The IRS has released guidance (Rev. Proc. 2023-15) providing a safe harbor method for taxpayers with natural gas transmission and distribution property to determine whether costs are deductible as repairs or must be capitalized as improvements.
The safe harbor provides percentages and per se rules for when activities are capitalizable, definitions of units of property, de minimis rules for blanket work orders, and some time-limited flexibility for implementing with a Section 481(a) or on a cut-off basis. The long-awaited safe harbor was requested by the industry over 10 years ago to reduce uncertainty regarding repairs to their network assets and resolve controversy with the IRS.
The guidance comes in at almost 100 pages of multi-faceted rules that can appear complex but are somewhat similar to the electric transmission and distribution safe harbor rules provided by Rev. Proc. 2011-43, which also creates separate rules for linear and non-linear assets. Under the natural gas transmission property safe harbor method of accounting (“NGSH Method”), a taxpayer may apply the NGSH Method to either its linear transmission and distribution property (e.g., pipes, fittings, and valves) or apply the NGSH method to both its linear transmission and distribution property and the non-linear transmission and distribution property (e.g., compressors, regulators, and meters).
The following describes the safe harbor rules for linear property:
- Transmission property: The guidance defines what a unit of property is for linear transmission property and provides that taxpayers may deduct costs for replacing 10% or less of the length of a unit of linear transmission property. The cost for replacing lengths exceeding this threshold must be capitalized under Sections 263(a) and 263A. If a taxpayer has blanket work order and is unable to identify whether the replacement is greater than 10%, then the taxpayer may use any reasonable method to allocate costs charged to the blanket work order if the method is consistently applied by the taxpayer. A special de minimis rule applies that allows the expensing of blanket work orders if the taxpayer follows a policy that limits charges to a blanket work order of $50,000 or less.
- Distribution mains: For distribution mains, the guidance does not define a unit of property, but provides that if more than four miles of distribution mains are replaced, then the costs must be capitalized. Under this threshold, the costs may be deducted. For blanket work orders where a taxpayer cannot identify whether the replacement is greater than four miles, the taxpayer can use any reasonable method to allocate costs charged to the blanket work order if the method is consistently applied by the taxpayer. A similar $50,000 de minimis rule for blanket work orders applies.
- Distribution service line costs: Distribution service line costs that are per se capital expenditures must be capitalized. For costs that are not per se capital expenditures, the taxpayer should determine if the costs relate to: (1) replacement of distribution main (should be treated consistently with distribution main), (2) service line only (not required to be capitalized), or (3) unidentified distribution service line costs (follow an allocation formula generally based on capitalized distribution main replacement costs to total distribution main replacement costs).
The rules for nonlinear property are described below:
- Nonlinear transmission and distribution property: Appendix A defines the unit of property and the major components for nonlinear property subject to the safe harbor. Replacement of a unit of non-linear property or a major component must be capitalized, but generally the costs for replacing smaller components may be deducted.
The safe harbor contains a list of activities that are per se capital expenditures, including, for example, costs necessary to add one or more new customers, costs for materially increasing capacity, costs of additions and extensions, and costs for replacing property if the taxpayer took gain/loss on the replaced property (e.g., casualty loss, disposition). Certain aggregation and anti-abuse rules apply for purposes of all the safe harbor rules.
To account for dispositions of natural transmission and distribution property, the safe harbor requires taxpayers using the NGSH Method to include the affected assets in general asset accounts as described under Section 168(i)(4) and the regulations thereunder. This limits the ability of taxpayers to recognize a loss, which avoids triggering the disposition/loss per se capitalization rules. To facilitate the transition to the use of general asset accounts, this guidance provides a late general asset account election for the affected natural gas transmission and distribution property that the taxpayer placed in service in prior years and owns at the beginning of its year of change. The guidance further provides taxpayers with a time-limited option of implementing the late general asset election change with a Section 481(a) adjustment or a cut-off basis, which impacts the assets that must be included in the late general asset election.
The guidance provides automatic consent procedures to change to the NGSH method by adding a new section 3.12 to Rev. Proc. 2022-14. The manner for implementing the change offers many options with varying concurrent impacts on the late general asset election and appears to provide incentives to change in the first year, with differing rules for changing in year 2 and 3 versus waiting until year 4 or later. For example, taxpayers that change to the safe harbor method for their first, second, or third taxable year ending after May 1, 2023, may choose to implement the change with a Section 481(a) adjustment or on a cut-off basis. Additionally, taxpayers that change to the NGSH Method for their first taxable year ending after May 1, 2023, do not apply certain per se capitalization rules to amounts paid or incurred to replace or repair linear or non-linear property for which gains/losses were taken on disposition in prior years. However, a change made for the fourth taxable year ending after May 1, 2023, or subsequent taxable years are only allowed on a cut-off basis, except for the concurrent late general asset election. A taxpayer that makes the change to the safe harbor method on a cut-off basis does not receive audit protection. Appendix B of Rev. Proc. 2023-15 provides the exclusive extrapolation methodology to determine the Section 481(a) adjustment.
This long-awaited guidance is part of the IRS guidance plan to provide safe harbors for network assets, which the government generally reserved on in the Section 263(a) regulations. The lengthy guidance may be a bit overwhelming to untangle, but it draws many bright lines and provides helpful de minimis rules that may resolve uncertainty and controversy for otherwise complicated fact patterns. For taxpayers not already using a similar analysis, the safe harbor may not reduce the compliance burden compared to book methods, so taxpayers should consider implementing new data tracking processes to help.
Taxpayers may want to act quickly to determine if implementing in the first taxable year ending after May 1, 2023, is the best option. Depending on the route chosen, taxpayers not already using a similar analysis to the safe harbor may be facing a large undertaking to implement all the various rules.
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