arate unit of property for regulatory accounting pur-
ing that a component is, or is not, a sepa- erty for purposes of this paragraph (d)(2). poses. Although each locomotive consists of various
components, such as an engine, generators, batteries,
rate unit of property. The unit of property For purposes of paragraph (d)(2), the term trucks, etc., those components are functionally inter-
determination made under this paragraph any Federal income tax purpose includes, dependent. Thus, the locomotive is an initial unit of
(d)(2)(v) is subject to paragraph (d)(2)(vii) but is not limited to, the use of different property as determined under paragraph (d)(2)(ii) of
of this section, which may require one or placed-in-service dates (other than the use this section. Similarly, each freight car consists en-
more components to be treated as separate of a new placed-in-service date for an im- tirely of functionally interdependent components and,
thus, each freight car is an initial unit of property un-
units of property. The following factors provement (as determined under this sec- der paragraph (d)(2)(ii) of this section. Each loco-
must be taken into account: tion) to the unit of property or a different motive and freight car must next be analyzed under
(A) Whether the component is— placed-in-service date for a particular floor paragraph (d)(2)(iii) of this section because X is en-
(1) Marketed separately to the taxpayer of a building) or different classes of prop- gaged in a trade or business in an industry for which a
by a party other than the seller/lessor of the erty as set forth in section 168(e) (MACRS Federal regulator has a USOA. Under the rules in that
paragraph, X must treat each locomotive and each
property of which the component is a part classes), for the component and the prop- freight car as a separate unit of property for deter-
at the time the property is initially acquired erty of which the component is a part. If mining whether an amount paid improves the unit of
or leased; the taxpayer properly recognizes a loss un- property for Federal income tax purposes.
(2) Acquired or leased separately by der section 165, or under another applica- Example 3. Category I. Assume the same facts as
the taxpayer from a party other than the ble provision, from a retirement of a com- in Example 2, except that X is a Class II railroad. The
STB does not regulate Class II railroads. However,
seller/lessor of the property of which the ponent of property or from the worthless- because X is engaged in a trade or business in an in-
component is a part at the time the prop- ness or abandonment of a component of dustry (the railroad industry) for which a Federal reg-
erty is initially acquired or leased; property, the taxpayer must treat the com- ulator has a USOA, the rules in paragraph (d)(2)(iii)
(3) Subject to a separate warranty ponent as a separate unit of property for of this section apply, regardless of whether X is sub-
contract (from a party other than the purposes of this paragraph (d)(2). There- ject to those rules. Based on these facts, X must treat
each locomotive and each freight car as a separate
seller/lessor of the property of which the fore, any property that replaces the compo- unit of property for determining whether an amount
component is a part); nent also will be treated as a separate unit paid improves the unit of property for Federal income
(4) Subject to a separate maintenance of property. See §1.263(a)–2(d)(1). For tax purposes.
manual or written maintenance policy; purposes of this paragraph (d)(2), merely Example 4. Category I. X is a telecommunica-
(5) Appraised separately; or claiming a tax credit related to tangible tions company regulated by the Federal Communi-
cations Commission (FCC) and subject to a USOA
(6) Sold or leased separately by the tax- property does not constitute treatment of for telephone companies. The assets of X include a
payer to another party; that property as a separate unit of property telephone central office switching center, which con-
(B) Whether the component is treated for a Federal income tax purpose. tains numerous switches and various other switching
as a separate unit of property in industry (viii) Examples. The rules of this para- equipment that all work together to provide telephone
practice or by the taxpayer in its books and graph (d)(2) are illustrated by the follow- service to customers. The initial unit of property de-
termined under paragraph (d)(2)(ii) of this section is
records; ing examples, in which it is assumed (un- the central office switching center, which consists en-
(C) Whether the taxpayer treats the less otherwise stated) that the taxpayer has tirely of components that are functionally interdepen-
component as a rotable part (a part that not made a general asset account election dent. The telecommunications system must next be
is removable from property, repaired or with regard to the property and that para- analyzed under paragraph (d)(2)(iii) of this section

September 25, 2006 556 2006–39 I.R.B.


because X is engaged in a trade or business in an gine in its fleet. To perform maintenance on an en- for determining whether an amount paid improves the
industry for which a Federal regulator has a USOA. gine, X removes the engine from the aircraft and re- unit of property for Federal income tax purposes.
Under the rules in that paragraph, X must treat each places it with another used engine that has returned Example 11. Category III. X purchases a car to
switch and/or piece of equipment as defined in the from a maintenance visit. use in X’s taxi service. The invoice received by X
USOA of the FCC and used in the central office op- (ii) The initial unit of property determined under for the purchase of the car separately lists several op-
eration as a separate unit of property for determining paragraph (d)(2)(ii) of this section is the aircraft (and tions, including air conditioning, automatic transmis-
whether an amount paid improves the unit of property not the entire fleet of aircraft), which consists entirely sion, antilock braking system, side impact air bags,
for Federal income tax purposes. of components that are functionally interdependent. power group, and special alloy wheels. Under para-
Example 5. Category II. X owns a manufactur- The aircraft must next be analyzed under one of para- graph (d)(2)(ii) of this section, the initial unit of prop-
ing building containing various types of manufactur- graphs (d)(2)(iii) through (d)(2)(vi) of this section. erty is the car because the options are functionally in-
ing equipment that are not structural components of Although X is engaged in a trade or business in an in- terdependent with the car. The options are not subject
the manufacturing building. Because the property dustry regulated by the Federal Aviation Administra- to separate warranties. X is an individual and does not
is a building, as defined in §1.48–1(e)(1), paragraph tion (FAA), the FAA does not have a USOA. There- keep books and records other than for tax purposes.
(d)(2)(ii) of this section does not apply and the prop- fore, the rules of paragraph (d)(2)(iii) of this section For depreciation purposes, X properly treats the car
erty must be analyzed under paragraph (d)(2)(iv) of do not apply to X; instead, the rules of paragraph and options as one unit of property. X does not treat
this section. Under the rules in that paragraph, X (d)(2)(v) of this section apply to determine whether any of the options as rotable parts. Based on these
must treat the manufacturing building and its struc- the entire aircraft, or the engine, is the appropriate facts, the options are not separate units of property.
tural components as a single unit of property for de- unit of property. In this Example 8, the aircraft engine X must treat the car, including the options, as the unit
termining whether an amount paid improves the unit is acquired separately, is subject to a separate war- of property for determining whether an amount paid
of property for Federal income tax purposes. The ap- ranty and maintenance policy, is treated separately for improves the unit of property for Federal income tax
propriate unit of property determination for the man- financial accounting purposes, and is rotable. Based purposes.
ufacturing equipment must be made separately under on these facts, X must treat the engine as the unit of Example 12. Category III. X is a common car-
paragraph (d)(2)(v) of this section. property for determining whether an amount paid im- rier that owns a fleet of fuel hauling trucks and peri-
Example 6. Category III; additional rule. As- proves the engine for Federal income tax purposes. X odically performs maintenance on its truck engines.
sume the same facts as in Example 5, except that must treat the aircraft without the engine as a unit of The entire fleet of trucks is subject to a general as-
X does a cost segregation study of the manufactur- property for determining whether an amount paid im- set account election, one for the truck trailers and one
ing building and properly determines that refriger- proves the aircraft for Federal income tax purposes. for the truck tractors. Under paragraph (d)(2)(ii) of
ation equipment used to create a walk-in freezer in Example 9. Category III. X is a corporation that this section, X may not treat the entire fleet as the
the manufacturing building is section 1245 property owns a small aircraft for use in its trade or business. unit of property. Instead, the initial units of property
as defined in section 1245(a)(3). The refrigeration X performs required maintenance on its aircraft en- determined under paragraph (d)(2)(ii) of this section
equipment is not part of the HVAC system that re- gines. The aircraft engine is not marketed, purchased, are each truck tractor and each truck trailer. Each
lates to the general operation or maintenance of the leased, appraised, or sold separately, but it is subject tractor consists entirely of functionally interdepen-
building. For Federal income tax purposes, X prop- to a separate warranty and written maintenance policy dent components and each trailer consists entirely of
erly treats the refrigeration equipment as a separate provided by the engine manufacturer. For financial functionally interdependent components. To deter-
unit of property for depreciation purposes. The rules accounting purposes, X does not maintain separate mine whether the engine is a separate unit of property
of paragraph (d)(2)(v) of this section apply to deter- accounts on its books for individual engines. X does from the tractor, the factors in paragraph (d)(2)(v) of
mine whether the refrigeration equipment, or some not treat the engine as a rotable part. The initial unit of this section apply. The engines are marketed sepa-
smaller component, is the appropriate unit of prop- property determined under paragraph (d)(2)(ii) of this rately from the tractor and are subject to a separate
erty. In this example, assume that no components section is the aircraft, which consists entirely of com- warranty and written maintenance policy provided by
of the refrigeration equipment meet any of the facts ponents that are functionally interdependent. The air- the engine manufacturer. The engines are not treated
and circumstances listed in paragraph (d)(2)(v) of this craft must next be analyzed under paragraph (d)(2)(v) as a separate unit of property in industry practice or
section. Based on these facts, X must treat the refrig- of this section to determine whether the entire air- by X in its books and records. The engine is removed
eration equipment as the unit of property for deter- craft, or the engine, is the appropriate unit of prop- from the tractor, repaired or improved, and stored for
mining whether an amount paid improves the unit of erty. Based on these facts, the engine is not a separate later installation on another tractor. Based on these
property for Federal income tax purposes. unit of property. Therefore, X must treat the aircraft, facts, the engine is a separate unit of property. There-
Example 7. Category III; additional rule. As- including the aircraft engine, as the unit of property fore, X must treat the engine as the unit of property
sume the same facts as in Example 6, except that for determining whether an amount paid improves the for determining whether an amount paid improves the
the refrigeration equipment for the walk-in freezer unit of property for Federal income tax purposes. unit of property for Federal income tax purposes.
ceases to function. X decides not to repair the re- Example 10. Category III. X is a towboat op- Example 13. Category III. Assume the same facts
frigeration equipment, but to replace it altogether. X erator that owns and leases a fleet of towboats. X as in Example 12, except that the inquiry is whether
abandons the refrigeration equipment for the walk-in performs maintenance on its towboat engines every the oil filter in the tractor engine is a separate unit
freezer and properly recognizes a loss under section 3 to 4 years, in accordance with the engine manufac- of property. The oil filter is not marketed, acquired,
165 from the abandonment of the refrigeration equip- turer’s maintenance manuals. Towboat engines are leased, appraised, or sold separately, nor is it subject
ment. Therefore, X must treat the refrigeration equip- not marketed, purchased, leased, appraised, or sold to a separate warranty or maintenance manual. The
ment for the walk-in freezer as a separate unit of prop- separately; however, the engines are subject to a sep- filter is not treated as a separate unit of property in
erty for determining whether amounts paid to replace arate warranty and written maintenance policy pro- industry practice or by X in its books and records, nor
the equipment must be capitalized for Federal income vided by the engine manufacturer. For financial ac- is it treated as a rotable part. Based on these facts, the
tax purposes. See §1.263(a)–2(d)(1). counting purposes, X does not maintain separate ac- oil filter is not a separate unit of property. Therefore,
Example 8. Category III. (i) X is a commercial counts on its books for individual engines. X does not X must treat the engine, including the oil filter, as the
airline engaged in the business of transporting pas- treat the engine as a rotable part. The initial unit of unit of property for determining whether an amount
sengers and freight throughout the United States and property determined under paragraph (d)(2)(ii) of this paid improves the unit of property for Federal income
abroad. To conduct its business, X owns or leases var- section is the towboat (and not the entire fleet of tow- tax purposes.
ious types of aircraft. X purchases the aircraft engine boats), which consists entirely of components that are Example 14. Category III. (i) X manufactures
separately at the time the aircraft is acquired. The functionally interdependent. The towboat must next and sells computers and computer equipment. It also
engine is subject to a separate warranty and written be analyzed under paragraph (d)(2)(v) of this section. operates a separate computer maintenance business,
maintenance policy provided by the engine manufac- Based on these facts, the engine is not a separate unit for which X maintains pools of rotable spare parts
turer. For financial accounting purposes, X accounts of property. Therefore, X must treat the towboat, in- that are primarily used to repair computer equipment
for each type of aircraft by maintaining separate ac- cluding the towboat engine, as the unit of property purchased or leased by its customers. Most of X’s
counts on its books for each type of airframe and en- computer maintenance business is conducted pur-

2006–39 I.R.B. 557 September 25, 2006


suant to standardized maintenance agreements that separate unit of property. X must treat the entire lap- taxpayer (without regard to any applicable
obligate X to provide all parts and labor, product top computer, including the circuit board and CPU, convention under section 168(d));
upgrades, preventive maintenance, and telephone as the unit of property for determining whether an (iii) Adapts the unit of property to a new
assistance necessary to keep a customer’s computer amount paid improves the unit of property for Fed-
operational for the duration of the contract (usually eral income tax purposes.
or different use (including a permanent
one year) in exchange for a predetermined fee. In its (3) Compliance with regulatory re- structural alteration to the unit of prop-
computer maintenance business, X sends technicians
quirements. For purposes of this section, erty);
to its customer’s location, who use the supply of (iv) Results in a betterment (including a
rotable spare parts to diagnose problems in the cus-
a Federal, state, or local regulator’s re-
quirement that a taxpayer perform certain material increase in quality or strength) or
tomer’s equipment, and then exchange the working
parts for any malfunctioning parts. A customer’s repairs or maintenance on a unit of prop- a material addition (including an enlarge-
part that is identified as the cause of the malfunction erty to continue operating the property is ment, expansion, or extension) to the unit
is replaced with the identical functioning part from
not relevant in determining whether the of property; or
X’s rotable spare parts pool. The malfunctioning (v) Results in a material increase in
part removed from the customer’s equipment is then
amount paid improves the unit of property.
(4) Unavailability of replacement parts. capacity (including additional cubic or
repaired and placed in X’s rotable spare parts pool for
continued use in the computer maintenance business. For purposes of this section, if a taxpayer square space), productivity, efficiency, or
(ii) Under paragraph (d)(2)(ii) of this section, X needs to replace part of a unit of property quality of output of the unit of property.
may not treat the entire pool of rotable spare parts
that cannot practicably be replaced with (2) Exception. Notwithstanding the
as the unit of property. Instead, the initial unit of rules in paragraph (e)(1)(i) through
property determined under paragraph (d)(2)(ii) of this
the same type of part (for example, because
of technological advancements or prod- (e)(1)(v) of this section, an amount
section is each rotable spare part because each part
consists entirely of functionally interdependent com- uct enhancements), the replacement of the paid does not result in a material in-
ponents. Assume for purposes of this Example 14 part with an improved but comparable part crease in value to a unit of property if
that paragraph (d)(2)(v) of this section does not re-
does not, by itself, result in an improve- the economic useful life (as defined in
quire any components of the rotable spare parts to be §1.263(a)–3(f)(2)) of the unit of property
treated as separate units of property. Based on these
ment to the unit of property.
(5) Repairs performed during an im- is 12 months or less and the taxpayer did
facts, the entire pool of spare parts is not the unit of
property. Therefore, X must treat each rotable spare provement—(i) In general. Repairs that do not elect to capitalize the amounts paid
part as a unit of property for determining whether an not directly benefit or are not incurred by originally for the unit of property.
amount paid improves the unit of property for Federal
reason of an improvement are not required (3) Appropriate comparison. For
income tax purposes. purposes of paragraphs (e)(1)(iv) and
Example 15. Category III. (i) X is a dentist and
to be capitalized under section 263(a), re-
gardless of whether they are made at the (e)(1)(v) of this section, in cases in which
operates a small dental clinic. On March 1, 2008, X
purchases a new laptop computer, with a one-year same time as an improvement. See section a particular event necessitates an ex-
warranty, for use in the dental business. On May 1, 263A for rules requiring capitalization of penditure, the determination of whether
2009, after the warranty has expired, the computer
all direct costs of an improvement and all the amount paid materially increases the
malfunctions and X contacts the manufacturer’s value of the unit of property is made by
computer maintenance shop for assistance. The
indirect costs that directly benefit or are in-
curred by reason of the improvement. comparing the condition of the property
maintenance shop sends a technician to X’s dental
clinic, who uses a supply of rotable spare parts to (ii) Exception for individuals. A tax- immediately after the expenditure with
diagnose problems in X’s computer. The technician payer who is an individual may capital- the condition of the property immediately
determines that the circuit board must be replaced
ize amounts paid for repairs that are made prior to the event necessitating the expen-
and exchanges X’s malfunctioning circuit board with diture. When the event necessitating the
the identical functioning circuit board from the com-
at the same time as substantial capital im-
provements to property not used in the tax- expenditure is normal wear and tear to
puter maintenance operation’s rotable spare parts
pool. The malfunctioning circuit board removed payer’s trade or business or for the produc- the unit of property, the condition of the
from X’s computer is then repaired and placed in the tion of income if the repairs are done as property immediately prior to the event
manufacturer’s rotable spare parts pool for continued
part of a remodeling or restoration of the necessitating the expenditure is the condi-
use in the computer maintenance business. tion of the property after the last time the
(ii) The initial unit of property determined under
taxpayer’s residence.
(e) Value—(1) In general. A taxpayer taxpayer corrected the effects of normal
paragraph (d)(2)(ii) of this section is the computer,
which consists entirely of components (circuit board must capitalize amounts paid that materi- wear and tear (whether the amounts paid
or motherboard, central processing unit or CPU, hard ally increase the value of a unit of prop- were for maintenance or improvements)
drive, RAM, keyboard, monitor, case, etc.) that are
erty. An amount paid materially increases or, if the taxpayer has not previously cor-
functionally interdependent. To determine whether rected the effects of normal wear and tear,
the circuit board is a separate unit of property from
the value of a unit of property only if it—
(i) Ameliorates a condition or defect the condition of the property when placed
the computer, the factors in paragraph (d)(2)(v) of this
section apply. The circuit board was not marketed that either existed prior to the taxpayer’s in service by the taxpayer.
separately to X or acquired separately by X, nor is it acquisition of the unit of property or arose (4) Examples. The following examples
subject to a separate warranty. The CPU, however,
during the production of the unit of prop- illustrate the rules of this paragraph (e) and
was marketed separately to the taxpayer, but not ac- assume that the amounts paid are not re-
quired separately. No component, including the cir-
erty, whether or not the taxpayer was aware
of the condition or defect at the time of ac- quired to be capitalized under any other
cuit board and CPU of the laptop computer, is treated
as a separate unit of property by X in its books and quisition or production; provision of this section (paragraph (f), for
records, nor does X treat any component as a rotable (ii) Is for work performed prior to the example):
part. The computer does not function for its intended Example 1. Pre-existing condition. In 2008, X
date the property is placed in service by the purchased a store located on 10 acres of land that
use without the circuit board and the CPU. Based on
these facts, neither the circuit board nor the CPU is a contained underground gasoline storage tanks left by

September 25, 2006 558 2006–39 I.R.B.


prior occupants. The tanks had leaked, causing soil In 2010, X placed the building in service and began ponents are the unit of property. Amounts paid for
contamination. X was not aware of the contamination using the building as its business office. For purposes work done in anticipation of selling the building are
at the time of purchase. When X discovered the con- of this Example 3, assume the building and its struc- not required to be capitalized unless the amounts paid
tamination, it incurred costs to remediate the soil. For tural components are the appropriate unit of property. materially increase the value as defined in paragraph
purposes of this Example 1, assume the 10 acres of The amounts paid must be capitalized as an improve- (e)(3) of this section or prolong the economic useful
land is the appropriate unit of property. The amounts ment to the building because they were for work per- life as defined in paragraph (f)(3). The amounts paid
paid for soil remediation must be capitalized as an formed prior to X’s placing the building in service. by X are not transaction costs paid to facilitate the sale
improvement to the land because they ameliorated a The comparison rule in paragraph (e)(3) of this sec- of property under §1.263(a)–1(c), nor do they mate-
condition or defect that existed prior to the taxpayer’s tion does not apply to these amounts paid. rially increase the value of the building. Although
acquisition of the land. The comparison rule in para- Example 4. Work performed prior to placing the the amounts were paid for the purpose of selling the
graph (e)(3) of this section does not apply to these property in service. In January 2008, X purchased building, the sale does not constitute a new or differ-
amounts paid. new machinery for use in an existing production line ent use. Therefore, X is not required to capitalize as
Example 2. Not a pre-existing condition; repair of its manufacturing business. After the machinery an improvement under paragraph (e) of this section
performed during an improvement. (i) X owned was installed, X performed critical testing on the ma- the amounts paid for work performed on the build-
land on which it constructed a building in 1969 for chinery to ensure that it was operational. On Novem- ing. The comparison rule in paragraph (e)(3) of this
use as a bank. The building was constructed with ber 1, 2008, the new machinery became operational section does not apply to these amounts paid.
asbestos-containing materials. The health dangers of and, thus, the machinery was placed in service on Example 8. Not a material increase in value. (i)
asbestos were not widely known when the building November 1, 2008 (although X continued to perform X is a commercial airline engaged in the business
was constructed. The presence of asbestos did not testing for quality control). The amounts paid must of transporting passengers and freight throughout the
necessarily endanger the health of building occu- be capitalized as an improvement to the machinery United States and abroad. To conduct its business, X
pants. The danger arises when asbestos-containing because they were for work performed prior to X’s owns or leases various types of aircraft. As a con-
materials are damaged or disturbed, thereby releas- placing the machinery in service. The comparison dition of maintaining its airworthiness certification
ing asbestos fibers into the air (where they can be rule in paragraph (e)(3) of this section does not ap- for these aircraft, X is required by the Federal Avia-
inhaled). In 1971, Federal regulatory agencies des- ply to these amounts paid. tion Administration (FAA) to establish and adhere to
ignated asbestos a hazardous substance. In 2008, X Example 5. New or different use. X is an inte- a continuous maintenance program for each aircraft
determined it needed additional space in its building rior decorating company and manufactures its own within its fleet. These programs, which are designed
to accommodate additional operations at its branch designs. In 2008, X decides to stop manufacturing by X and the aircraft’s manufacturer and approved by
and decided to remodel the building. However, any and converts the manufacturing facility into a show- the FAA are incorporated into each aircraft’s main-
remodeling work could not be undertaken without room for X’s business. To convert the facility, X tenance manual. The maintenance manuals require
disturbing the asbestos-containing materials. The removes certain load-bearing walls and builds new a variety of periodic maintenance visits at various
governmental regulations required that asbestos be load-bearing walls to provide a better layout for the intervals during the operating lives of each aircraft.
removed if any remodeling was undertaking that showroom and its offices. As part of building the new One type of maintenance visit is an engine shop visit
would disturb asbestos-containing materials. There- walls, X moves or replaces electrical, cable, and tele- (ESV), which is performed on X’s aircraft engines ap-
fore, X decided to remove the asbestos-containing phone wiring and paints the walls. X also repairs the proximately every 4 years.
materials from the building in coordination with the floors, builds a fire escape, and performs small car- (ii) In 2004, X purchased a new aircraft and en-
overall remodeling project. pentry jobs related to making the showroom acces- gine. In 2008, X performs its first ESV on the air-
(ii) For purposes of this Example 2, assume that sible, including installing ramps and widening door- craft engine. The ESV includes some or all of the fol-
the building is the appropriate unit of property and ways. For purposes of this Example 5, assume the lowing activities: disassembly, cleaning, inspection,
that the amounts paid to remodel are required to be building and its structural components are the unit of repair, replacement, reassembly, and testing. Dur-
capitalized under §1.263(a)–3. The amounts paid to property and that the work is performed on the struc- ing the ESV, the engine is removed from the aircraft
remove the asbestos are not required to be capitalized tural components. The amounts paid by X to con- and shipped to an outside vendor who performs the
as a separate improvement under paragraph (e)(1)(i) vert the manufacturing facility into a showroom must ESV. When the engine arrives at the vendor, the en-
of this section because the asbestos, although later de- be capitalized as an improvement to the building be- gine is cleaned and externally inspected. Regard-
termined to be unsafe under certain circumstances, cause they adapted the building to a new or different less of condition, it is thoroughly inspected visually
was not an inherent defect to the property. The re- use. The comparison rule in paragraph (e)(3) of this and, as appropriate, further inspected using a number
moval of the asbestos, by itself, also did not result in a section does not apply to these amounts paid. of non-destructive testing procedures. The engine is
material increase in value under paragraphs (e)(1)(ii) Example 6. New or different use. X owned a then disassembled into major parts and, if necessary,
through (e)(1)(v) of this section. Under paragraph building consisting of five separate retail stores, each into smaller parts. If inspection or testing discloses
(d)(5)(i) of this section, repairs that do not directly of which it rented to different tenants. In 2008, two a discrepancy in a part’s conformity to the specifi-
benefit or are not incurred by reason of an improve- of the stores rented became vacant and remained va- cations in X’s maintenance program, the part is re-
ment are not required to be capitalized under sec- cant for several months. One of the remaining ten- paired, or if necessary, replaced with a new or used
tion 263(a). Under section 263A, all indirect costs, ants agreed to expand its occupancy to the two va- serviceable part conforming to the specifications. If
including otherwise deductible repair costs, that di- cant stores, which adjoined its own retail store. X in- a part can be repaired, but not in time to be returned to
rectly benefit or are incurred by reason of the im- curred costs to break down walls between the exist- the engine with which the part had arrived, the ven-
provement must be capitalized as part of the improve- ing stores and construct an additional rear entrance. dor first attempts to replace the part with a similar part
ment. The amounts paid to remove the asbestos were For purposes of this Example 6, assume the building from customer stock (used parts from X’s aircraft that
incurred by reason of the remodeling project, which and its structural components are the appropriate unit were replaced or exchanged and repaired during an
was an improvement. Therefore, X must capitalize of property. The amounts paid by X to convert three earlier ESV and then stored for future use on X’s air-
under section 263A to the remodeling improvement retail stores into one larger store must be capitalized craft). If a part is not available from customer stock,
amounts paid to remove the asbestos. because they resulted in a permanent structural alter- the part is exchanged with a used, serviceable part in
Example 3. Work performed prior to placing the ation, and thus a new or different use, to the building. the vendor’s inventory. A part is replaced (generally
property in service. In 2008, X purchased a build- The comparison rule in paragraph (e)(3) of this sec- with a used serviceable part) only if the part removed
ing for use as a business office. The building was tion does not apply to these amounts paid. from X’s engine cannot be repaired timely.
in a state of disrepair. In 2009, X incurred costs to Example 7. Not a new or different use. X owns (iii) For purposes of this Example 8, assume
repair cement steps; shore up parts of the first and a building for rental purposes and decides to sell it. the aircraft engine is the appropriate unit of prop-
second floors; replace electrical wiring; remove and In preparation of selling, X paints the interior walls, erty. To determine whether the ESV results in a
replace old plumbing; and paint the outside and in- cleans the gutters, repairs cracks in the porch, and re- material increase in value under paragraph (e)(1)(iv)
side of the building. Assume all the work was per- finishes the hardwood floors. For purposes of this Ex- or (e)(1)(v) of this section, the comparison rule in
formed on the building or its structural components. ample 7, assume the building and its structural com- paragraph (e)(3) of this section applies. Because the

2006–39 I.R.B. 559 September 25, 2006


event necessitating the ESV was normal wear and seepage problem. The Federal meat inspectors’ re- Example 15. Material increase in capacity. In
tear, and X had not previously performed an ESV on quirement that X correct the seepage to continue oper- 2008, X purchased harbor facilities consisting of a
the engine, the relevant comparison is the condition ating the plant is not relevant in determining whether slip for the loading and unloading of barges and a
of the property immediately after the ESV with the the amount paid improved the plant. See paragraph channel leading from the slip to the river. At the time
condition of the property when placed in service by (d)(3) of this section. of purchase, the channel was 150 feet wide, 1,000
X. Using this comparison, the ESV did not result in a Example 11. Not a material increase in value; re- feet long, and 10 feet deep. To allow for ingress and
material addition, betterment, or material increase in placement with same part. X owns a small retail shop. egress and for the unloading of its barges, X needed
capacity, productivity, efficiency, or quality of output In 2008, a storm damaged the roof of X’s shop by dis- to deepen the channel to a depth of 20 feet. X hired a
of the engine compared to the condition of the engine placing numerous wooden shingles. X decides to re- contractor to dredge the channel to the required depth.
when placed in service, nor did it adapt the engine place all the wooden shingles on the roof and hired For purposes of this Example 15, assume the channel
to a new or different use. Therefore, the amounts a contractor to replace all the shingles on the roof is the appropriate unit of property. X must capital-
paid by X for the ESV did not result in a material with new wooden shingles. No part of the sheath- ize as an improvement amounts paid for the dredging
increase in value to the engine. X is not required to ing, rafters, or joists was replaced. For purposes of because it resulted in a material increase in the capac-
capitalize as an improvement under paragraph (e) of this Example 11, assume the shop and its structural ity of the channel. The comparison rule in paragraph
this section amounts paid for the ESV. components are the appropriate unit of property. The (e)(3) of this section does not apply to these amounts
Example 9. Betterment; regulatory requirement. event necessitating the expenditure was the storm. paid because the expenditure was not necessitated by
X owned a hotel in City that included five foot high Prior to the storm, the retail shop was functioning for a particular event.
unreinforced terra cotta and concrete parapets with its intended use. The expenditure did not result in a Example 16. Not a material increase in capac-
overhanging cornices around the entire roof perime- material addition, betterment, or material increase in ity. Assume the same facts as in Example 15, except
ter. The parapets and cornices were in good condi- capacity, productivity, efficiency, or quality of out- that the channel was susceptible to siltation and, by
tion. In 2008, City passed an ordinance setting higher put of the shop compared to the condition of the shop 2009, the channel depth had been reduced to 18 feet.
safety standards for parapets and cornices because prior to the storm, nor did it adapt the shop to a new X hired a contractor to redredge the channel to a depth
of the hazardous conditions caused by earthquakes. or different use. Therefore, the amounts paid by X to of 20 feet. The event necessitating the expenditure
To comply with the ordinance, X replaced the old reshingle the roof with wooden shingles do not mate- was the siltation of the channel. Both prior to the sil-
parapets and cornices with new ones made of glass rially increase the value of the shop. X is not required tation and after the redredging, the depth of the chan-
fiber reinforced concrete, which made them lighter to capitalize as an improvement under paragraph (e) nel was 20 feet. Therefore, the amounts paid by X for
and stronger than the original ones. They were at- of this section amounts paid to replace the shingles. redredging the channel did not materially increase the
tached to the hotel using welded connections instead Example 12. Not a material increase in value; re- capacity of the unit of property. X is not required to
of wire supports, making them more resistant to dam- placement with comparable part. Assume the same capitalize as an improvement under paragraph (e) of
age from lateral movement. For purposes of this Ex- facts as in Example 11, except that wooden shingles this section amounts paid to redredge.
ample 9, assume the hotel building and its structural are not available on the market. X decides to re- Example 17. Not a material increase in capacity.
components are the appropriate unit of property. The place all the wooden shingles with comparable as- X owns a building used in its trade or business. The
event necessitating the expenditure was the 2008 City phalt shingles. The amounts paid by X to reshingle first floor has a drop-ceiling. X decides to remove
ordinance. Prior to the ordinance, the old parapets the roof with asphalt shingles do not materially in- the drop-ceiling and repaint the original ceiling. For
and cornices were in good condition, but were deter- crease the value of the shop, even though the asphalt purposes of this Example 17, assume the building and
mined by City to create a potential hazard. After the shingles may be an improvement over the wooden its structural components are the appropriate unit of
expenditure, the new parapets and cornices signifi- shingles. Because the wooden shingles could not property. The removal of the drop-ceiling does not
cantly improved the structural soundness of the hotel. practicably be replaced with new wooden shingles, create additional capacity in the building that was not
Therefore, the amounts paid by X to replace the para- the replacement of the old shingles with comparable there prior to the removal. Therefore, the amounts
pets and cornices must be capitalized because they re- asphalt shingles does not, by itself, result in an im- paid by X to remove the drop-ceiling and repaint the
sulted in a betterment to the hotel. City’s requirement provement to the shop. X is not required to capitalize original ceiling did not materially increase the capac-
that X correct the potential hazard to continue oper- as an improvement under paragraph (e) of this section ity of the unit of property. X is not required to capital-
ating the hotel is not relevant in determining whether amounts paid to replace the shingles. ize as an improvement under paragraph (e) of this sec-
the amount paid improved the hotel. See paragraph Example 13. Betterment; replacement with im- tion amounts paid related to removing the drop-ceil-
(d)(3) of this section. proved parts. Assume the same facts as in Example ing. The comparison rule in paragraph (e)(3) of this
Example 10. Not a material increase in value; 11, except that, instead of replacing the wooden shin- section does not apply to these amounts paid because
regulatory requirement. X owned a meat process- gles with asphalt shingles, X decides to replace all the the expenditure was not necessitated by a particular
ing plant. In 2008, X discovered that oil was seep- wooden shingles with shingles made of lightweight event.
ing through the concrete walls of the plant, creating composite materials that are maintenance-free and do (f) Restoration—(1) In general. A tax-
a fire hazard. Federal meat inspectors advised X that not absorb moisture. The new shingles have a 50-year
payer must capitalize amounts paid that re-
it must correct the seepage problem or shut down its warranty and a Class A fire rating. X must capitalize
plant. To correct the problem, X incurred costs to add as an improvement amounts paid to reshingle the roof
store a unit of property. Amounts paid re-
a concrete lining to the walls from the floor to a height because they result in a betterment to the shop. store property if the amounts paid substan-
of about four feet and also to add concrete to the floor Example 14. Material increase in capacity. X tially (as defined in paragraph (f)(3) of this
of the plant. For purposes of this Example 10, assume owns a factory building with a storage area on the section) prolong the economic useful life
the plant building and its structural components are second floor. In 2008, X replaces the columns and
of the unit of property.
the appropriate unit of property. The event necessitat- girders supporting the second floor to permit storage
ing the expenditure was the seepage of the oil. Prior of supplies with a gross weight 50 percent greater
(2) Economic useful life—(i) Taxpayers
to the seepage, the plant did not leak and was func- than the previous load-carrying capacity of the stor- with an applicable financial statement.
tioning for its intended use. The expenditure did not age area. For purposes of this Example 14, assume For taxpayers with an applicable finan-
result in a material addition, betterment, or material the factory building and its structural components are cial statement (as defined in paragraph
increase in capacity, productivity, efficiency, or qual- the appropriate unit of property. X must capitalize as
(f)(2)(iii) of this section), the economic
ity of output of the plant compared to the condition an improvement amounts paid for the columns and
of the plant prior to the seepage of the oil, nor did it girders because they result in a material increase in
useful life of a unit of property generally
adapt the plant to a new or different use. Therefore, the load-carrying capacity of the building. The com- is presumed to be the same as the useful
the amounts paid by X to correct the seepage do not parison rule in paragraph (e)(3) of this section does life used by the taxpayer for purposes of
materially increase the value of the plant. X is not not apply to these amounts paid because the expendi- determining (at the time the property is
required to capitalize as an improvement under para- ture was not necessitated by a particular event.
originally acquired or produced by the
graph (e) of this section amounts paid to correct the

September 25, 2006 560 2006–39 I.R.B.


taxpayer) depreciation in its applicable (A) Wear and tear and decay or decline prolonged (as determined under this para-
financial statement, regardless of any from natural causes; graph (e)(3)(i)), the end of the taxable year
salvage value of the property. A tax- (B) The normal progress of the art, eco- immediately succeeding the taxable year
payer may rebut this presumption only nomic changes, inventions, and current de- in which the prolonged economic useful
if there is a clear and convincing basis velopments within the industry and the life was expected to cease.
that the economic useful life (as defined taxpayer’s trade or business; (ii) Replacements. Amounts paid will
in paragraph (f)(2)(ii) of this section for (C) The climatic and other local con- be deemed to substantially prolong the
taxpayers without an applicable financial ditions peculiar to the taxpayer’s trade or economic useful life of the unit of prop-
statement) of the unit of property is signif- business; and erty if a major component or a substantial
icantly different than the useful life used (D) The taxpayer’s policy as to repairs, structural part of the unit of property is re-
by the taxpayer for purposes of determin- renewals, and replacements. placed with either a new part or a part that
ing depreciation in its applicable financial (iii) Definition of “applicable financial has been restored to like-new condition as
statement. If a taxpayer does not have statement”. The taxpayer’s applicable described in paragraph (f)(3)(iii) of this
an applicable financial statement at the financial statement is the taxpayer’s fi- section. Thus, the replacement of a part
time the property was originally acquired nancial statement listed in paragraphs with another part that is not new or is not
or produced, but does have an applicable (f)(2)(ii)(A) through (C) of this section in like-new condition (for example, a used
financial statement at some later date, the that has the highest priority (including or reconditioned part) does not constitute
economic useful life of the unit of prop- within paragraph (f)(2)(ii)(B) of this sec- the replacement of a major component or
erty must be determined under paragraph tion). The financial statements are, in substantial structural part of the unit of
(f)(2)(ii) of this section. Further, if a tax- descending priority — property under this paragraph (f)(3)(ii).
payer treats amounts paid for a unit of (A) A financial statement required to Further, replacement of a relatively minor
property as an expense in its applicable be filed with the Securities and Exchange portion of the physical structure of the unit
financial statement on a basis other than Commission (SEC) (the 10-K or the An- of property or a relatively minor portion of
the property having a useful life of one nual Statement to Shareholders); any of its major parts, even if those parts
year or less, the economic useful life of (B) A certified audited financial state- are new, does not constitute the replace-
the unit of property must be determined ment that is accompanied by the report of ment of a major component or substantial
under paragraph (f)(2)(ii) of this section. an independent CPA (or in the case of a structural part of the unit of property.
For example, if a taxpayer has a policy foreign entity, by the report of a similarly (iii) Restoration to like-new condition.
of treating as an expense on its applica- qualified independent professional), that is Amounts paid will be deemed to substan-
ble financial statement amounts paid for used for— tially prolong the economic useful life of
property costing less than a certain dollar (1) Credit purposes, the unit of property if they result in the unit
amount, notwithstanding that the property (2) Reporting to shareholders, partners, of property or a major component or sub-
has a useful life of more than one year, the or similar persons; or stantial structural part of the unit of prop-
economic useful life of the property must (3) Any other substantial non-tax pur- erty being restored to a like-new condi-
be determined under paragraph (f)(2)(ii) pose; or tion (including bringing the unit of prop-
of this section. (C) A financial statement (other than erty or a major component or substantial
(ii) Taxpayers without an applicable fi- a tax return) required to be provided to structural part of the property to the status
nancial statement. For taxpayers that do the Federal or a state government or any of new, rebuilt, remanufactured, or simi-
not have an applicable financial statement Federal or state agencies (other than the lar status under the terms of any Federal
(as defined in paragraph (f)(2)(iii) of this SEC or the Internal Revenue Service). regulatory guideline or the manufacturer’s
section), the economic useful life of a unit (3) Substantially prolonging economic original specifications).
of property is not necessarily the useful useful life—(i) In general. An amount paid (iv) Restoration after a casualty loss.
life inherent in the property but is the pe- substantially prolongs the economic useful Amounts paid will be deemed to substan-
riod over which the property may reason- life of the unit of property if it extends the tially prolong the useful life of the unit of
ably be expected to be useful to the tax- period over which the property may rea- property if the taxpayer properly deducts
payer or, if the taxpayer is engaged in a sonably be expected to be useful to the tax- a casualty loss under section 165 with
trade or business or an activity for the pro- payer in its trade or business or for the pro- respect to the unit of property and the
duction of income, the period over which duction of income, as applicable (or, if the amounts paid restore the unit of property
the property may reasonably be expected taxpayer is not engaged in a trade or busi- to a condition that is the same or better
to be useful to the taxpayer in its trade or ness or an activity for the production of than before the casualty.
business or for the production of income, income, the period over which the prop- (4) Examples. The following examples
as applicable. This period is determined erty may reasonably be expected to be use- illustrate the rules of this paragraph (f) and,
by reference to the taxpayer’s experience ful to the taxpayer) beyond the end of the except as otherwise provided, assume that
with similar property, taking into account taxable year immediately succeeding the the amounts paid would not be required to
present conditions and probable future de- taxable year in which the economic use- be capitalized under any other provision of
velopments. Factors to be considered in ful life of the unit of property was orig- this section (paragraph (e), for example):
determining this period include, but are not inally expected to cease, or if the prop- Example 1. Prolonged economic useful life. X
limited to— erty’s economic useful life was previously is a Class I railroad that owns a fleet of locomotives.

2006–39 I.R.B. 561 September 25, 2006


In 1989, X purchased a new locomotive with an eco- ing. The replacement of the shingles, sheathing, and X hires a contractor to perform the removal and re-
nomic useful life (as defined in paragraph (f)(2) of rafters restored to a like-new condition a substantial placement, which consists of removing the old tanks
this section) of 22 years (from 1989 - 2011). X per- structural part of the shop. Therefore, under para- and installing new tanks with leak detection systems.
forms substantially the same cyclical maintenance on graphs (f)(1) and (f)(3)(iii) of this section, X must The removal of the old tanks includes removing the
its locomotives approximately every 6 years. X per- capitalize as an improvement to the shop amounts paving material covering the tanks, excavating a hole
formed cyclical maintenance on the locomotive in paid to replace the roof of the shop. large enough to gain access to the old tanks, discon-
1995, in 2001, and in 2007. Assume that the loco- Example 5. Not a major component or structural necting any strapping and pipe connections to the old
motive (which includes the engine) is the appropriate part. X uses a car in providing a taxi service. X pur- tanks, and lifting the old tanks out of the hole. Instal-
unit of property and that none of the cyclical main- chased the car in 2008. Assume that the unit of prop- lation of the new tanks includes placement of a liner
tenance projects resulted in a restoration under para- erty is the car. The car has an economic useful life in the excavated hole, placement of the new tanks,
graph (f)(3)(ii) or (f)(3)(iii) of this section. Amounts of 5 years. In 2011, the battery dies and X takes the installation of a leak detection system, installation of
paid for cyclical maintenance in 1995 and 2001 do car to a repair shop, which replaces the battery. Al- an overfill system, connection of the tank to the pipes
not substantially prolong the economic useful life of though the battery itself may last beyond the end of leading to the pumps, backfilling of the hole, and re-
the locomotive. However, the cyclical maintenance the car’s economic useful life, the amount paid for the placement of the paving. X is also required to pay a
performed in 2007 will prolong the economic use- battery does not substantially prolong the economic permit fee to the county to undertake the installation
ful life of the locomotive to 2013, which is beyond useful life of the car because the battery will not ex- of the new tanks.
the end of the next succeeding taxable year after the tend beyond 2013 the period over which the car may (ii) X pays the permit fee to the county on October
economic useful life of the locomotive ceases (2011). reasonably be expected to be useful to X in its trade 15, 2008. The contractor performs all of the required
Therefore, under paragraphs (f)(1) and (f)(3)(i) of or business. Although the battery is a necessary com- work and, on November 1, 2008, bills X for the costs
this section, X must capitalize as an improvement to ponent of the car, the battery is not a substantial struc- of removing the old USTs. On November 15, 2008,
the locomotive amounts paid for the cyclical main- tural part or major component of the car. Therefore, the contractor bills X for the remainder of the work.
tenance performed in 2007, regardless of whether X the amount paid to replace the battery does not sub- Assume the fuel distribution system is the appropriate
was required to capitalize the amounts paid in previ- stantially prolong the economic useful life of the car. unit of property. The USTs are major components of
ous years for cyclical maintenance. Example 6. Major component or structural part. the fuel distribution system. Therefore, under para-
Example 2. Economic useful life not prolonged. Assume the same facts as Example 5, except rather graphs (f)(1) and (f)(3)(ii) of this section, X must cap-
Assume the same facts as in Example 1, except that than the battery dying, the car overheats and causes italize as an improvement to the fuel distribution sys-
in 2009, X replaces a filter in the locomotive engine. so much damage that the engine has to be rebuilt. The tem the aggregate of related amounts paid to replace
X generally replaces this type of filter every 4 years. engine is a major component of the car. Therefore, X the USTs, which related amounts include the amount
Although the filter itself would last beyond the end is required to capitalize as an improvement to the car paid to the county, the amount paid to remove the old
of the locomotive’s economic useful life in 2011, the under paragraphs (f)(1) and (f)(3)(iii) of this section USTs, and the amount paid to install the new USTs
amount paid for the filter does not substantially pro- the amounts paid to rebuild the engine. (regardless that the amounts were separately invoiced
long the economic useful life of the locomotive be- Example 7. Repair performed during an improve- and paid to two different parties).
cause the filter will not extend beyond 2009 the pe- ment; coordination with section 263A. Assume the Example 9. Major component or substantial
riod over which the locomotive may reasonably be same facts as Example 6, except that X has a bro- structural part. X is a common carrier that owns
expected to be useful to X in its trade or business. ken taillight fixed at the same time that the engine a fleet of petroleum hauling trucks. In 2008, X
Additionally, although the filter is a necessary com- was rebuilt. The repair to the taillight was not in- replaces the existing engine, cab, and petroleum tank
ponent of the locomotive, the filter is not a substantial curred because the engine was rebuilt, nor did it ben- of a truck with a new engine, cab, and tank. Assume
structural part or major component of the locomotive. efit the rebuild of the engine. The repair of the bro- the tractor of the truck (which includes the cab and
Therefore, the amount paid to replace the filter does ken taillight is a deductible expense under §1.162–4. the engine) is a separate unit of property from the
not substantially prolong the economic useful life of Under section 263A, all indirect costs, including oth- rest of the truck. Also assume that the trailer (which
the locomotive. erwise deductible repair and maintenance costs that contains the petroleum tank) is a separate unit of
Example 3. Minor part replacement. X owns a directly benefit or are incurred by reason of the im- property from the truck. The engine and the cab
small retail shop. In 2008, a storm damaged the roof provement must be capitalized as part of the improve- are major components of the truck tractor, and the
of X’s shop by displacing numerous wooden shin- ment. Therefore, all amounts paid that are incurred petroleum tank is a major component of the trailer.
gles. X decides to replace all the wooden shingles by reason of the engine being rebuilt must be capital- Therefore, under paragraphs (f)(1) and (f)(3)(ii) of
on the roof and hires a contractor to replace all the ized, including, for example, amounts paid for activi- this section, X must capitalize as an improvement to
shingles on the roof with new wooden shingles. No ties that would usually be deductible maintenance ex- the tractor amounts paid to replace the engine and
part of the sheathing, rafters, or joists was replaced. penses, such as refilling the engine with oil and radia- cab, and must capitalize as an improvement to the
For purposes of this Example 3, assume the shop and tor fluid. Amounts paid to repair the broken taillight, trailer amounts paid to replace the petroleum tank.
its structural components are the appropriate unit of however, are not incurred by reason of the engine be- Example 10. Restoration of major component to
property. The replacement of the shingles did not ing rebuilt, nor do the amounts paid directly benefit like-new condition. (i) X is a towboat operator that
extend the useful life of the shop under paragraph the engine rebuild, despite being repaired at the same owns and leases a fleet of towboats. In 2008, X re-
(f)(3)(i) of this section. The portion of the roof re- time. Thus, X is not required to capitalize to the im- places an existing towboat engine with a rebuilt en-
placed is not a substantial structural part of the shop, provement of the car (the rebuild of the engine) the gine. A towboat engine is rebuilt through a series of
nor does the replacement of the shingles restore to a amounts paid to repair the broken taillight. steps designed to put the engine in like-new operat-
like-new condition a major component or substantial Example 8. Related amounts to replace major ing condition to the maximum extent possible. En-
structural part of the shop. Therefore, the amounts component or structural part. (i) X owns a retail gines in a towboat nearing the end of its useful life or
paid by X to reshingle the roof with wooden shingles gasoline station, consisting of a paved area used for engines that have been removed from towboats due
do not substantially prolong the economic useful life automobile access to the pumps and parking areas, a to a catastrophic malfunction are likely candidates
of the shop. building used to market gasoline, and a canopy cov- for the rebuilding process. The goal of the rebuild-
Example 4. Major component or substantial ering the gasoline pumps. The premises also consists ing process is to bring each of an engine’s compo-
structural part. Assume the same facts as in Exam- of underground storage tanks (USTs) that are con- nent parts to the manufacturer’s original dimensional
ple 3, except that when the contractor began work on nected by piping to the pumps and are part of the specifications for new parts.
the shingles, the contractor discovered that a major machinery used in the immediate retail sale of gas. (ii) Replacement of the existing towboat engine
portion of the sheathing had rotted, and the rafters The pumps also are connected to a monitoring unit with a rebuilt engine involves dry-docking the tow-
were weakened as well. The contractor replaced all in the building that allows the sales clerk to monitor boat. The rebuilding and replacement process takes
the sheathing and a significant portion of the rafters. the gasoline sales. To comply with regulations issued approximately 3 to 5 months. The process requires
The roof (including the shingles, sheathing, rafters, by the Environmental Protection Agency, X is re- the removal of the engine from the towboat and
and joists) is a substantial structural part of a build- quired to remove and replace leaking USTs. In 2008, the removal of all of the moving and nonmoving

September 25, 2006 562 2006–39 I.R.B.


components from the engine as well. The engine’s ductible repair costs that directly benefit or are in- the appropriate unit of property and that the amount
crankcase and oil pan are separated, and every part of curred by reason of the improvement must be capi- paid does not prolong the economic useful life of the
the engine is cleaned, inspected using intense illumi- talized as part of the improvement. Therefore, under plant under paragraph (f)(3)(i) of this section. The
nation, machined, and treated with special materials paragraph (d)(5)(i) of this section, X must capital- portion of the roof structure being replaced is not a
to restore the engine to like-new operating condition. ize to the improvement of the towboat (the rebuild) substantial structural part of the plant, nor does the
The engine crankcase and oil pan are extensively ma- amounts paid that otherwise would be deductible re- work performed return to like-new condition a major
chined and welded, and numerous dimensional tests pair costs that directly benefit or are incurred by rea- component or substantial structural part of the plant.
and checks are performed to ensure that the engine is son of the improvement. Further, because X could not practicably replace the
returned to a like-new condition through the rebuild- Example 13. Restoration to like-new condition. roof material with the same type of material, the re-
ing process. In addition, a reconditioned crankshaft X is a Class I railroad that owns a fleet of freight placement of the original roof material with an im-
and camshaft normally are installed in the engine cars. Approximately every 10 years, X rebuilds its proved, but comparable, material does not, by itself,
during the rebuilding process. The power packs are freight cars. The rebuild includes a complete dis- result in an improvement. Therefore, the amount paid
completely rebuilt with a large number of new parts assembly, inspection, and reconditioning and/or re- to remove and replace a minor part of the plant’s roof
during the rebuilding process. The oil pumps, water placement of components of the suspension and draft decking and roofing materially does not substantially
pumps, engine turbochargers, and governors are systems, trailer hitches, and other special equipment. prolong the economic useful life of the plant. How-
normally removed and exchanged for rebuilt parts Modifications are made to the car to upgrade various ever, under section 263A, all indirect costs, includ-
during the rebuilding process. The accessory drive components to the latest engineering standards. The ing otherwise deductible costs, that directly benefit or
gears, all of the piping on the front and aft ends of the freight car essentially is stripped to the frame, with are incurred by reason of the taxpayer’s manufactur-
engine, the governor drive gear, and the turbocharger all of its substantial components either reconditioned ing activities must be capitalized to the property pro-
drive gears are removed and normally exchanged for or replaced. The frame itself is the longest-lasting duced for sale. Therefore, because the amounts paid
rebuilt parts during the rebuilding process. The goal part of the car and is reconditioned. The walls of for the roof decking and materials are incurred by
of the rebuilding process is to bring each of an en- the freight-train car are replaced or are sandblasted reason of X’s manufacturing operations, the amounts
gine’s component parts to the engine manufacturer’s and repainted. New wheels typically are installed paid must be capitalized under section 263A to the
original dimensional specifications for new parts. on the car. All the remaining components of the car property produced for sale by X.
Assume the towboat (which includes the engine) is are restored before they are reassembled. At the end Example 16. Minor part replacement. (i) X is a
the appropriate unit of property. The work done on of the rebuild, the freight cars have been restored to commercial airline engaged in the business of trans-
the towboat engine constitutes a remanufacture or like-new condition. Assume the freight car is the porting passengers and freight throughout the United
rebuild of the engine, which is a major component appropriate unit of property. The work done to the States and abroad. To conduct its business, X owns
of the towboat. Therefore, under paragraphs (f)(1) freight car constitutes a remanufacture or rebuild of or leases various types of aircraft. As a condition of
and (f)(3)(iii) of this section, X must capitalize as an the freight car. Therefore, under paragraphs (f)(1) and maintaining its airworthiness certification for these
improvement to the towboat amounts paid to rebuild (f)(3)(iii) of this section, X must capitalize as an im- aircraft, X is required by the Federal Aviation Ad-
the towboat engine. provement to the freight car amounts paid to rebuild ministration (FAA) to establish and adhere to a con-
Example 11. Repairs performed during an im- the freight car. tinuous maintenance program for each aircraft within
provement; coordination with section 263A. Assume Example 14. Restoration of major component to its fleet. These programs, which are designed by
the same facts as in Example 10, except that while like-new condition. X owned a factory that it ac- X and the aircraft’s manufacturer and approved by
the towboat is in dry-dock to have the engine rebuilt, quired in 1997. In 2008, the factory roof began to the FAA are incorporated into each aircraft’s main-
X also makes repairs to the hull and rudders that are leak. These leaks on occasion resulted in damage to tenance manual. The maintenance manuals require
not by themselves an improvement under this sec- X’s products and prevented the use of certain portions a variety of periodic maintenance visits at various
tion. The amounts paid to repair the hull and rud- of the factory. X decided to reroof the entire factory intervals during the operating lives of each aircraft.
ders do not directly benefit nor are incurred by rea- and hired a contractor to perform the reroofing. The One type of maintenance visit is an engine shop visit
son of the engine rebuild. Under section 263A, all structure of the roof, including substantial portions (ESV), which is performed on X’s aircraft engines ap-
indirect costs, including otherwise deductible repair of the rafters and joists, was restored to a like-new proximately every 4 years.
costs that directly benefit or are incurred by reason condition. Assume the factory building and its struc- (ii) In 2004, X purchased a new aircraft and en-
of the improvement must be capitalized as part of the tural components are the appropriate unit of property. gine. In 2008, X performs its first ESV on the air-
improvement. Therefore, all amounts paid that are The roofing process constitutes a remanufacture or craft engine. The ESV includes some or all of the fol-
incurred by reason of the engine being rebuilt must rebuild of the roof, which is a substantial structural lowing activities: disassembly, cleaning, inspection,
be capitalized to the improvement, including, for ex- part of the factory. Therefore, under paragraphs (f)(1) repair, replacement, reassembly, and testing. Dur-
ample, amounts paid for activities such as cleaning and (f)(3)(iii) of this section, X must capitalize as an ing the ESV, the engine is removed from the aircraft
and inspecting the engine, which usually would be improvement to the factory amounts paid to reroof the and shipped to an outside vendor who performs the
deductible maintenance costs. Amounts paid to re- factory. ESV. When the engine arrives at the vendor, the en-
pair the hull and rudders, however, are not incurred by Example 15. Minor part replacement; coordina- gine is cleaned and externally inspected. Regard-
reason of the engine being rebuilt, nor do the amounts tion with section 263A. X is in the business of smelt- less of condition, it is thoroughly inspected visually
paid directly benefit the engine rebuild, despite being ing aluminum. X’s aluminum smelting facility in- and, as appropriate, further inspected using a number
incurred at the same time. Thus, in accordance with cludes a plant where molten aluminum is poured into of non-destructive testing procedures. The engine is
paragraph (d)(5)(i) of this section, X is not required molds and allowed to solidify. Because of the poten- then disassembled into major parts and, if necessary,
to capitalize to the towboat amounts paid to repair the tial of fire from a molten metal explosion, the plant’s into smaller parts. If inspection or testing discloses
hull and rudders to the improvement. roof must be made of fire-resistant material. The roof a discrepancy in a part’s conformity to the specifi-
Example 12. Restoration to like-new condition; must also be without leaks because rain water hitting cations in X’s maintenance program, the part is re-
coordination with section 263A. Assume the same the molten aluminum could cause an explosion. The paired, or if necessary, replaced with a new or used
facts as Example 10, except that while the towboat roof of the plant was made of roofing material and serviceable part conforming to the specifications. If
is in dry-dock, X also makes substantial improve- corrugated sheet metal decking, which supports the a part can be repaired, but not in time to be returned to
ments to the propulsion systems and the mechani- roofing material. During 2008, X removed and re- the engine with which the part had arrived, the ven-
cal systems, including rebuilding large sections of placed a minor portion of the plant’s roof decking dor first attempts to replace the part with a similar part
the hull, and rebuilding, replacing, or upgrading the and roofing material. At the time of the replacement, from customer stock (used parts from X’s aircraft that
steering systems, shafting systems, and electrical sys- the pattern of the original metal support decking was were replaced or exchanged and repaired during an
tems, such that almost the entire towboat is restored not available. Therefore, X used comparable fire re- earlier ESV and then stored for future use on X’s air-
to like-new condition. This process constitutes a re- sistant wood decking to replace the corrugated metal craft). If a part is not available from customer stock,
manufacture or rebuild of the towboat. Under sec- decking. For purposes of this Example 15, assume the part is exchanged with a used, serviceable part in
tion 263A, all indirect costs, including otherwise de- the plant building and its structural components are the vendor’s inventory. A part is replaced (generally

2006–39 I.R.B. 563 September 25, 2006


with a used serviceable part) only if the part removed tives. In 1994, X purchased a new locomotive (Lo- italization rules in §1.263(a)–3(d) do not
from X’s engine cannot be repaired timely. Although comotive A) with an economic useful life (as defined apply to property for which the taxpayer
many minor parts may be replaced during the ESV, in paragraph (f)(2) of this section) of 20 years (from uses the repair allowance method under
the ESV does not return the engine to a like-new con- 1994 - 2014). X performed cyclical maintenance on
dition. Locomotive A in 2000, and again in 2008. In 2000,
this paragraph (g). See section 263A for
(iii) For purposes of this Example 16, assume the X replaced the power cylinders on Locomotive A’s the scope of costs required to be capital-
aircraft engine is the appropriate unit of property. The engine, and performed work on other components of ized to property produced by the taxpayer
ESV does not result in the replacement of the engine Locomotive A. In 2008, X removed the engine and re- or to property acquired for resale.
nor does it restore the engine to a like-new condition. placed it with one it had previously remanufactured to (2) Election of repair allowance
Therefore, the amount paid for the ESV does not sub- the manufacturer’s original specifications, and again
stantially prolong the economic useful life of the en- performed work on other components of Locomotive
method. In the case of repair allowance
gine. A. The engine that X removed from Locomotive A property (as defined in paragraph (g)(6)
Example 17. Repairs performed during an in 2008 was remanufactured to the manufacturer’s of this section), a taxpayer may elect to
improvement; coordination with section 263A. (i) original specifications and installed on Locomotive use the repair allowance method described
Assume the same facts as in Example 16, except that B later in 2008. in paragraph (g)(3) of this section. See
X purchased the aircraft in 1986 and, in addition to (ii) Assume the locomotive (which includes the
the continuous maintenance program for engines, engine) is the appropriate unit of property. The re-
paragraph (g)(9) of this section for the
X adheres to a continuous maintenance program placement of the power cylinders and the other work manner of electing the repair allowance.
for its aircraft airframes. One type of maintenance performed on Locomotive A in 2000 did not prolong A taxpayer that elects to use the repair
visit is a heavy maintenance visit (HMV), which is the economic useful life of Locomotive A under para- allowance method must use that method
performed on X’s aircraft airframes approximately graph (f)(3) of this section. However, the amounts for all of its repair allowance property
every 8 years. In 2008, X decided to make substan- paid in 2008 to remove the engine and replace it with
tial modifications to the airframe, which resulted in a previously manufactured engine must be capitalized
in all MACRS classes (including prop-
the restoration of the airframe to like-new condition. under paragraph (f)(3)(ii) of this section. Assume the erty classified into a MACRS class for
The modifications included removing all the belly amounts paid in 2008 to perform work on other com- purposes of the repair allowance method
skin panels on the aircraft’s fuselage and replacing ponents of Locomotive A are not required to be cap- under paragraph (g)(6)(ii) of this section).
them with new skin panels; replacing the metal italized as a separate improvement to Locomotive A. A taxpayer electing the repair allowance
supports under the lavatories and galleys; removing Under section 263A, all indirect costs, including oth-
the wiring in the leading edges of both wings and erwise deductible repair costs that directly benefit or
method must use that method consistently
replacing it with new wiring; removing the fuel tank are incurred by reason of the improvement must be for all future years unless the taxpayer
bladders, harnesses, wiring systems, and connectors capitalized as part of the improvement. Therefore, revokes the election in accordance with
and replacing them with new components; opening X must capitalize to the improvement of Locomo- paragraph (g)(10) of this section.
every lap joint on the airframe and replacing the tive A (the installation of the remanufactured engine) (3) Application of repair allowance
epoxy and rivets used to seal the lap joints with a amounts paid that usually would be ordinary and nec-
non-corrosive sealant and larger rivets; reconfiguring essary repair costs, including any amounts paid for
method. Under the repair allowance
and upgrading the avionics and the equipment in the work on other components that directly benefit or are method, a taxpayer must treat all amounts
cockpit; replacing all the seats, overhead bins, side- incurred by reason of the improvement to Locomo- paid (other than amounts paid for ex-
wall panels, partitions, carpeting, windows, galleys, tive A. X is not required, however, to capitalize to the cluded additions, as defined in paragraph
lavatories, and ceiling panels with new items; in- improvement of Locomotive A any amounts paid for (g)(7) of this section) for materials and
stalling a cabin smoke and fire detection system, and work performed on other components that do not di-
a ground proximity warning system; and painting rectly benefit or are not incurred by reason of the im-
labor to repair, maintain, or improve all
the exterior of the aircraft. In addition, X performed provement to Locomotive A. Further, X must capital- the repair allowance property in a particu-
much of the same work that would be performed ize to the improvement of Locomotive B (the instal- lar MACRS class as deductible expenses
during an HMV. lation of remanufactured engine) the amounts paid to under section 162 for the taxable year, up
(ii) For purposes of this Example 17, assume the remanufacture the engine removed from Locomotive to the repair allowance amount (as deter-
aircraft airframe is the appropriate unit of property. A and amounts paid to install the remanufactured en-
The amounts paid to modify the airframe are required gine on Locomotive B.
mined in paragraph (g)(4) of this section)
to be capitalized as an improvement to the airframe (g) Repair allowance method—(1) In for that MACRS class, and treat the excess
under paragraph (f) of this section because the mod-
general. This paragraph (g) provides an of all amounts paid to repair, maintain, or
ifications restored the airframe to a like-new condi- improve all the repair allowance prop-
tion. Assume the amounts paid for the HMV are
optional simplified method (the repair al-
lowance method) for determining whether erty in that MACRS class (the capitalized
not required to be capitalized as a separate improve-
ment to the airframe. Under section 263A, all indi- amounts paid to repair, maintain, or im- amount) in accordance with paragraph
rect costs, including otherwise deductible repair costs prove certain tangible property are to be (g)(5) of this section.
that directly benefit or are incurred by reason of the
treated as deductible expenses or capital (4) Repair allowance amount—(i) In
improvement must be capitalized as part of the im- general. Except as provided in paragraph
provement. Therefore, X must capitalize to the im-
expenditures. A taxpayer that elects to
use the repair allowance method described (g)(4)(iv) of this section (with regard to
provement of the airframe (the restoration) amounts
paid that usually would be ordinary and necessary re- in paragraph (g)(3) of this section may buildings), under the repair allowance
pair costs, including any amounts paid for the HMV use that method instead of determining method for a particular taxable year, the
that directly benefit or are incurred by reason of the
whether amounts paid to repair, maintain, repair allowance amount for a particular
improvement to the airframe. X is not required, how- MACRS class consisting of repair al-
ever, to capitalize to the improvement of the airframe
or improve property are capital expendi-
tures or deductible expenses under the gen- lowance property is an amount equal to
any amounts paid for the HMV that do not directly
benefit or are not incurred by reason of the improve- eral principles of sections 162(a), 212, and the average unadjusted basis (as defined
ment to the airframe. 263(a). Thus, except for the rules in para- in paragraph (g)(4)(ii) of this section) of
Example 18. Restoration of major component to
graph (d)(2) of this section for determining repair allowance property in the MACRS
like-new condition; coordination with section 263A. class multiplied by the repair allowance
(i) X is a Class I railroad that owns a fleet of locomo-
the appropriate unit of property, the cap-

September 25, 2006 564 2006–39 I.R.B.


percentage in effect for the MACRS class the capitalized amount to specific repair by multiplying the capitalized amount for
for the taxable year. allowance property in the MACRS class that MACRS class (as determined under
(ii) Average unadjusted basis. For pur- in accordance with paragraph (g)(5)(iii) of paragraph (g)(5)(i) of this section) by a
poses of this section, average unadjusted this section. percentage that is equal to the unadjusted
basis is the average of the unadjusted basis (ii) Single asset treatment of capital- basis of all section 168(g) repair allowance
(as defined in paragraph (g)(4)(iii) of this ized amount. In general, the capitalized property in that MACRS class as of the be-
section) of all repair allowance property in amount for a particular MACRS class may ginning of the taxable year divided by the
the MACRS class at the beginning of the be treated by the taxpayer as a separate unadjusted basis of all repair allowance
taxable year and the unadjusted basis of all single asset and depreciated in accordance property in that MACRS class as of the
repair allowance property in the MACRS with that MACRS class. The single asset beginning of the taxable year. The section
class at the end of the taxable year. is treated as a section 168(i)(6) improve- 168(g) total capitalized amount for a par-
(iii) Unadjusted basis. For purposes ment and is treated as placed in service by ticular MACRS class then is allocated to
of this section, unadjusted basis is the ba- the taxpayer on the last day of the first half each section 168(g) repair allowance prop-
sis as determined under section 1012, or of the taxable year in which the amount erty in that MACRS class by multiplying
other applicable sections of subchapter O, is paid, before application of the conven- the section 168(g) total capitalized amount
and subchapters C (relating to corporate tion under section 168(d). Except for a for that MACRS class by a percentage
distributions and adjustments), K (relating sale of assets constituting a trade or busi- that is equal to the unadjusted basis of the
to partners and partnerships), and P (re- ness, no gain or loss is recognized on cap- particular section 168(g) repair allowance
lating to capital gains and losses). Un- italized amounts treated as a single asset property in that MACRS class as of the
adjusted basis is determined without re- under this paragraph (g)(5)(ii) upon dispo- beginning of the taxable year divided by
gard to any adjustments described in sec- sition of any repair allowance property to the unadjusted basis of all section 168(g)
tion 1016(a)(2) or (3) or to amounts for which the capitalized amounts are related. repair allowance property in that MACRS
which the taxpayer has elected to treat as A disposition includes the sale, exchange, class as of the beginning of the taxable
an expense (for example, under section retirement, physical abandonment, or de- year. The capitalized amount allocated
179, 179B, or 179C), but with regard to ba- struction of property. Taxpayers must con- to each section 168(g) repair allowance
sis reductions which are required because tinue to depreciate the single asset over the property is depreciated in accordance with
of credits taken on the property (for exam- remainder of the MACRS applicable re- section 168(g), is treated as a section
ple, under section 44, 45G, 45H, or 50(c)). covery period. 168(i)(6) improvement to the underlying
Unadjusted basis also must reflect the re- (iii) Allocation treatment of capitalized repair allowance property, and is treated
duction in basis for the percentage of the amount. Instead of treating the capitalized as placed in service by the taxpayer on the
taxpayer’s use of property for the taxable amount as a single asset under paragraph last day of the first half of the taxable year
year other than for use in the taxpayer’s (g)(5)(ii) of this section, a taxpayer may al- in which the amount is paid, before ap-
trade or business (or for the production of locate the capitalized amount for a partic- plication of the convention under section
income). ular MACRS class to all repair allowance 168(d).
(iv) Buildings. In the case of buildings property in the particular MACRS class in (v) Section 168(g) election. If a tax-
and structural components that are repair proportion to the unadjusted basis of the payer makes an election under section
allowance property, the repair allowance property in that MACRS class as of the be- 168(g)(7) for a particular MACRS class
method is applied separately with respect ginning of the taxable year. The capital- with respect to property placed in service
to each unit of property. ized amount allocated to repair allowance in the current taxable year, the election
(5) Capitalized amount—(i) In general. property is treated as a section 168(i)(6) applies to the capitalized amount for that
Under the repair allowance method for improvement to the underlying repair al- MACRS class. If such an election is made,
a particular taxable year, the capitalized lowance property and is treated as placed the taxpayer must allocate the capitalized
amount is the excess of all amounts paid to in service by the taxpayer on the last day amount for that MACRS class to all repair
repair, maintain, or improve all the repair of the first half of the taxable year in which allowance property in the MACRS class
allowance property in a MACRS class the amount is paid, before application of in proportion to the unadjusted basis of
over the repair allowance amount for that the convention under section 168(d). the property in that MACRS class as of
MACRS class. In addition, the capitalized (iv) Section 168(g) repair allowance the beginning of the taxable year. The
amount includes all of the indirect costs of property. If any repair allowance property capitalized amount is treated as a section
producing the repair allowance property in a particular MACRS class as of the 168(i)(6) improvement to the underlying
in the MACRS class, which must be cap- beginning of the taxable year is depre- repair allowance property and is treated as
italized in accordance with the taxpayer’s ciated under section 168(g) pursuant to placed in service by the taxpayer on the
method of accounting for section 263A section 168(g)(1)(A) through (D) or other last day of the first half of the taxable year
costs. Except as provided in paragraphs provisions of the Internal Revenue Code, in which the amount is paid, before ap-
(g)(5)(iv), (g)(5)(v), and (g)(5)(vi) of this the portion of the capitalized amount for plication of the convention under section
section, a taxpayer may choose to treat that MACRS class that is attributable to 168(d). The depreciation of the capital-
the capitalized amount as a single asset all section 168(g) repair allowance prop- ized amount allocated to repair allowance
under paragraph (g)(5)(ii) of this section erty in that MACRS class (section 168(g) property must be determined under section
or, alternatively, may choose to allocate total capitalized amount) is determined 168(g) whether or not the repair allowance

2006–39 I.R.B. 565 September 25, 2006


property in the MACRS class as of the be- beginning of the taxable year in accor- counting provided in section 263(d) (with
ginning of the taxable year is depreciated dance with paragraph (g)(5)(iii) of this regard to certain railroad rolling stock);
under section 168(g). section, and allocate the non-public util- the method of accounting provided in Rev.
(vi) Public utility property. If any re- ity property total capitalized amount for Proc. 2001–46, 2001–2 C.B. 263, or Rev.
pair allowance property in a particular a particular MACRS class in proportion Proc. 2002–65, 2002–2 C.B. 700 (with re-
MACRS class is public utility property to the unadjusted basis of the non-public gard to railroad track) (see §601.601(d)(2)
(as defined in section 168(i)(10) or for- utility property in that MACRS class as of this chapter); or any other property or
mer section 167(l)(3)(A)), the portion of of the beginning of the taxable year in method of accounting that is designated in
the capitalized amount for that MACRS accordance with paragraph (g)(5)(iii) of guidance published in the Federal Regis-
class that is attributable to all public util- this section. In either case, the public ter or the Internal Revenue Bulletin (see
ity property in that MACRS class (public utility property total capitalized amount §601.601(d)(2) of this chapter).
utility property total capitalized amount) for a particular MACRS class is subject to (7) Excluded additions—(i) In general.
is determined by multiplying the capital- the normalization requirements of section Excluded addition means any amount
ized amount for that MACRS class (as 168(i)(9). paid—
determined under paragraph (g)(5)(i) of (6) Repair allowance property—(i) In (A) For the acquisition or production of
this section) by a percentage that is equal general. Except as provided in paragraph a specific unit of property;
to the unadjusted basis of all public utility (g)(6)(iii) of this section, repair allowance (B) For work that ameliorates a condi-
property in that MACRS class as of the be- property means real or personal property tion or defect that either existed prior to the
ginning of the taxable year divided by the subject to section 168 of the Internal Rev- taxpayer’s acquisition of the unit of prop-
unadjusted basis of all repair allowance enue Code of 1986, or treated as subject erty or arose during the production of the
property in that MACRS class as of the to section 168 under paragraph (g)(6)(ii) of unit of property, whether or not the tax-
beginning of the taxable year. The public this section, that is used in the taxpayer’s payer was aware of the condition or defect
utility property total capitalized amount trade or business or for the production of at the time of acquisition or production;
for a particular MACRS class then is sub- income. (C) For work performed prior to the
tracted from the unadjusted basis of all (ii) Certain property not subject to sec- date the unit of property is placed in ser-
repair allowance property in that MACRS tion 168. Repair allowance property in- vice by the taxpayer (without regard to
class as of beginning of the taxable year cludes tangible depreciable property not any applicable convention under section
to determine the non-public utility prop- otherwise in a MACRS class if the tax- 168(d));
erty total capitalized amount. A taxpayer payer classifies the property, only for pur- (D) That adapts the unit of property to
may choose to treat the public utility poses of the repair allowance method in a new or different use; or
property total capitalized amount for a paragraph (g)(4) of this section, to deter- (E) That increases the cubic or square
particular MACRS class as a single asset mine the appropriate MACRS class and space of a building.
in accordance with paragraph (g)(5)(ii) either the taxpayer placed the property in (ii) Treatment of excluded additions.
of this section, and the non-public utility service before the effective date of section Any amount paid for an excluded addition
property total capitalized amount for that 168 of the Internal Revenue Code of 1986 is treated as a capital expenditure under
MACRS class as another single asset in or the taxpayer properly elected out of sec- sections 263(a) and 263A.
accordance with paragraph (g)(5)(ii) of tion 168 with regard to the property. (8) Repair allowance percentage. Ex-
this section. Alternatively, the taxpayer (iii) Exclusions from repair allowance cept as provided in any future guidance
may choose to allocate the public utility property. Repair allowance property published in the Federal Register or the
property total capitalized amount for a does not include any property for which Internal Revenue Bulletin, the repair al-
particular MACRS class in proportion to the taxpayer has elected to use the as- lowance percentage in effect for each
the unadjusted basis of the public utility set guideline class repair allowance in MACRS class for a particular taxable year
property in that MACRS class as of the §1.167(a)–11(d)(2); the method of ac- is as follows:

MACRS Class MACRS Recovery Repair Allowance


Period Percentage
3-year property 3 years 16.5
5-year property 5 years 10
7-year property 7 years 7.14
10-year property 10 years 5
15-year property 15 years 3.33
20-year property 20 years 2.5
Water utility property 25 years 2
Residential rental property 27.5 years 1.82
Nonresidental rental property 39 years 1.28
Railroad grading or tunnel bore 50 years 1

September 25, 2006 566 2006–39 I.R.B.


(9) Manner of election. [Reserved] tailing, $2,200 for scheduled maintenance such as (k) Accounting method changes. [Re-
(10) Manner of revoking election. A oil changes, tire rotation, new brakes, minor parts, served]
taxpayer may revoke an election made un- and fluid replacements, etc.; $80 for new headlights;
$250 for new tires; and $4,800 to rebuild the engine Mark E. Matthews,
der the repair allowance method only by after the car overheated. Assume that none of X’s
obtaining the Commissioner’s consent to expenditures are an excluded addition as defined in
Deputy Commissioner for
revoke the election. An election must be paragraph (g)(7) of this section. The car is classified Services and Enforcement.
revoked prospectively and may not be re- as MACRS 5-year property. Assume that X has no
(Filed by the Office of the Federal Register on August 18,
voked through the filing of an amended other MACRS 5-year property. The repair allowance 2006, 8:45 a.m., and published in the issue of the Federal
percentage for MACRS 5-year property is 10 per- Register for August 21, 2006, 71 F.R. 48590)
Federal income tax return. A taxpayer that cent. X’s repair allowance amount and capitalized
revokes an election may not re-elect the amount are computed as follows:
repair allowance method for a period of (i) X determines its average unadjusted basis of
at least five taxable years, beginning with MACRS 5-year property is $25,000. Notice of Proposed
the year of the revocation unless, based on (ii) X multiplies its average unadjusted basis of Rulemaking and Notice of
MACRS 5-year property by the prescribed repair al-
a showing of unusual and compelling cir- lowance percentage for MACRS 5-year property to
Public Hearing
cumstances, consent is specifically granted arrive at the repair allowance amount: $25,000 x 10%
by the Commissioner to re-elect the repair = $2,500. User Fees Relating to
allowance at an earlier time. (iii) Because X’s amounts to repair, maintain, or
improve MACRS 5-year property ($2,200 + $80 +
Enrollment
(11) Examples. The following exam-
$250 + $4,800 = $7,330) exceed the repair allowance
ples illustrate the rules of this paragraph amount for MACRS 5-year property ($2,500), X REG–145154–05
(g) and assume that none of the rules in treats $2,500 as an otherwise deductible ordinary
paragraph (g)(5)(iv) or (g)(5)(v) of this and necessary expenditure under section 162(a) and AGENCY: Internal Revenue Service
section applies: capitalizes $4,830 as the amounts paid in excess of (IRS), Treasury.
Example 1. X elects the repair allowance method the repair allowance amount.
described in this paragraph (g). X’s total unadjusted (iv) The capitalized amount ($4,830) is treated as ACTION: Notice of proposed rulemaking
basis of all of its MACRS 10-year property as of Jan- an improvement under section 168(i)(6). The im-
provement is depreciated as 5-year property under
and notice of public hearing.
uary 1, 2008 is $10 million. X’s total unadjusted ba-
sis of all MACRS 10-year property as of December section 168 and is considered placed in service on the
last day of the first half of 2008. SUMMARY: This document contains pro-
31, 2008 is $15 million (computed without regard to
amounts capitalized under this repair allowance pro- (h) Treatment of capital expenditures. posed amendments to the regulations re-
vision). During 2008, X pays $1,000,000 to repair, Amounts required to be capitalized un- lating to user fees for the special enroll-
maintain, or improve MACRS 10-year property. As-
der this section are capital expenditures ment examination to become an enrolled
sume that none of X’s property is an excluded ad- agent, the application for enrollment of en-
dition as defined in paragraph (g)(7) of this section.
and must be taken into account through
a charge to capital account or basis, or in rolled agents, and the renewal of this en-
The repair allowance percentage for MACRS 10-year
property is 5 percent. X’s repair allowance amount the case of property that is inventory in rollment. The charging of user fees is au-
and capitalized amount are computed as follows: the hands of a taxpayer, through inclusion thorized by the Independent Offices Ap-
(i) X determines its average unadjusted ba-
in inventory costs. See section 263A for propriations Act (IOAA) of 1952. This
sis of MACRS 10-year property: ($10,000,000 + document also contains a notice of public
$15,000,000)/2 = $12,500,000.
the treatment of amounts referred to in
this section as well as other amounts paid hearing on these proposed regulations.
(ii) X multiplies its average unadjusted basis of
MACRS 10-year property by the prescribed repair in connection with the production of real
allowance percentage for MACRS 10-year property
DATES: Written or electronically-gen-
property and personal property, includ-
to arrive at the repair allowance amount: $12,500,000 erated comments must be received by
ing films, sound recordings, video tapes,
x 5% = $625,000. September 28, 2006. Outlines of topics to
(iii) Because X’s amounts paid to repair,
books, or similar properties.
be discussed at the public hearing sched-
maintain, or improve MACRS 10-year property (i) Recovery of capitalized amounts.
uled for September 29, 2006, must be
($1,000,000) exceed the repair allowance amount Amounts that are capitalized under this
for MACRS 10-year property ($625,000), X deducts
received by September 28, 2006.
section are recovered through deprecia-
under section 162(a) amounts paid to the extent of the
tion, cost of goods sold, or by an adjust- ADDRESSES: Comments are encour-
repair allowance amount ($625,000) and capitalizes
the amounts paid in excess of the repair allowance
ment to basis at the time the property is aged to be submitted to: CC:PA:LPD:PR
amount ($1,000,000 - $625,000 = $375,000). placed in service, sold, used, or otherwise (REG–145154–05), room 5203, Inter-
(iv) The capitalized amount ($375,000) is treated disposed of by the taxpayer. Cost recovery nal Revenue Service, P.O. Box 7604,
as an improvement under section 168(i)(6). The im- is determined by the applicable Internal Ben Franklin Station, Washington, DC
provement is depreciated as 10-year property under
Revenue Code and regulation provisions 20044. Submissions may be sent elec-
section 168 and is considered placed in service on the
last day of the first half of 2008.
relating to the use, sale, or disposition of tronically via the IRS Internet site at
Example 2. X elects the repair allowance method property. www.irs.gov/regs or via the Federal eRule-
described in this paragraph (g). X uses a car in (j) Effective date. The rules in this sec- making Portal at www.regulations.gov
providing a taxi service. X’s unadjusted basis in tion apply to taxable years beginning on or (IRS–REG–145154–05).
the car is $25,000. Assume that the unit of prop-
after the date of publication of the Treasury
erty (as determined under paragraph (d)(2) of this
section) is the car. In 2008, X incurs various costs
decision adopting these rules as final reg- FOR FURTHER INFORMATION
to maintain, repair, and improve the car, including: ulations in the Federal Register. CONTACT: Concerning submissions
$4,500 for gasoline; $550 for car washes and de- of comments and/or to be placed

2006–39 I.R.B. 567 September 25, 2006


on the building access list to at- employees if the former employee meets still maintain an oversight role with respect
tend the hearing, Richard Hurst at certain requirements, including length of to the SEE. The contractor will collect a
Richard.A.Hurst@irscounsel.treas.gov employment with the IRS and substantive user fee on behalf of the IRS based on the
or at (202) 622-7180; concerning cost tax expertise. Application for enrollment full costs incurred by the IRS. These pro-
methodology, Eva Williams at (202) based on former employment with the IRS posed regulations only establish a user fee
622–6400; concerning the proposed must be made within three years from the with respect to the government costs for
regulations, Matthew Cooper at (202) date of separation from such employment. overseeing the SEE and do not include any
622–4940 (not toll-free numbers). Once eligible for enrollment, by either fee that the contractor may charge for its
passing the examination or because of for- services. Accordingly, while the user fee
SUPPLEMENTARY INFORMATION: mer employment with the IRS, an appli- imposed pursuant to these regulations is
cant must file an application for enroll- less than the user fee that applicants were
Background ment on Form 23, “Application for Enroll- charged in 2005, the total fee that appli-
ment to Practice Before the Internal Rev- cants will be charged is greater. The IRS
Section 330 of Title 31 of the United
enue Service,” with the Director of OPR. estimates that by using a contractor, how-
States Code authorizes the Secretary of the
As part of the application for enrollment ever, the total fees incurred will be less
Treasury to regulate practice before the
process, the applicant must enclose a check than the total fees that would otherwise be
Treasury Department. Pursuant to section
or money order payable to the IRS in the charged by the IRS in order to recover the
330 of Title 31, the Secretary has published
amount set forth on Form 23, which consti- full cost of the IRS administering all as-
regulations governing practice before the
tutes a fee charged to each applicant for en- pects of the SEE.
IRS in 31 CFR part 10 and reprinted them
rollment. The fee is nonrefundable regard-
as Treasury Department Circular No. 230 User Fees for Special Enrollment
less of whether the applicant is granted en-
(Circular 230). These regulations are ad- Examination, Enrollment, and Renewal
rollment. The current user fee for enroll-
ministered by the IRS Office of Profes- of Enrollment
ment on the Form 23 (Rev. February 2005)
sional Responsibility (OPR).
is $80. The Director of OPR will act upon
Section 10.3 of Circular 230 generally The user fee that the IRS currently
an application for enrollment and issue an
authorizes attorneys, certified public ac- charges applicants in order to take the SEE
enrollment card to each individual whose
countants, enrolled agents and enrolled ac- is being modified to reflect the change in
application for enrollment to practice be-
tuaries to practice before the IRS. An en- IRS costs of administering the exam pro-
fore the IRS is approved.
rolled agent is defined as an individual en- gram as a result of the contracting out
Pursuant to section 10.6(d), each indi-
rolled as an agent pursuant to the provi- of the exam. The user fees that the IRS
vidual, once enrolled, is required to renew
sions of Circular 230. The provisions of currently charge applicants for the enroll-
the enrollment every three years to main-
Circular 230 provide that an individual de- ment and renewal of enrollment process
tain an active enrollment to practice before
siring to become an enrolled agent is eligi- are less than the actual cost of oversee-
the IRS. In order to qualify for renewal,
ble for enrollment through either the suc- ing the enrollment process. The IRS is
an applicant must certify the completion of
cessful passing of a written examination proposing new user fees to take the SEE to
the continuing professional education re-
or through demonstration of sufficient ex- become an enrolled agent, the application
quirements set forth in section 10.6(e) of
pertise in tax administration based on for- for enrollment and the renewal of such
Circular 230. A nonrefundable user fee of
mer employment with the IRS. Specifi- enrollment.
$80 is currently charged for each applica-
cally, section 10.4(a) authorizes the Direc- Proposed section 300.4 establishes an
tion for renewal of enrollment filed with
tor of OPR to grant enrollment to an ap- $11 per part user fee for the SEE. Proposed
the Director of OPR on Form 8554, “Appli-
plicant who demonstrates special compe- sections 300.5 and 300.6 establish separate
cation for Renewal of Enrollment to Prac-
tence in tax matters by passing a written $125 user fees for the enrollment and re-
tice Before the Internal Revenue Service.”
examination administered by, or adminis- newal of enrollment process.
tered under the oversight of, the Director Contracting Out of Special Enrollment
of OPR and who has not engaged in any Examination Authority
conduct that would justify the censure, sus-
pension, or disbarment of any practitioner OPR has recently contracted out certain The IOAA of 1952 (31 U.S.C. 9701)
under the provisions of Circular 230. Ac- functions pertaining to the SEE to a pri- authorizes agencies to prescribe regula-
cordingly, every year OPR develops and vate contractor. The contractor will fur- tions that establish charges for services
administers a Special Enrollment Exami- nish the resources, facilities, and services provided by the agency. The charges must
nation (SEE) that is given to all applicants necessary to administer the entire SEE pro- be fair and be based on the costs to the
desiring to become enrolled agents so that gram, which includes examination devel- Government, the value of the service to
they can practice before the IRS. The IRS opment, administration of SEE, notifica- the recipient, the public policy or inter-
charged applicants a user fee of $55 ($45 tion to IRS of candidates who took the ex- est served, and other relevant facts. The
if taking the examination in part) in order amination, and the results of the exami- IOAA of 1952 provides that regulations
to take the 2005 SEE. nation. The contractor will receive pay- implementing user fees are subject to poli-
Section 10.4(b) authorizes the Director ment for its services by charging a fee to cies prescribed by the President, which are
of OPR to grant enrollment for former IRS exam applicants. OPR will, nonetheless, currently set forth in OMB Circular A–25,

September 25, 2006 568 2006–39 I.R.B.


58 FR 38142 (July 15, 1993) (the OMB fee is voluntary. The only persons sub- Drafting Information
Circular). ject to the fee are those who elect to take
The OMB Circular encourages user the special enrollment exam. Persons who The principal author of these regula-
fees for Government-provided services elect to take the exam will have determined tions is Matthew S. Cooper of the Office
that confer benefits on identifiable re- that it is in their economic interest to do of the Associate Chief Counsel (Procedure
cipients over and above those benefits so. Pursuant to section 7805(f) of the In- & Administration), Administrative Provi-
received by the general public. Under the ternal Revenue Code, this notice of pro- sions & Judicial Practice Division.
OMB Circular, an agency that seeks to posed rulemaking will be submitted to the *****
impose a user fee for Government-pro- Chief Counsel for Advocacy of the Small
vided services must calculate its full cost Business Administration for comment on Proposed Amendments to the
of providing those services. In general, its impact. Regulations
a user fee should be set at an amount in
Comments and Public Hearing Accordingly, 26 CFR Part 300 is pro-
order for the agency to recover the cost of
posed to be amended as follows:
providing the special service, unless the
Before these proposed regulations are
Office of Management and Budget grants PART 300—USERS FEES
adopted as final regulations, consideration
an exception. Pursuant to the guidelines
will be given to any written (a signed origi-
in the OMB Circular, the IRS has calcu- Paragraph 1. The authority citation for
nal and eight (8) copies) or electronic com-
lated its cost of providing services under part 300 continues to read as follows:
ments that are submitted timely to the IRS.
the enrolled agents program. The IRS has Authority: 31 U.S.C. 9701.
The IRS and Treasury Department request
determined that the full cost to the IRS Par. 2. Section 300.0 is amended as
comments on the substance of the pro-
of overseeing the SEE is $11 per part per follows:
posed regulations, as well as on the clarity
applicant. The IRS has determined that 1. Paragraphs (b)(4), (5), and (6) are
of the proposed rules and how they can be
the full cost of administering the enroll- added.
made easier to understand. All comments
ment and renenrollment process is $125 2. Paragraph (c) is revised.
will be available for public inspection and
per enrolled agent. The additions and revision read as fol-
copying.
The proposed user fees will be imple- lows:
A public hearing has been scheduled
mented under the authority of the IOAA of
for September 29, 2006, at 10 a.m. in §300.0 User fees, in general.
1952 and the OMB Circular.
the 11th floor conference room at 1901 S.
Proposed Effective Date Bell Street, Arlington, VA 22202. Due to *****
building security procedures, all visitors (b) * * *
These regulations are proposed to apply must present photo identification to enter (4) Taking the special enrollment exam-
thirty days after the date of publication in the building. Because of access restric- ination to become an enrolled agent.
the Federal Register of the final regula- tions, visitors will not be admitted beyond (5) Enrolling an enrolled agent.
tions. the immediate entrance area more than 30 (6) Renewing the enrollment of an en-
minutes before the hearing starts. For in- rolled agent.
Special Analyses formation about having your name placed (c) Effective Date. This part 300 is ap-
on the building access list to attend the plicable March 16, 1995, except that the
It has been determined that this notice
hearing, see the “FOR FURTHER INFOR- user fee for processing offers in compro-
of proposed rulemaking is not a significant
MATION CONTACT” section of this pre- mise is applicable November 1, 2003, and
regulatory action as defined in Executive
amble. the user fee for the special enrollment ex-
Order 12866. Therefore, a regulatory as-
The rules of 26 CFR 601.601(a)(3) ap- amination, enrollment, and renewal of en-
sessment is not required. It is hereby cer-
ply to the hearing. Persons who wish to rollment for enrolled agents is applicable
tified that these regulations will not have a
present oral comments at the hearing must thirty days after the date of publication in
significant economic impact on a substan-
submit electronic or written comments and the Federal Register of the final regula-
tial number of small entities. Accordingly,
an outline of the comments to be discussed tions.
a regulatory flexibility analysis is not re-
and the time to be devoted to each topic Par. 3. Section 300.4 is added to read
quired. This certification is based on the
(signed original and eight (8) copies) by as follows:
information that follows. The economic
September 28, 2006. A period of ten (10)
impact of these regulations on any small §300.4 Special enrollment examination
minutes will be allotted to each person for
entity would result from a small entity, in- fee.
making comments. An agenda showing
cluding a sole proprietor, being required
the scheduling of the speakers will be pre-
to pay a fee prescribed by these regula- (a) Applicability. This section applies
pared after the deadline for receiving out-
tions in order to obtain a particular service. to the special enrollment examination to
lines has passed. Copies of the agenda will
The dollar amount of the fee is not, how- become an enrolled agent pursuant to 31
be available free of charge at the hearing.
ever, substantial enough to have a signif- CFR 10.4(a).
icant economic impact on any entity sub- (b) Fee. The fee for taking the special
ject to the fee. Moreover, payment of the enrollment examination is $11.00 per part.

2006–39 I.R.B. 569 September 25, 2006


(c) Person liable for the fee. The person Notice of Proposed www.irs.gov/regs or via the Federal eRule-
liable for the special enrollment examina- Rulemaking by making Portal at www.regulations.gov
tion fee is the applicant taking the exami- Cross-Reference to (IRS REG–120509–06).
nation.
Par. 4. Section 300.5 is added to read Temporary Regulations FOR FURTHER INFORMATION
as follows: CONTACT: Concerning the regula-
Determination of Interest tions, Gregory Spring or Paul Epstein,
§300.5 Enrollment of enrolled agent fee. Expense Deduction of Foreign (202) 622–3870, concerning submis-
sions of comments, Richard A. Hurst,
(a) Applicability. This section applies Corporations
Richard.A.Hurst@irscounsel.treas.gov, or
to the initial enrollment of enrolled agents (202) 622–7180 (not toll-free numbers).
with the IRS Office of Professional Re- REG–120509–06
sponsibility pursuant to 31 CFR 10.5(b). SUPPLEMENTARY INFORMATION:
AGENCY: Internal Revenue Service
(b) Fee. The fee for initially enrolling
(IRS), Treasury. Paperwork Reduction Act
as an enrolled agent with the IRS Office of
Professional Responsibility is $125.00. ACTION: Notice of proposed rulemaking The collection of information contained
(c) Person liable for the fee. The per- by cross-reference to temporary regula- in this notice of proposed rulemaking has
son liable for the enrollment fee is the ap- tions. been submitted to the Office of Manage-
plicant filing for enrollment as an enrolled
ment and Budget for review in accordance
agent with the IRS Office of Professional SUMMARY: In this issue of the Bulletin,
with the Paperwork Reduction Act of 1995
Responsibility. the IRS is issuing temporary regulations
(44 U.S.C. 3507(d)). Comments on the
Par. 5. Section 300.6 is added to read (T.D. 9281) under sections 882 and 884
collection of information should be sent to
as follows: relating to the determination of the inter-
the Office of Management and Budget,
est expense deduction of foreign corpora-
§300.6 Renewal of enrollment of enrolled Attn: Desk Officer for the Department of
tions engaged in a trade or business within
agent fee. Treasury, Office of Information and Reg-
the United States. These regulations up-
ulatory Affairs, Washington, DC 20503,
date the 1996 final interest expense allo-
(a) Applicability. This section applies with copies to the Internal Revenue Ser-
cation rules for foreign corporations and
to the renewal of enrollment of enrolled vice, Attn: IRS Reports Clearance Officer,
take into account changes in the foreign
agents with the IRS Office of Profes- SE:W:CAR:MP:T:T:SP, Washington, DC
banking industry. The rule changes are
sional Responsibility pursuant to 31 CFR 20224. Comments on the collection of in-
necessary to conform the final regulations
10.6(d)(6). formation should be received by October
more closely to current operating condi-
(b) Fee. The fee for renewal of enroll- 16, 2006. Comments are requested specif-
tions in the foreign banking industry, and
ment as an enrolled agent with the IRS ically concerning:
to harmonize the deemed earnings repa-
Office of Professional Responsibility is Whether the proposed collection of in-
triation from a foreign corporation’s trade
$125.00. formation is necessary for the proper per-
or business within the United States, with
(c) Person liable for the fee. The person formance of the functions of the Internal
the manner in which dividends are repatri-
liable for the renewal of enrollment fee is Revenue Service, including whether the
ated from U.S. resident companies to their
the person renewing their enrollment as information will have practical utility;
foreign shareholders. These regulations
an enrolled agent with the IRS Office of The accuracy of the estimated burden
are expected to simplify compliance bur-
Professional Responsibility. associated with the proposed collection of
dens for many foreign corporations that al-
information (see below);
Mark E. Matthews, locate interest expense to effectively con-
How the quality, utility, and clarity of
Deputy Commissioner for nected income and provide greater latitude
the information to be collected may be en-
Services and Enforcement. to taxpayers in determining when their ef-
hanced;
fectively connected earnings are treated as
(Filed by the Office of the Federal Register on August 25, How the burden of complying with the
remitted. The text of these regulations also
2006, 12:09 p.m., and published in the issue of the Federal proposed collection of information may be
Register for August 29, 2006, 71 F.R. 51179) serves as the text of these proposed regu-
minimized, including through the appli-
lations.
cation or automated collection techniques
DATES: Written or electronic comments or other forms of information technology;
and requests for a public hearing must be and
received by November 15, 2006. Estimates of capital or start-up costs
and costs of operation, maintenance, and
ADDRESSES: Send submissions to: purchase of service to provide information.
CC:PA:LPD:PR (REG–120509–06), In- The collections of information
ternal Revenue Service, PO Box 7604, in these proposed regulations are
Ben Franklin Station, Washington, DC in §§1.882–5T(d)(5)(ii)(B) and
20044. Submissions may be sent elec- 1.884–1T(e)(3)(iv). This collection
tronically, via the IRS Internet site at of information is required to facilitate

September 25, 2006 570 2006–39 I.R.B.


administrability of reporting of allocable of those regulations published in this issue Proposed Amendments to the
expense from without the United States. of the Bulletin also serves as the text of Regulations
Section 1.882–5T(d)(5)(ii)(B) provides these proposed regulations. The preamble
a simplified procedure for taxpayers to to those temporary regulations explains the Accordingly, 26 CFR 1 is proposed to
calculate an allocable amount of U.S. dol- temporary regulations and these proposed be amended as follows:
lar denominated interest expense booked regulations.
PART 1—INCOME TAXES
by foreign banks in foreign locations.
The collection of information provides Special Analyses
Paragraph 1. The authority citation for
certainty of application and immediate part 1 continues to read in part as follows:
It has been determined that this notice
verification in the advance review and Authority: 26 U.S.C. 7805 * * *
of proposed rulemaking is not a signifi-
resolution of such treatment on examina- Par. 2. Section 1.882–5 is amended to
cant regulatory action as defined in Exec-
tion. Section 1.884–1T(e)(3)(iv) provides read as follows:
utive Order 12866. Therefore, a regula-
the identical collection of information that 1. Paragraphs (a)(1), (a)(1)(i),
tory assessment is not required. It has also
was promulgated in final regulations in (a)(1)(ii), (a)(1)(ii)(A), (a)(1)(ii)(B),
been determined that section 553(b) of the
T.D. 8432, 1992–2 C.B. 157. The rule (a)(2), (a)(7), (a)(7)(i), (a)(7)(ii),
Administrative Procedure Act (5 U.S.C.
provides an election to reduce liabilities (b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4),
chapter 5) does not apply to these reg-
for purposes of treating effectively con- (d)(2)(ii)(A)(2), (d)(2)(ii)(A)(3),
ulations, and because the regulations do
nected earnings and profits as reinvested. (d)(2)(iii)(A), and (d)(5)(ii) are re-
not impose a collection of information on
It also requires that U.S. connected vised.
small entities, the Regulatory Flexibility
liabilities be reduced for purposes of 2. Paragraph (d)(6) Example 5 is added.
Act (5 U.S.C. chapter 6) does not apply.
determining the allocation of interest The revisions and addition read as fol-
Pursuant to section 7805(f) of the Code,
expense to effectively connected income. lows:
this regulation has been submitted to the
The collection of information facilitates
Chief Counsel for Advocacy of the Small
identification and verification of the §1.882–5 Determination of interest
Business Administration for comment on
coordinated treatment of the sections 882 deduction.
its impact on small business.
and 884 provisions in accordance with
the time, place and manner restrictions (a) * * *
Comments and Requests for Public
for making the election. The collections (a)(1) through (a)(2) [The text of this
Hearing
of information are mandatory. The likely proposed amendment is the same as the
respondents are foreign banks. Before these proposed regulations are text of §1.882–5T(a)(1) through (a)(2)
Estimated total annual reporting bur- adopted as final regulations, considera- published elsewhere in this issue of the
den: 37.5. tion will be given to any written (a signed Bulletin].
Estimated average annual burden hours original and eight (8) copies) or electronic *****
per respondent: 1/2 hour. comments that are submitted timely to the (a)(7) [The text of this proposed
Estimated number of respondents: 75. IRS. The IRS and the Treasury Depart- amendment is the same as the text of
Estimated annual frequency of re- ment specifically request comments on §1.882–5T(a)(7) published elsewhere in
sponses: annually. the clarity of the proposed regulations and this issue of the Bulletin].
An agency may not conduct or sponsor, how they can be made easier to under-
*****
and a person is not required to respond to, a stand. All comments will be available for
(b) * * *
collection of information unless it displays public inspection and copying. A public
(2) * * *
a valid control number assigned by the Of- hearing will be scheduled if requested by
(ii) * * *
fice of Management and Budget. any person who timely submits comments.
(b)(2)(ii)(A) [The text of this proposed
Books and records relating to a collec- If a public hearing is scheduled, notice of
amendment is the same as the text of
tion of information must be retained as the date, time and place for the hearing
§1.882–5T(b)(2)(ii)(A) published else-
long as their contents may become mate- will be published in the Federal Register.
where in this issue of the Bulletin].
rial in the administration of any internal
revenue law. Generally, tax returns and tax Drafting Information *****
return information are confidential, as re- (b)(2)(iv) [The text of this proposed
The principal authors of these amendment is the same as the text of
quired by 26 U.S.C. 6103.
regulations are Paul S. Epstein and §1.882–5T(b)(2)(iv) published elsewhere
Background Gregory A. Spring of the Office of As- in this issue of the Bulletin].
sociate Chief Counsel (International).
In this issue of the Bulletin, the IRS is *****
***** (b)(3) [The text of this proposed
issuing temporary regulations under sec-
tions 882 and 884 relating to the determi- amendment is the same as the text of
nation of the interest expense deduction of §1.882–5T(b)(3) published elsewhere in
foreign corporations engaged in a trade or this issue of the Bulletin].
business within the United States. The text *****

2006–39 I.R.B. 571 September 25, 2006


(c) * * * §1.882–5T(d)(2)(iii)(A) published else- (3) * * *
(2) * * * where in this issue of the Bulletin]. (e)(3)(ii) [The text of this proposed
(c)(2)(iv) [The text of this proposed ***** amendment is the same as the text of
amendment is the same as the text of (5) * * * §1.884–1T(e)(3)(ii) published elsewhere
§1.882–5T(c)(2)(iv) published elsewhere (i) * * * in this issue of the Bulletin].
in this issue of the Bulletin]. (d)(5)(ii) [The text of this proposed *****
***** amendment is the same as the text of (e)(3)(iv) [The text of this proposed
(c)(4) [The text of this proposed §1.882–5T(d)(5)(ii) published elsewhere amendment is the same as the text of
amendment is the same as the text of in this issue of the Bulletin]. §1.884–1T(e)(3)(iv) published elsewhere
§1.882–5T(c)(4) published elsewhere in ***** in this issue of the Bulletin].
this issue of the Bulletin]. (d)(6) Example 5 [The text of this pro- *****
***** posed amendment is the same as the text (5) * * *
(d) * * * of §1.882–5T(d)(6) Example 5 published (e)(5) Example 2 [The text of this pro-
(2) * * * elsewhere in this issue of the Bulletin]. posed amendment is the same as the text
(ii) * * * ***** of §1.884–1T(e)(5) Example 2 published
(A) * * * Par. 3. Section 1.884–1 is amended elsewhere in this issue of the Bulletin].
(d)(2)(ii)(A)(2) through (3) [The text of by revising the entries for paragraphs *****
these proposed amendments are the same §1.884–1(e)(3)(ii), (e)(3)(iv) and (e)(5)
as the text of §1.882–5T(d)(2)(ii)(A)(2) Example 2 to read as follows: Mark E. Matthews,
through (3) published elsewhere in this is- Deputy Commissioner for
sue of the Bulletin]. §1.884–1 Determination of interest Services and Enforcement.
deduction
(Filed by the Office of the Federal Register on August 15,
***** 2006, 8:45 a.m., and published in the issue of the Federal
(d)(2)(iii)(A) [The text of this proposed ***** Register for August 17, 2006, 71 F.R. 47459)
amendment is the same as the text of (e) * * *

Announcement of Disciplinary Actions Involving


Attorneys, Certified Public Accountants, Enrolled Agents,
and Enrolled Actuaries — Suspensions, Censures,
Disbarments, and Resignations
Announcement 2006-57
Under Title 31, Code of Federal Regu- person to practice before the Internal Rev- their names, their city and state, their pro-
lations, Part 10, attorneys, certified public enue Service during a period of suspen- fessional designation, the effective date
accountants, enrolled agents, and enrolled sion, disbarment, or ineligibility of such of disciplinary action, and the period of
actuaries may not accept assistance from, other person. suspension. This announcement will ap-
or assist, any person who is under disbar- To enable attorneys, certified public pear in the weekly Bulletin at the earliest
ment or suspension from practice before accountants, enrolled agents, and enrolled practicable date after such action and will
the Internal Revenue Service if the assis- actuaries to identify persons to whom continue to appear in the weekly Bulletins
tance relates to a matter constituting prac- these restrictions apply, the Director, Of- for five successive weeks.
tice before the Internal Revenue Service fice of Professional Responsibility, will
and may not knowingly aid or abet another announce in the Internal Revenue Bulletin

September 25, 2006 572 2006–39 I.R.B.


Consent Suspensions From Practice Before the Internal
Revenue Service
Under Title 31, Code of Federal Regu- may offer his or her consent to suspension The following individuals have been
lations, Part 10, an attorney, certified pub- from such practice. The Director, Office placed under consent suspension from
lic accountant, enrolled agent, or enrolled of Professional Responsibility, in his dis- practice before the Internal Revenue Ser-
actuary, in order to avoid the institution cretion, may suspend an attorney, certified vice:
or conclusion of a proceeding for his or public accountant, enrolled agent, or en-
her disbarment or suspension from prac- rolled actuary in accordance with the con-
tice before the Internal Revenue Service, sent offered.

Name Address Designation Date of Suspension

Crane, Stephen Palm Springs, CA Enrolled Agent May 4, 2006


to
August 3, 2007
Cohen, Ronald J. Newburgh, NY Attorney Indefinite
from
June 21, 2006
Layson, David A. Corydon, IN Attorney April 7, 2006
to
October 6, 2007
Brough, Donald L. Salem, IN CPA July 1, 2006
to
June 30, 2010
Gulian, Yervant Great Neck, NY CPA April 17, 2006
to
December 16, 2007
Rivera-Smith, Dawn Brick, NJ CPA May 30, 2006
to
November 29, 2008
Eckstein, Matthew Woodbury, NY CPA June 15, 2006
to
March 14, 2007
Hecht, Jodee L. Clifton, VA CPA Indefinite
from
June 19, 2006
Finch, Phillip W. Yorktown, VA CPA Indefinite
from
June 22, 2006
Troese Jr., Henry A. Clarion, PA Enrolled Agent Indefinite
from
June 22, 2006
Robbins, Ronald E. Pittsford, VT CPA June 24, 2006
to
June 23, 2008
Shapiro, Sidney C. West Palm Beach, FL CPA Indefinite
from
July 1, 2006

2006–39 I.R.B. 573 September 25, 2006


Name Address Designation Date of Suspension

Martini, Anthony Stamford, CT CPA June 18, 2006


to
December, 17, 2007
Cunningham, William Philadelphia, PA CPA July 1, 2006
to
March 31, 2007
Simontacchi, Joseph F. Morris Plains, NJ CPA Indefinite
from
July 1, 2006
Carroccio, Ronald P. Staten Island, NY CPA Indefinite
from
July 1, 2006
Miller, Walter P. Roanoke, VA CPA Indefinite
from
July 1, 2006
Aneji, Patrick Houston, TX CPA Indefinite
from
June 22, 2006
Rosenbloom, Mark L. Chicago, IL Attorney August 15, 2006
to
August 14, 2007
Viener, Ira S. Fort Lee, NJ CPA Indefinite
from
August 1, 2006
Ganz, Sheldon M. Great Neck, NJ CPA Indefinite
from
August 1, 2006
Tomasulo, Maria Wantagh, NY CPA Indefinite
from
August 7, 2006
Galpern, Joel G. North Miami, FL CPA Indefinite
from
September 1, 2006

September 25, 2006 574 2006–39 I.R.B.


Expedited Suspensions From Practice Before the Internal
Revenue Service
Under Title 31, Code of Federal Regu- the expedited proceeding is instituted (1) The following individuals have been
lations, Part 10, the Director, Office of Pro- has had a license to practice as an attor- placed under suspension from practice be-
fessional Responsibility, is authorized to ney, certified public accountant, or actuary fore the Internal Revenue Service by virtue
immediately suspend from practice before suspended or revoked for cause or (2) has of the expedited proceeding provisions:
the Internal Revenue Service any practi- been convicted of certain crimes.
tioner who, within five years from the date

Name Address Designation Date of Suspension

Dolan Jr., John L. Memphis, TN Attorney Indefinite


from
April 3, 2006
St. Mary, Randall L. Snohomish, WA Attorney Indefinite
from
April 3, 2006
Theriault, Michael J. Bel Air, MD Attorney Indefinite
from
April 3, 2006
Smith, Bernard P. Marblehead, MA Attorney Indefinite
from
April 3, 2006

Bradley, Phillip M. West Point, VA Attorney Indefinite


from
April 3, 2006
Haefele, Richard J. Wayzata, MN Attorney Indefinite
from
April 3, 2006
Decker, William E. Mandeville, LA Attorney Indefinite
from
April 3, 2006
Arbour, John J. Monroe, LA Attorney Indefinite
from
April 3, 2006

Keller, John S. Martin Kenner, LA Attorney Indefinite


from
April 3, 2006
Fallon, Charles D. Neptune, NJ Attorney Indefinite
from
April 3, 2006
Agresti, Thomas J. Centennial, CO Attorney Indefinite
from
April 3, 2006

Kirsch, Craig F. Pittsburgh, PA CPA Indefinite


from
April 3, 2006

2006–39 I.R.B. 575 September 25, 2006


Name Address Designation Date of Suspension

Hall, Lenny G. McDowell, KY CPA Indefinite


from
April 11, 2006

Hultgren, Jerry R. Fresno, CA Attorney Indefinite


from
April 11, 2006

Loutos, Peter A. Chicago, IL Attorney Indefinite


from
April 11, 2006

Smith III, Frank L. Bushnell, FL Attorney Indefinite


from
April 11, 2006

Morley, Michael J. Springfield, PA CPA Indefinite


from
April 11, 2006

Waters, Richard W. Smithfield, UT CPA Indefinite


from
April 11, 2006

Hartgraves, Travis M. Abilene, TX Attorney Indefinite


from
April 14, 2006

Dunn, George T. Lockhart, TX Attorney Indefinite


from
April 14, 2006

Adkins, Thomas R. Houston, TX Attorney Indefinite


from
April 14, 2006

Hairston, John W. Sugar Land, TX Attorney Indefinite


from
April 26, 2006

Marcone, Frank J. Upper Providence, PA Attorney Indefinite


from
May 1, 2006

Fraley, Donald J. Minneapolis, MN Attorney Indefinite


from
May 3, 2006

Tooke, S. Judd Shreveport, LA Attorney Indefinite


from
May 3, 2006

Reilly, Michael G. Council Bluffs, IA Attorney Indefinite


from
May 3, 2006

Faneuil, Robert A. Newton, MA Attorney Indefinite


from
May 3, 2006

September 25, 2006 576 2006–39 I.R.B.


Name Address Designation Date of Suspension

Maignan, Peter R. Upper Marlboro, MD Attorney Indefinite


from
May 3, 2006
Son, David Phoenix, AZ Attorney Indefinite
from
May 5, 2006
Susman, Warren I. New York, NY Attorney Indefinite
from
May 8, 2006
Wurst, Jerome Arlington, TX Attorney Indefinite
from
May 8, 2006
O’Shea, Joseph G. Jackson Heights, NY Attorney Indefinite
from
May 8, 2006
Biegelson, Alan Brooklyn, NY Attorney Indefinite
from
May 8, 2006
Leonard, Robert K. Winston-Salem, NC Attorney Indefinite
from
May 8, 2006
Cassidy, Michael M. Madison, WI Attorney Indefinite
from
May 8, 2006
Dobkin, Daniel B. New Hyde Park, NY Attorney Indefinite
from
May 8, 2006
Nealy, Joseph L. Sugarland, TX Attorney Indefinite
from
May 16, 2006
Conmey, Edwin W. Oconomowoc, WI Attorney Indefinite
from
May 16, 2006
Knott Jr., Robert T. Los Angeles, CA Attorney Indefinite
from
May 16, 2006
Diamond, Howard S. Mendham, NJ Attorney Indefinite
from
May 16, 2006
Fitzgerald, Bill L. Lubbock, TX Attorney Indefinite
from
May 16, 2006
Brubaker, Gregory A. San Francisco, CA Attorney Indefinite
from
May 18, 2006
Dodenbier, Robert F. Lehi, UT Attorney Indefinite
from
May 18, 2006

2006–39 I.R.B. 577 September 25, 2006


Name Address Designation Date of Suspension

Young, Paul J. Taft, CA Attorney Indefinite


from
June 8, 2006
Dahodwala, Fatema Andover, MA Attorney Indefinite
from
June 8, 2006
Mendola, Joseph E. Monessen, PA CPA Indefinite
from
June 8, 2006
Rooney, Edward F. Minneapolis, MN Attorney Indefinite
from
June 8, 2006
Long, Rebecca L. Wichita, KS Attorney Indefinite
from
June 8, 2006
West, Clifton C. Fayetteville, NC Attorney Indefinite
from
June 8, 2006
Silva, Zoilo I. City Island, NY Attorney Indefinite
from
June 8, 2006
Tyler Jr., Earle S. Bangor, ME Attorney Indefinite
from
June 12, 2006
Horneber, Alice S. Sioux City, IA Attorney Indefinite
from
June 12, 2006
Donnelly, Christine M. Blue Springs, MO Attorney Indefinite
from
June 12, 2006
Driscoll Jr., Peter Columbia, MD Attorney Indefinite
from
June 12, 2006
Souza, John C. Pocatello, ID Attorney Indefinite
from
June 12, 2006
Crockett, Kevin J. Midvale, UT Attorney Indefinite
from
June 12, 2006
White, Debra M. Wyatt Navasota, TX CPA Indefinite
from
June 12, 2006
Wilkins, Daniel J. Chelmsford, MA Attorney Indefinite
from
June 12, 2006
Merica, Chad L. Murray, UT CPA Indefinite
from
June 12, 2006

September 25, 2006 578 2006–39 I.R.B.


Name Address Designation Date of Suspension

Wintroub, David S. Omaha, NE Attorney Indefinite


from
June 12, 2006
Smith, Roderick E. Kansas City, MO Attorney Indefinite
from
June 12, 2006
Guida, Joseph M. Aberdeen, MD Attorney Indefinite
from
June 12, 2006
Sonibare, Nash St. Paul, MN CPA Indefinite
from
June 12, 2006
Braun, Marc W. St. Louis, MO Attorney Indefinite
from
June 12, 2006
Coffey, John J. Rye, NH Attorney Indefinite
from
June 12, 2006
Whitehead, H. Allen New York, NY Attorney Indefinite
from
June 12, 2006
Lansky, Sidney Mattapoisett, MA Attorney Indefinite
from
June 12, 2006
Pazniokas, Paul M. Norwood, MA Attorney Indefinite
from
June 12, 2006
Bajgrowicz, James J. Santa Rosa, CA Attorney Indefinite
from
June 12, 2006
Davis, Bret J. Los Angeles, CA Attorney Indefinite
from
June 12, 2006
McAvoy, Timothy Chicago, IL Attorney Indefinite
from
June 12, 2006
Loffadelli, Thomas C. Studio City, CA Attorney Indefinite
from
June 12, 2006
Emeziem, Kelechi C. Antioch, CA Attorney Indefinite
from
June 12, 2006
Pugh, William C. Wayzata, MN Attorney Indefinite
from
June 12, 2006
Lamanna, Eugene C. Reading, PA Attorney Indefinite
from
June 12, 2006

2006–39 I.R.B. 579 September 25, 2006


Name Address Designation Date of Suspension

Bartels, John R. St. Paul, MN Attorney Indefinite


from
June 12, 2006
Shapiro, Kenneth S. Bala Cynwyd, PA CPA Indefinite
from
June 14, 2006
Stone, Jerry W. Austin, TX Attorney Indefinite
from
June 21, 2006
Vanriper, Philip E. Binghamton, NY Attorney Indefinite
from
June 21, 2006
Simuro, Valerie T. Gardiner, NY Attorney Indefinite
from
June 21, 2006
Simms, William K. Brooklyn, NY Attorney Indefinite
from
June 21, 2006
Weaver, Terring M. Clarksburg, WV CPA Indefinite
from
July 1, 2006
Norman, Clarence Brooklyn, NY Attorney Indefinite
from
August 3, 2006
Knight, John G. Winston-Salem, NC Attorney Indefinite
from
August 3, 2006
Kronegold, Sheldon H. Englewood, NJ Attorney Indefinite
from
August 3, 2006
Foushee, Wayne H. Winston-Salem, NC Attorney Indefinite
from
August 3, 2006

Suspensions From Practice Before the Internal Revenue


Service After Notice and an Opportunity for a Proceeding
Under Title 31, Code of Federal Reg- ministrative law judge, the following indi- from practice before the Internal Revenue
ulations, Part 10, after notice and an op- viduals have been placed under suspension Service:
portunity for a proceeding before an ad-

Name Address Designation Effective Date

Kahn, Harold Hollis, NY CPA June 26, 2006


to
June 25, 2010

September 25, 2006 580 2006–39 I.R.B.


Disbarments From Practice Before the Internal Revenue
Service After Notice and an Opportunity for a Proceeding
Under Title 31, Code of Federal Regu- tunity for a proceeding before an adminis- als have been disbarred from practice be-
lations, Part 10, after notice and an oppor- trative law judge, the following individu- fore the Internal Revenue Service:

Name Address Designation Effective Date

Gailey, James N. Huntersville, NC CPA June 5, 2006

Censure Issued by Consent


Under Title 31, Code of Federal Reg- or enrolled actuary, may offer his or her The following individuals have con-
ulations, Part 10, in lieu of a proceeding consent to the issuance of a censure. Cen- sented to the issuance of a Censure:
being instituted or continued, an attorney, sure is a public reprimand.
certified public accountant, enrolled agent,

Name Address Designation Date of Censure

Williams, Daniel S. Carlsbad, CA Attorney March 29, 2006


Azan, Reinaldo L. Miami Beach, FL CPA July 24, 2006
Golub, Stephen B. Norwalk, CT CPA August 3, 2006

2006–39 I.R.B. 581 September 25, 2006


Definition of Terms
Revenue rulings and revenue procedures and B, the prior ruling is modified because of a prior ruling, a combination of terms
(hereinafter referred to as “rulings”) that it corrects a published position. (Compare is used. For example, modified and su-
have an effect on previous rulings use the with amplified and clarified, above). perseded describes a situation where the
following defined terms to describe the ef- Obsoleted describes a previously pub- substance of a previously published ruling
fect: lished ruling that is not considered deter- is being changed in part and is continued
Amplified describes a situation where minative with respect to future transac- without change in part and it is desired to
no change is being made in a prior pub- tions. This term is most commonly used in restate the valid portion of the previously
lished position, but the prior position is be- a ruling that lists previously published rul- published ruling in a new ruling that is self
ing extended to apply to a variation of the ings that are obsoleted because of changes contained. In this case, the previously pub-
fact situation set forth therein. Thus, if in laws or regulations. A ruling may also lished ruling is first modified and then, as
an earlier ruling held that a principle ap- be obsoleted because the substance has modified, is superseded.
plied to A, and the new ruling holds that the been included in regulations subsequently Supplemented is used in situations in
same principle also applies to B, the earlier adopted. which a list, such as a list of the names of
ruling is amplified. (Compare with modi- Revoked describes situations where the countries, is published in a ruling and that
fied, below). position in the previously published ruling list is expanded by adding further names in
Clarified is used in those instances is not correct and the correct position is subsequent rulings. After the original rul-
where the language in a prior ruling is be- being stated in a new ruling. ing has been supplemented several times, a
ing made clear because the language has Superseded describes a situation where new ruling may be published that includes
caused, or may cause, some confusion. the new ruling does nothing more than re- the list in the original ruling and the ad-
It is not used where a position in a prior state the substance and situation of a previ- ditions, and supersedes all prior rulings in
ruling is being changed. ously published ruling (or rulings). Thus, the series.
Distinguished describes a situation the term is used to republish under the Suspended is used in rare situations
where a ruling mentions a previously pub- 1986 Code and regulations the same po- to show that the previous published rul-
lished ruling and points out an essential sition published under the 1939 Code and ings will not be applied pending some
difference between them. regulations. The term is also used when future action such as the issuance of new
Modified is used where the substance it is desired to republish in a single rul- or amended regulations, the outcome of
of a previously published position is being ing a series of situations, names, etc., that cases in litigation, or the outcome of a
changed. Thus, if a prior ruling held that a were previously published over a period of Service study.
principle applied to A but not to B, and the time in separate rulings. If the new rul-
new ruling holds that it applies to both A ing does more than restate the substance

Abbreviations
The following abbreviations in current use ER—Employer. PRS—Partnership.
and formerly used will appear in material ERISA—Employee Retirement Income Security Act. PTE—Prohibited Transaction Exemption.
EX—Executor. Pub. L.—Public Law.
published in the Bulletin.
F—Fiduciary. REIT—Real Estate Investment Trust.
FC—Foreign Country. Rev. Proc.—Revenue Procedure.
A—Individual.
FICA—Federal Insurance Contributions Act. Rev. Rul.—Revenue Ruling.
Acq.—Acquiescence.
B—Individual. FISC—Foreign International Sales Company. S—Subsidiary.
FPH—Foreign Personal Holding Company. S.P.R.—Statement of Procedural Rules.
BE—Beneficiary.
F.R.—Federal Register. Stat.—Statutes at Large.
BK—Bank.
B.T.A.—Board of Tax Appeals. FUTA—Federal Unemployment Tax Act. T—Target Corporation.
FX—Foreign corporation. T.C.—Tax Court.
C—Individual.
G.C.M.—Chief Counsel’s Memorandum. T.D. —Treasury Decision.
C.B.—Cumulative Bulletin.
CFR—Code of Federal Regulations. GE—Grantee. TFE—Transferee.
GP—General Partner. TFR—Transferor.
CI—City.
GR—Grantor. T.I.R.—Technical Information Release.
COOP—Cooperative.
Ct.D.—Court Decision. IC—Insurance Company. TP—Taxpayer.
I.R.B.—Internal Revenue Bulletin. TR—Trust.
CY—County.
LE—Lessee. TT—Trustee.
D—Decedent.
DC—Dummy Corporation. LP—Limited Partner. U.S.C.—United States Code.
LR—Lessor. X—Corporation.
DE—Donee.
M—Minor. Y—Corporation.
Del. Order—Delegation Order.
DISC—Domestic International Sales Corporation. Nonacq.—Nonacquiescence. Z —Corporation.
O—Organization.
DR—Donor.
P—Parent Corporation.
E—Estate.
PHC—Personal Holding Company.
EE—Employee.
PO—Possession of the U.S.
E.O.—Executive Order.
PR—Partner.

September 25, 2006 i 2006–39 I.R.B.


Numerical Finding List1 Notices— Continued: Treasury Decisions— Continued:

Bulletins 2006–27 through 2006–39 2006-82, 2006-39 I.R.B. 529 9274, 2006-33 I.R.B. 244
9275, 2006-35 I.R.B. 327
Announcements: Proposed Regulations:
9276, 2006-37 I.R.B. 424
REG-135866-02, 2006-27 I.R.B. 34 9277, 2006-33 I.R.B. 226
2006-42, 2006-27 I.R.B. 48
REG-146893-02, 2006-34 I.R.B. 317 9278, 2006-34 I.R.B. 256
2006-43, 2006-27 I.R.B. 48
REG-159929-02, 2006-35 I.R.B. 341 9279, 2006-36 I.R.B. 355
2006-44, 2006-27 I.R.B. 49
REG-148864-03, 2006-34 I.R.B. 320 9280, 2006-38 I.R.B. 450
2006-45, 2006-31 I.R.B. 121
REG-168745-03, 2006-39 I.R.B. 532 9281, 2006-39 I.R.B. 517
2006-46, 2006-28 I.R.B. 76
REG-109512-05, 2006-30 I.R.B. 100 9282, 2006-39 I.R.B. 512
2006-47, 2006-28 I.R.B. 78
2006-48, 2006-31 I.R.B. 135 REG-145154-05, 2006-39 I.R.B. 567
2006-49, 2006-29 I.R.B. 89 REG-112994-06, 2006-27 I.R.B. 47
2006-50, 2006-34 I.R.B. 321 REG-118775-06, 2006-28 I.R.B. 73
2006-51, 2006-32 I.R.B. 222 REG-118897-06, 2006-31 I.R.B. 120
2006-52, 2006-33 I.R.B. 254 REG-120509-06, 2006-39 I.R.B. 570
2006-53, 2006-33 I.R.B. 254 REG-124152-06, 2006-36 I.R.B. 368
2006-54, 2006-33 I.R.B. 254 REG-125071-06, 2006-36 I.R.B. 375
2006-55, 2006-35 I.R.B. 342 Revenue Procedures:
2006-56, 2006-35 I.R.B. 342
2006-57, 2006-35 I.R.B. 343 2006-29, 2006-27 I.R.B. 13
2006-58, 2006-36 I.R.B. 388 2006-30, 2006-31 I.R.B. 110
2006-59, 2006-36 I.R.B. 388 2006-31, 2006-27 I.R.B. 32
2006-60, 2006-36 I.R.B. 389 2006-32, 2006-28 I.R.B. 61
2006-61, 2006-36 I.R.B. 390 2006-33, 2006-32 I.R.B. 140
2006-62, 2006-37 I.R.B. 444 2006-34, 2006-38 I.R.B. 460
2006-63, 2006-37 I.R.B. 445 2006-35, 2006-37 I.R.B. 434
2006-64, 2006-37 I.R.B. 447 2006-36, 2006-38 I.R.B. 498
2006-65, 2006-37 I.R.B. 447 2006-37, 2006-38 I.R.B. 499
2006-66, 2006-37 I.R.B. 448 2006-38, 2006-39 I.R.B. 530
2006-67, 2006-38 I.R.B. 509 Revenue Rulings:
2006-68, 2006-38 I.R.B. 510
2006-69, 2006-37 I.R.B. 449 2006-35, 2006-28 I.R.B. 50
2006-36, 2006-36 I.R.B. 353
Notices:
2006-37, 2006-30 I.R.B. 91
2006-56, 2006-28 I.R.B. 58 2006-38, 2006-29 I.R.B. 80
2006-57, 2006-27 I.R.B. 13 2006-39, 2006-32 I.R.B. 137
2006-58, 2006-28 I.R.B. 59 2006-40, 2006-32 I.R.B. 136
2006-59, 2006-28 I.R.B. 60 2006-41, 2006-35 I.R.B. 331
2006-60, 2006-29 I.R.B. 82 2006-42, 2006-35 I.R.B. 337
2006-61, 2006-29 I.R.B. 85 2006-43, 2006-35 I.R.B. 329
2006-62, 2006-29 I.R.B. 86 2006-44, 2006-36 I.R.B. 361
2006-63, 2006-29 I.R.B. 87 2006-45, 2006-37 I.R.B. 423
2006-64, 2006-29 I.R.B. 88 2006-46, 2006-39 I.R.B. 511
2006-65, 2006-31 I.R.B. 102 2006-47, 2006-39 I.R.B. 511
2006-66, 2006-30 I.R.B. 99 2006-48, 2006-39 I.R.B. 516
2006-67, 2006-33 I.R.B. 248 Treasury Decisions:
2006-68, 2006-31 I.R.B. 105
2006-69, 2006-31 I.R.B. 107 9265, 2006-27 I.R.B. 1
2006-70, 2006-33 I.R.B. 252 9266, 2006-28 I.R.B. 52
2006-71, 2006-34 I.R.B. 316 9267, 2006-34 I.R.B. 313
2006-72, 2006-36 I.R.B. 363 9268, 2006-30 I.R.B. 94
2006-73, 2006-35 I.R.B. 339 9269, 2006-30 I.R.B. 92
2006-74, 2006-35 I.R.B. 339 9270, 2006-33 I.R.B. 237
2006-75, 2006-36 I.R.B. 366 9271, 2006-33 I.R.B. 224
2006-76, 2006-38 I.R.B. 459 9272, 2006-35 I.R.B. 332
9273, 2006-37 I.R.B. 394

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin
2006–26, dated June 26, 2006.

2006–39 I.R.B. ii September 25, 2006


Finding List of Current Actions on Revenue Rulings— Continued:
Previously Published Items1 87-10
Amplified and modified by
Bulletins 2006–27 through 2006–39
Rev. Rul. 2006-43, 2006-35 I.R.B. 329
Announcements:
2002-41
2005-59 Amplified by
Updated and superseded by Rev. Rul. 2006-36, 2006-36 I.R.B. 353
Ann. 2006-45, 2006-31 I.R.B. 121 2003-43
Notices: Amplified by
Notice 2006-69, 2006-31 I.R.B. 107
2002-45
2005-24
Amplified by
Amplified by
Rev. Rul. 2006-36, 2006-36 I.R.B. 353
Rev. Rul. 2006-36, 2006-36 I.R.B. 353
2006-20
Treasury Decisions:
Supplemented and modified by
Notice 2006-56, 2006-28 I.R.B. 58 9254
2006-53 Corrected by
Modified by Ann. 2006-44, 2006-27 I.R.B. 49
Notice 2006-71, 2006-34 I.R.B. 316 Ann. 2006-66, 2006-37 I.R.B. 448

9258
Proposed Regulations:
Corrected by
REG-135866-02 Ann. 2006-46, 2006-28 I.R.B. 76
Corrected by 9260
Ann. 2006-65, 2006-37 I.R.B. 447 Corrected by
Ann. 2006-64, 2006-37 I.R.B. 447
Ann. 2006-67, 2006-38 I.R.B. 509
REG-134317-05
9262
Corrected by
Corrected by
Ann. 2006-47, 2006-28 I.R.B. 78
Ann. 2006-56, 2006-35 I.R.B. 342
Revenue Procedures: 9264
2002-9 Corrected by
Modified and amplified by Ann. 2006-46, 2006-28 I.R.B. 76
Notice 2006-67, 2006-33 I.R.B. 248 9272
2004-63 Corrected by
Superseded by Ann. 2006-68, 2006-38 I.R.B. 510
Rev. Proc. 2006-34, 2006-38 I.R.B. 460

2005-41
Superseded by
Rev. Proc. 2006-29, 2006-27 I.R.B. 13

2005-49
Superseded by
Rev. Proc. 2006-33, 2006-32 I.R.B. 140

2006-12
Modified by
Rev. Proc. 2006-37, 2006-38 I.R.B. 499

Revenue Rulings:

81-35
Amplified and modified by
Rev. Rul. 2006-43, 2006-35 I.R.B. 329

81-36
Amplified and modified by
Rev. Rul. 2006-43, 2006-35 I.R.B. 329

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin 2006–26, dated June 26, 2006.

September 25, 2006 iii 2006–39 I.R.B.


INDEX EMPLOYMENT TAX
Internal Revenue Bulletins 2006–27 through Controlled services transactions under section 482, treatment, al-
location of income and deductions from intangibles, and stew-
2006–39
ardship expense (TD 9278) 34, 256; (REG–146893–02) 34,
The abbreviation and number in parenthesis following the index entry 317
refer to the specific item; numbers in roman and italic type following Disaster relief:
the parenthesis refers to the Internal Revenue Bulletin in which the item Additional postponement under section 7508A for filing cer-
may be found and the page number on which it appears. tain 2004 and 2005 individual tax returns by certain taxpay-
ers affected by Hurricane Katrina (Notice 56) 28, 58
Key to Abbreviations: Leave-sharing plans (Notice 59) 28, 60
Ann Announcement Disclosure of return information, Bureau of Economic Analysis
CD Court Decision (TD 9267) 34, 313; (REG–148864–03) 34, 320
DO Delegation Order Federal Insurance Contributions Act (FICA), application to pay-
EO Executive Order ments made for certain services (TD 9266) 28, 52
PL Public Law Offers in compromise, nonrefundable down payments required
PTE Prohibited Transaction Exemption (Notice 68) 31, 105
RP Revenue Procedure Proposed Regulations:
RR Revenue Ruling 26 CFR 31.3121(s)–1, amended; treatment of services under
SPR Statement of Procedural Rules section 482, allocation of income and deductions from in-
TC Tax Convention tangibles, stewardship expense (REG–146893–02) 34, 317
TD Treasury Decision 26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
TDO Treasury Department Order turn information to the Bureau of Economic Analysis
(REG–148864–03) 34, 320
EMPLOYEE PLANS Regulations:
26 CFR 31.3102–1, amended; 31.3121(a)–2, (a)(7)–1,
Anti-cutback rules, section 411(d)(6) protected benefits (TD (a)(8)–1, (i)–1, amended; 31.3121(a)(10)–1, revised; ap-
9280) 38, 450 plication of the Federal Insurance Contributions Act to
Disaster relief, additional postponement under section 7508A for payments made for certain services (TD 9266) 28, 52
filing certain 2004 and 2005 individual tax returns by certain 26 CFR 31.3121(s)–1, amended; 31.3121(s)–1T, added; treat-
taxpayers affected by Hurricane Katrina (Notice 56) 28, 58 ment of services under section 482, allocation of income
Employee stock ownership plan (ESOP), disallowance of deduc- and deductions from intangibles, stewardship expense (TD
tion for reacquisition payments (TD 9282) 39, 512 9278) 34, 256
Exempt organization employees, minimum coverage require- 26 CFR 31.3401(a)–1, –4, amended; 31.3402(g)–1, amended;
ments of section 410(b) (TD 9275) 35, 327 31.3402(j)–1, amended; 31.3402(n)–1, revised; flat rate
Full funding limitations, weighted average interest rate: supplemental wage withholding (TD 9276) 37, 423
For July 2006 (Notice 66) 30, 99 26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
For August 2006 (Notice 74) 35, 339 added; disclosure of return information to the Bureau of
Pension Protection Act of 2006 modifications (Notice 75) 36, Economic Analysis (TD 9267) 34, 313
366 Supplemental wages, withholding (TD 9276) 37, 423
Nonbank trustee and nonbank custodian, approval list (Ann 45) Tip reporting, Attributed Tip Income Program (ATIP) (RP 30)
31, 122 31, 110
Qualified retirement plans:
Government pick-up plans, employer contributions (RR 43) ESTATE TAX
35, 329
Prohibited transaction excise tax, amount involved in elective Disaster relief, additional postponement under section 7508A for
deferral (RR 38) 29, 80 filing certain 2004 and 2005 individual tax returns by certain
Regulations: taxpayers affected by Hurricane Katrina (Notice 56) 28, 58
26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ- Disclosure of return information, Bureau of Economic Analysis
ees of 501(c)(3) organizations in 401(k) and 401(m) plans (TD 9267) 34, 313; (REG–148864–03) 34, 320
(TD 9275) 35, 327 Offers in compromise, nonrefundable down payments required
26 CFR 1.411(a)–8, amended; 1.411(d)–3, amended; section (Notice 68) 31, 105
411(d)(6) protected benefits (TD 9280) 38, 450 Proposed Regulations:
26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividends 26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
paid deduction for stock held in employee stock ownership turn information to the Bureau of Economic Analysis
plan (TD 9282) 39, 512 (REG–148864–03) 34, 320
Roth IRAs, distributions of designated Roth contributions, public
hearing on REG–146459–05 (Ann 42) 27, 48

2006–39 I.R.B. iv September 25, 2006


ESTATE TAX—Cont. GIFT TAX—Cont.
Regulations: Offers in compromise, nonrefundable down payments required
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T, (Notice 68) 31, 105
added; disclosure of return information to the Bureau of Proposed Regulations:
Economic Analysis (TD 9267) 34, 313 26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
turn information to the Bureau of Economic Analysis
EXCISE TAX (REG–148864–03) 34, 320
Regulations:
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
Disaster relief, additional postponement under section 7508A for
added; disclosure of return information to the Bureau of
filing certain 2004 and 2005 individual tax returns by certain
Economic Analysis (TD 9267) 34, 313
taxpayers affected by Hurricane Katrina (Notice 56) 28, 58
Disclosure of return information, Bureau of Economic Analysis
(TD 9267) 34, 313; (REG–148864–03) 34, 320 INCOME TAX
Disclosure requirements with respect to prohibited tax shelter
transactions to which tax-exempt entities are parties (Notice Accounting methods:
65) 31, 102 Advance consent to change procedures (RP 37) 38, 499
Excise taxes with respect to prohibited tax shelter transactions to Revised instructions for Form 3115, Application for Change
which tax-exempt entities are parties (Notice 65) 31, 102 in Accounting Method (Ann 52) 33, 254
Health Savings Accounts (HSAs) under section 4980G, em- Capitalization of amounts paid to acquire, produce, or improve
ployer comparable contributions (TD 9277) 33, 226 tangible property (REG–168745–03) 39, 532
Offers in compromise, nonrefundable down payments required Collection, IRS’s use of private collection agencies (PCAs) in
(Notice 68) 31, 105 2006 (Ann 63) 37, 445
Proposed Regulations: Computer software, domestic production activities deduction un-
26 CFR 301.6103(j)(1)–1, amended; disclosure of re- der section 199(c)(5)(B):
turn information to the Bureau of Economic Analysis Change in hearing location for REG–111578–06 (Ann 53) 33,
(REG–148864–03) 34, 320 254
Regulations: Correction to TD 9262 (Ann 56) 35, 342
26 CFR 54.4980G–0 thru –5, added; employer comparable Conservation Security Program (CSP), cost-share payments (RR
contributions to Health Savings Accounts under section 46) 39, 511
4980G (TD 9277) 33, 226 Consolidated returns, basis reallocation, loss suspension, and ex-
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T, piration of losses on certain stock dispositions, correction to
added; disclosure of return information to the Bureau of TD 9254 (Ann 44) 27, 49; correction (Ann 66) 37, 448
Economic Analysis (TD 9267) 34, 313 Controlled services cost method under section 482 regulations,
identification of specified eligible covered services (Ann 50)
EXEMPT ORGANIZATIONS 34, 321
Controlled services transactions under section 482, treatment, al-
location of income and deductions from intangibles, and stew-
Disaster relief, additional postponement under section 7508A for
ardship expense (TD 9278) 34, 256; (REG–146893–02) 34,
filing certain 2004 and 2005 individual tax returns by certain
317
taxpayers affected by Hurricane Katrina (Notice 56) 28, 58
Corporations:
Disclosure requirements with respect to prohibited tax shelter
Attribution of earnings and profits to stock of controlled
transactions to which tax-exempt entities are parties (Notice
foreign corporations (REG–135866–02) 27, 34; correction
65) 31, 102
(Ann 64) 37, 447; additional corrections (Ann 65) 37, 447
Excise taxes with respect to prohibited tax shelter transactions to
Distributions of interests in a loss corporation from qualified
which tax-exempt entities are parties (Notice 65) 31, 102
trusts (TD 9269) 30, 92
List of organizations classified as private foundations (Ann 51)
Foreign corporation interest expense allocations, branch prof-
32, 222
its tax election, branch profits tax liability reduction (TD
Revocations (Ann 48) 31, 136; (Ann 54) 33, 254; (Ann 55) 35,
9281) 39, 517; (REG–120509–06) 39, 570
342; (Ann 60) 36, 389; (Ann 69) 37, 449
Information returns required with respect to certain foreign
corporations and certain foreign-owned domestic corpora-
GIFT TAX tions (TD 9268) 30, 94; (REG–109512–05) 30, 100
Inversions, surrogate foreign corporations (Notice 70) 33, 252
Disaster relief, additional postponement under section 7508A for Look-through treatment of dividends from noncontrolled sec-
filing certain 2004 and 2005 individual tax returns by certain tion 902 corporations, correction to TD 9260 (Ann 67) 38,
taxpayers affected by Hurricane Katrina (Notice 56) 28, 58 509
Disclosure of return information, Bureau of Economic Analysis
(TD 9267) 34, 313; (REG–148864–03) 34, 320

September 25, 2006 v 2006–39 I.R.B.


INCOME TAX—Cont. INCOME TAX—Cont.
Surrogate foreign corporation status for purposes of section 1098, 1099, 5498 and W-2G, requirements for filing electron-
7874 (TD 9265) 27, 1; (REG–112994–06) 27, 47 ically or magnetically (revised 8-2006) (RP 33) 32, 140
Credits: 3115, Application for Change in Accounting Method, instruc-
Enhanced oil recovery credit, 2006 inflation adjustment (No- tions revised May 2006 (Ann 52) 33, 254
tice 62) 29, 86 8027, Employer’s Annual Information Return of Tip Income
For income, war profits, excess profits taxes paid to foreign and Allocated Tips, specifications for filing electronically
country or U.S. possession (REG–124152–06) 36, 368 or magnetically (RP 29) 27, 13
Low-income housing credit: 8802, Application for United States Residency Certification,
Carryovers to qualified states, 2006 National Pool (RP 38) user fees for processing (RP 35) 37, 434
39, 530 8830, Enhanced Oil Recovery Credit, credit phased out for
Satisfactory bond, “bond factor” amounts for the period: 2006 (Ann 62) 37, 444
January through September 2006 (RR 37) 30, 91 8840, Closer Connection Exception Statement for Aliens, re-
New markets tax credit, low-income community business vision (Notice 73) 35, 339
(Notice 60) 29, 82 8898, Statement for Individuals Who Begin or End Bona Fide
Nonbusiness energy property, siding not component specifi- Residence in a U.S. Possession, postponement of filing date
cally and primarily designed to reduce heat loss or gain of for tax years 2001 through 2005 (Notice 57) 27, 13; revision
dwelling (Notice 71) 34, 316 (Notice 73) 35, 339
Work opportunity and welfare-to-work tax credits (Ann 49) Health reimbursement arrangements, taxable benefits of benefi-
29, 89 ciaries (RR 36) 36, 353
Debit cards used to reimburse participants in self-insured medical Health Savings Accounts (HSAs) under section 4980G, em-
reimbursement plans and dependent care assistance programs ployer comparable contributions (TD 9277) 33, 226
(Notice 69) 31, 107 Indian tribal governments, limitation on issuance of tax-ex-
Disaster relief: empt bonds, advance notice of proposed rulemaking
Additional postponement under section 7508A for filing cer- (REG–118788–06) (Ann 59) 36, 388
tain 2004 and 2005 individual tax returns by certain taxpay- Information reporting:
ers affected by Hurricane Katrina (Notice 56) 28, 58 For payments to attorneys, reporting of gross proceeds pay-
Casualty and theft loss deductions attributable to Hurricanes ments (TD 9270) 33, 237
Katrina, Rita, and Wilma, safe harbor methods for individ- Requirements for qualified tuition and related expenses (No-
uals, personal-use residential real property and certain per- tice 72) 36, 363
sonal belongings (RP 32) 28, 61 Insurance companies:
Depreciation, Gulf Opportunity (GO) Zone additional first Life-nonlife tacking rule, correction to TD 9258 (Ann 46) 28,
year depreciation deduction (Notice 67) 33, 248 76
Leave-sharing plans (Notice 59) 28, 60 Recomputed differential earnings rate for 2004 (RR 45) 37,
Disciplinary actions involving attorneys, certified public accoun- 423
tants, enrolled agents, and enrolled actuaries (Ann 57) 35, 343 Interest:
Disclosure of return information: Investment:
Bureau of Economic Analysis (TD 9267) 34, 313; Federal short-term, mid-term, and long-term rates for:
(REG–148864–03) 34, 320 July 2006 (RR 35) 28, 50
By certain officers and employees for investigative purposes August 2006 (RR 39) 32, 137
(TD 9274) 33, 244 September 2006 (RR 44) 36, 361
E-file, guidance necessary to facilitate business electronic filing Portfolio interest rules as applied to payments made to part-
and burden reduction, correction to TD 9264 (Ann 46) 28, 76; nerships and simple or grantor trusts (REG–118775–06) 28,
correction to REG–134317–05 (Ann 47) 28, 78 73; hearing rescheduled (Ann 58) 36, 388
Effect of elections in certain multi-step transactions (TD 9271) Inventory:
33, 224 LIFO, price indexes used by department stores for:
Employee stock ownership plan (ESOP), disallowance of deduc- May 2006 (RR 40) 32, 136
tion for reacquisition payments (TD 9282) 39, 512 June 2006 (RR 41) 35, 331
Exempt organization employees, minimum coverage require- July 2006 (RR 48) 39, 516
ments of section 410(b) (TD 9275) 35, 327 Involuntary conversions, livestock sold on account of drought,
Fast Track Settlement (FTS) for SB/SE taxpayers to expedite extension of replacement period (Notice 82) 39, 529
case resolution (Ann 61) 36, 390 Levy, use of superpriority lien arguments as a defense to (RR 42)
Forms: 35, 337
1042-S, Foreign Person’s U.S. Source Income Subject to Marginal production rates, 2006 (Notice 61) 29, 85
Withholding, specifications for filing electronically or Nonqualified deferred compensation, permitted accelerated pay-
magnetically (RP 34) 38, 460 ment (Notice 64) 29, 88

2006–39 I.R.B. vi September 25, 2006


INCOME TAX—Cont. INCOME TAX—Cont.
Offers in compromise, nonrefundable down payments required Publications:
(Notice 68) 31, 105 1187, Specifications for Filing Form 1042-S, Foreign Per-
Partnerships, portfolio interest rules as applied to payments made son’s U.S. Source Income Subject to Withholding, Elec-
to partnerships and simple or grantor trusts (REG–118775–06) tronically or Magnetically, revised (RP 34) 38, 460
28, 73 1220, Specifications for Filing Forms 1098, 1099, 5498 and
Postponement of filing date for Form 8898, Statement for Indi- W-2G Electronically or Magnetically, 2006 revision (RP
viduals Who Begin or End Bona Fide Residence in a U.S. Pos- 33) 32, 140
session, for tax years 2001 through 2005 (Notice 57) 27, 13 1239, Specifications for Filing Form 8027, Employer’s An-
Private foundations, organizations now classified as (Ann 51) 32, nual Information Return of Tip Income and Allocated Tips,
222 Electronically or Magnetically, revised (RP 29) 27, 13
Procedures for requesting special statistical studies and compila- Real Estate Investment Trust (REIT) income tests, rents from real
tions involving return information (RP 36) 38, 498 property (Notice 58) 28, 59
Proposed Regulations: Real Estate Mortgage Investment Conduit (REMIC), allocation
26 CFR 1.162–4, revised; 1.263(a)–0, amended; 1.263(a)–1 of income to foreign persons by certain entities (TD 9272) 35,
thru –3, revised; guidance regarding deduction and cap- 332; correction (Ann 68) 38, 510; (REG–159929–02) 35, 341
italization of expenditures related to tangible property Record retention requirements for tax-exempt bonds (Notice 63)
(REG–168745–03) 39, 532 29, 87
26 CFR 1.367(b)–2, –4, revised; 1.1248–1, –2, –3, –7, re- Regulations:
vised; 1.1248–8, added; section 1248 attribution principles 26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividends
(REG–135866–02) 27, 34; correction (Ann 64) 37, 447; ad- paid deduction for stock held in employee stock ownership
ditional corrections (Ann 65) 37, 447 plan (TD 9282) 39, 512
26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–9, 26 CFR 1.199–3T, –8T, amended; computer software under
added; 1.861–8, amended; 1.6038A–3(a)(3), amended; section 199(c)(5)(B), correction to TD 9262 (Ann 56) 35,
1.6662–6, amended; treatment of services under section 342
482, allocation of income and deductions from intangibles, 26 CFR 1.338–3, amended; 1.338(h)(10)–1, amended;
stewardship expense (REG–146893–02) 34, 317 1.338(h)(10)–1T, removed; effect of elections in certain
26 CFR 1.671–5, amended; reporting rules for widely held multi-step transactions (TD 9271) 33, 224
fixed investment trusts (REG–125071–06) 36, 375 26 CFR 1.367(b)–0 thru –3, amended; 1.367(b)–6, revised;
26 CFR 1.706–1, amended; 1.901–2, revised; definition of 1.367(b)–7, –8, –9, added; 1.381(a)–1, revised; stock trans-
taxpayer for purposes of section 901 and related matters fer rules, carryover of earnings and taxes (TD 9273) 37, 394
(REG–124152–06) 36, 368 26 CFR 1.382–1, amended; 1.382–10, added; 1.382–10T, re-
26 CFR 1.860A–1, amended; 1.860G–3, amended; 1.863–1, moved; distributions of interests in a loss corporation from
amended; 1.1441–2, amended; REMIC residual interests- qualified trusts (TD 9269) 30, 92
accounting for REMIC net income (including any excess 26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ-
inclusions (foreign holders) (REG–159929–02) 35, 341 ees of 501(c)(3) organizations in 401(k) and 401(m) plans
26 CFR 1.871–14, amended; 1.881–2, amended; revisions to (TD 9275) 35, 327
regulations relating to repeal of tax on interest of nonres- 26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–0T, –1T,
ident alien individuals and foreign corporations received –2T, –4T, –6T, –8T, –9T, added; 1.861–8, –8T, amended;
from certain portfolio debt investments (REG–118775–06) 1.6038–3(a)(3), amended; 1.6038A–3T, added; 1.6662–6,
28, 73; hearing rescheduled (Ann 58) 36, 388 amended; 1.6662–6T, added; treatment of services under
26 CFR 1.882–5, amended; 1.884–1, amended; determina- section 482, allocation of income and deductions from in-
tion of interest expense deduction of foreign corporations tangibles, stewardship expense (TD 9278) 34, 256
(REG–120509–06) 39, 570 26 CFR 1.671–5, amended; 1.671–5T, added; reporting rules
26 CFR 1.985–3, amended; United States dollar approximate for widely held fixed investment trusts (TD 9279) 36, 355
separate transactions method (REG–118897–06) 31, 121 26 CFR 1.860A–0, –1, amended; 1.860A–1T, added;
26 CFR 1.6038–2, amended; 1.6038A–2, amended; informa- 1.860G–3, amended; 1.860G–3T, added; 1.863–0, –1,
tion returns required with respect to certain foreign cor- amended; 1.863–1T, added; 1.1441–0, –2, amended;
porations and certain foreign-owned domestic corporations 1.1441–2T, added; REMIC residual interests-accounting
(REG–109512–05) 30, 100 for REMIC net income (including any excess inclusions)
26 CFR 1.7874–2, added; guidance regarding expatriated en- (foreign holders) (TD 9272) 35, 332; correction (Ann 68)
tities and their foreign parents (REG–112994–06) 27, 47 38, 510
26 CFR 300.0, amended; 300.4, .5, .6, added; user fees relat- 26 CFR 1.882–0, –5, amended; 1.882–5T, added; 1.884–1,
ing to enrollment (REG–145154–05) 39, 567 amended; 1.884–1T, added; 602.101, amended; determina-
26 CFR 301.6103(j)(1)–1, amended; disclosure of re- tion of interest expense deduction of foreign corporations
turn information to the Bureau of Economic Analysis (TD 9281) 39, 517
(REG–148864–03) 34, 320

September 25, 2006 vii 2006–39 I.R.B.


INCOME TAX—Cont. SELF-EMPLOYMENT TAX
26 CFR 1.904–4, amended; application of separate limitations Disaster relief, additional postponement under section 7508A for
to dividends from noncontrolled section 902 corporations, filing certain 2004 and 2005 individual tax returns by certain
correction to TD 9260 (Ann 67) 38, 509 taxpayers affected by Hurricane Katrina (Notice 56) 28, 58
26 CFR 1.1502–35, amended; suspension of losses on certain Offers in compromise, nonrefundable down payments required
stock dispositions, correction to TD 9254 (Ann 44) 27, 49; (Notice 68) 31, 105
correction (Ann 66) 37, 448
26 CFR 1.1502–76T, amended; 1.1563–1, amended; 602.101,
amended; amendment of tacking rule requirements of life-
nonlife consolidated regulations, and guidance necessary to
facilitate business electronic filing and burden reduction,
correction to TD 9258 and TD 9264 (Ann 46) 28, 76
26 CFR 1.6038–2, –2T, amended; 1.6038A–2, –2T, amended;
602.101(b), amended; information returns required with re-
spect to certain foreign corporations and certain foreign-
owned domestic corporations (TD 9268) 30, 94
26 CFR 1.6041–1, –3, amended; 1.6045–5, added; reporting
of gross proceeds payments to attorneys (TD 9270) 33, 237
26 CFR 1.7874–2T, added; guidance regarding expatriated
entities and their foreign parents (TD 9265) 27, 1
26 CFR 54.4980G–0 thru –5, added; employer comparable
contributions to Health Savings Accounts under section
4980G (TD 9277) 33, 226
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
added; disclosure of return information to the Bureau of
Economic Analysis (TD 9267) 34, 313
26 CFR 301.6103(k)(6)–1, added; 301.6103(k)(6)–1T, re-
moved; disclosure of return information by certain officers
and employees for investigative purposes (TD 9274) 33,
244
Revocations, exempt organizations (Ann 48) 31, 136; (Ann 54)
33, 254; (Ann 55) 35, 342; (Ann 60) 36, 389; (Ann 69) 37, 449
Revoking an election under section 83(b) (RP 31) 27, 32
Standard Industry Fare Level (SIFL) formula (RR 47) 39, 511
Stock transfer rules, carryover of earnings and taxes (TD 9273)
37, 394
Tax Exempt Bond (TEB) Mediation Pilot Program, one-year re-
newal (Ann 43) 27, 48
Tuition and related expenses, qualified, information reporting re-
quirements (Notice 72) 36, 363
United States dollar approximate separate transactions method
(DASTM) (REG–118897–06) 31, 121
U.S. possessions, examples for determining whether income is
U.S. possession source or effectively connected with trade or
business in U.S. possession (Notice 76) 38, 459
User fees:
Enrollment examinations, enrollment of enrolled agents, re-
newal of enrollment (REG–145154–05) 39, 567
Processing Form 8802, Application for United States Resi-
dency Certification (RP 35) 37, 434
Widely held fixed investment trusts (WHFITs), reporting re-
quirements (TD 9279) 36, 355; (REG–125071–06) 36, 375

2006–39 I.R.B. viii September 25, 2006


September 25, 2006 2006–39 I.R.B.
2006–39 I.R.B. September 25, 2006
September 25, 2006 2006–39 I.R.B.
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