LB&I directive: Treatment of power plant component replacements

LB&I directive: Treatment of power plant component

The IRS today publicly released a Large Business and International (LB&I) directive as guidance to IRS examiners for use in determining when a taxpayer has replaced "substantially all" of a major component relating to steam or electric generation power, pursuant to Rev. Proc. 2013-24, for purposes of section 263(a). LB&I-04-0315-002 (dated July 6, 2015, and posted July 9, 2015)

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The LB&I directive provides:

  • Guidance concerning the examination of a taxpayer that has properly changed to the method of accounting provided in Rev. Proc. 2013-24 for steam or electric power generation property
  • Definitions of units of property and major components that taxpayers may use to determine whether expenditures to maintain, replace, or improve steam or electric power generation property must be capitalized under section 263(a)
  • Instructions to examiners on determining whether a major component pertaining to steam or electric power generation property is replaced under Reg. section 1.263(a)-3(k)
  • A major component Is replaced if "substantially all" of the major component is replaced

Summary

Today’s LB&I directive explains that taxpayers involved in generating steam or electric power incur significant expenditures to maintain, replace, and improve generation property. Whether these expenditures are deductible as repairs under section 162 or must be capitalized as improvements under section 263(a) depends on whether the expenditures improve a unit of property.

The LB&I directive notes that a generation plant is composed of numerous functionally interdependent items of machinery and equipment, and that it can be difficult to identify which items constitute discrete units of property, major components, or something else. Rev. Proc. 2013-24 provides definitions of units of property and major components for steam or electric power generation property that, if used in accordance with the requirements provided by Rev. Proc. 2013-24, will not be challenged by the IRS under section 263(a) and the related regulations.

Today’s LB&I directive sets forth instructions to the IRS field examiners related to examination activity of taxpayers that have changed their method of accounting to use the unit of property and major component definitions provided in Rev. Proc. 2013-24, as follows:

  • Tax years ending on or after December 31, 2012

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

  • Do not challenge a taxpayer's treatment of its expenditures when substantially all of a major component (or of a unit of property that has no major components) has been replaced and properly capitalized. For this purpose, the term "substantially all" means 80% or more.
  • Generally do not challenge of a taxpayer's treatment of its expenditures to replace a major component (or unit of property that has no major components) as not required to be capitalized if "less than substantially all" of the major component (or unit or property that has no major components) has been replaced. For this purpose, the term "less than substantially all" means less than 80%. If IRS examiners believe that such expenditures must be capitalized as an improvement (e.g., a betterment, an adaptation to a new and different use.), they may challenge the taxpayer's treatment of the expenditures, but only after consultation and concurrence by their assigned IRS Chief Counsel, and their Director of Field Operations.
  • Do not challenge the use of either of the following measurement methodologies to substantiate that less than substantially all of a major component (or a unit of property that has no major components) has been replaced:
    • Comparing the actual replacement cost recorded on the taxpayer's financial statements to the undepreciated financial statement cost of the major component (or the unit of property has no major components)
    • Comparing the actual replacement cost recorded on the taxpayer's financial statements to the estimated replacement cost of the entire major component (or the entire unit of property that has no major components)
  • Do not treat as a method of accounting a measurement methodology used by a taxpayer to substantiate that less that substantially all of a major component has been replaced and do not challenge a change in measurement methodology as an unauthorized change in method of accounting.

The LB&I directive concludes that it only clarifies when a major component (or a unit of property that has no major components) is replaced. The ultimate determination of whether an expenditure involving the replacement of "less than substantially all" of a major component (or a unit of property that has no major components) is deductible is based on application of the regulations.

Challenges made by the IRS examiner to the taxpayer’s deduction of an expenditure involving replacement of less than substantially all of a major component (or a unit of property that has no major components) must be coordinated with the IRS Chief Counsel and approved by the Director of Field Operations.

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