us-irs-revenue-rulings-irb-2006-39-pdf•Internal Revenue Bulletin 2006-39 (PDF rendition): IRS Revenue Rulings
Internal Revenue Bulletin 2006-39 (PDF rendition): IRS Revenue Rulings
us-irs-revenue-rulings-irb-2006-39-pdfInternal Revenue Bulletin 2006-39 (PDF rendition): IRS Revenue RulingsGuidance
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Bulletin No. 200 6-39 September 25, 20 06 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 Rev. Rul. 2006–46, page 511. Conservation Security Program (CSP).This ruling holds that the Conservation Security Program is substantially similar to the type of programs described in section 126(a)(1) through (8) of the Code within the meaning of section 126(a)(9). As a result, all or a portion of cost-share payments received under the CSP is eligible for exclusion from gross income to the extent permitted by section 126. Rev. Rul. 2006–47, page 511. Fringe be nefits aircraft valuation formula.The Standard Industry Fare Level (SIFL) cents-per-mile rates and terminal charge in effect for the second half of 2006 are set forth for purposes of determining the value of noncommercial flights on employ er-provided aircraft under section 1.61–21(g) of the regulat ions. Rev. Rul. 2006–48, page 516. LIFO; price indexes; department stores.The July 2006 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out inventory methods for valuing inventories for tax years ended on, or with reference to, July 31, 2006. T.D. 9281, page 517. REG–120509–06, page 570. 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. 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- tain clarifications and conforming updates are also made to the 1996 final regulations under section 1.882–5. 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. REG–168745–03, page 532. Proposed regulations under section 263 of the Code explain how section 263(a) applies to amounts paid to acquire, pro- duce, or improve tangible property. The proposed regula- tions clarify what amounts must be capitalized, rather than de- ducted currently, and how those capitalized amounts should be treated. A public hearing is scheduled for December 19, 2006. Notice 2006–82, page 529. Extension of replacement period for livestock sold on account of drought.This notice explains the circumstances under which the 4-year replacement period under section 1033(e)(2) of the Code is extended for livestock sold on account of drought. The noticeinforms taxpayers that the Service will publish an annual list of counties that experienced exceptional, extreme, or severe drought conditions, which a taxpayer can use to determine if an extension is available. (Continued on the next page) A nnouncements 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, 20062006–39 I.R.B. The IRS Mission Provide America’s taxpayers top quality service by helping them understand and meet their tax responsibilities and by applying the tax law with integrity and fairness to all. Introduction The Internal Revenue Bulletin is the authoritative instrument of the Commissioner of Internal Revenue for announcing official rulings and procedures of the Internal Revenue Service and for publishing Treasury Decisions, Executive Orders, Tax Conven- tions, legislation, court decisions, and other items of general interest. It is published weekly and may be obtained from the Superintendent of Documents on a subscription basis. Bulletin contents are compiled semiannually into Cumulative Bulletins, which are sold on a single-copy basis. It is the policy of the Service to publish in the Bulletin all sub- stantive rulings necessary to promote a uniform application of the tax laws, including all rulings that supersede, revoke, mod- ify, or amend any of those previously published in the Bulletin. All published rulings apply retroactively unless otherwise indi- cated. Procedures relating solely to matters of internal man- agement are not published; however, statements of internal practices and procedures that affect the rights and duties of taxpayers are published. Revenue rulings represent the conclusions of the Service on the application of the law to the pivotal facts stated in the revenue ruling. In those based on positions taken in rulings to taxpayers or technical advice to Service field offices, identifying details and information of a confidential nature are deleted to prevent unwarranted invasions of privacy and to comply with statutory requirements. 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 relied on, used, or cited as precedents by Service personnel in the disposition of other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations, court decisions, rulings, and procedures must be considered, and Service personnel and others concerned are cautioned against reaching the same conclusions in other cases unless the facts and circumstances are substantially the same. The Bulletin is divided into four parts as follows: Part I.—19 86 Code. This part i ncludes rulings and decisions based on provisions of the Intern al Revenue Code of 1986. Part II.—Treaties and Tax Legislation. This part is divided into two subparts as follows: Subpart A, Tax Conventions and Other Related Items, and Subpart B, Leg- islation and Related Committee Reports. 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 included in this part are Bank Secrecy Act Administrative Rul- ings. Bank Secrecy Act Administrative Rulings are issued by the Department of the Treasury’s Office of the Assistant Sec- retary (Enforcement). Part IV .—Items of General Interest. This par t includes notices of proposed rulemakings, disbar- ment an d suspension lists, and announcements. The last Bulletin for each month includes a cumulative index for the matters published during the preceding months. These monthly indexes are cumulated on a semiannual basis, and are published in the last Bulletin of each semiannual period. The c ontents 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, 20062006–39 I.R.B. Part I. Rulings and Decisions Under the Internal Revenue Code of 1986 Section 42.—Low-Income Housing Credit 26 CFR 1.42–14: Allocation rules for post-1989 State housing credit ceiling amounts. Guidance is provided to state housing credit agen- cies of qualified states that request an allocation of unused housing credit carryover under section 42(h)(3)(D) of the Internal Revenue Code. See Rev. Proc. 2006-38, page 530. Section 61.—Gross Income Defined 26 CFR 1.61–21: Taxation of fringe benefits. Fringe benefits aircraft valuation for- mula.The Standard Industry Fare Level (SIFL) cents-per-mile rates and terminal charge in effect for the second half of 2006 are set forth for purposes of determining the value of noncommercial flights on employer-provided aircraft under section 1.61–21(g) of the regulations. Rev. Rul. 2006–47 For purposes of the taxation of fringe benefits under section 61 of the Inter- nal Revenue Code, section 1.61–21(g) of the Income Tax Regulations provides a rule for valuing noncommercial flights on employer-provided aircraft. Section 1.61–21(g)(5) provides an aircraft valua- tion formula to determine the value of such flights. The value of a flight is determined under the base aircraft valuation formula (also known as the Standard Industry Fare Level formula or SIFL) by multiplying the SIFL cents-per-mile rates applicable for the period during which the flight was taken by the appropriate aircraft multiple provided in section 1.61–21(g)(7) and then adding the applicable terminal charge. The SIFL cents-per-mile rates in the formula and the terminal charge are calculated by the Department of Transportation and are reviewed semi-annually. The following chart sets forth the termi- nal charges and SIFL mileage rates: Period During Which the Flight Is Taken Terminal Charge SIFL Mileage 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 The principal author of this revenue rul ing is Kathleen Edmondson of the Of fice of Division Counsel/Associate Ch ief Counsel (Tax Exempt/Govern- me nt Entities). For further information re garding this revenue ruling, contact Ms . Edmondson at (202) 622–0047 (not a to ll-free call). Section 126.—Certain Cost-Sharing Payments Conservation Security Program (CSP).This ruling holds that the Con- servation Security Program is substan- tially similar to the type of programs describedinsection126(a)(1)through(8) of the Code within the meaning of section 126(a)(9). As a result, all or a portion of cost-share payments received under the CSP is eligible for exclusion from gross income to the extent permitted by section 126. Rev. Rul. 2006–46 ISSUE Is the Conservation Security Program (CSP) within the scope of § 126(a)(9) so that cost-share payments received under theCSPareeligibleforexclusionfrom gross income to the extent permitted by §126? FACTS The CSP, authorized under the provi- sions of §§ 1238–1238C of the Food Secu- rity Act of 1985, Pub. L. No. 99–198, 99 Stat. 1354, as amended by the Farm Se- curity and Rural Investment Act of 2002, Pub. L. No. 107–171, 116 Stat. 134, 16 U.S.C. §§ 3838–3838c, is a voluntary pro- gram that supports ongoing conservation stewardship of agricultural lands by pro- viding financial assistance to agricultural producers who maintain and enhance nat- ural resources. The CSP is administered by the U.S. Department of Agriculture (USDA). An agricultural producer who wishes to participate in the CSP must enter into a long-term conservation security con- tract with the USDA’s Natural Resources Conservation Service (NRCS). The CSP is available to agricultural producers owning private agricultural land (including crop- land, grassland, prairie land, improved pasture land, rangeland, land under the jurisdiction of an Indian tribe, or forested land that is an incidental part of an agri- cultural operation). The NRCS, using the USDA’s Commodity Credit Corpo- ration, provides contract payments that may include (1) an annual stewardship component for the existing base level con- servation treatment; (2) an annual existing practice component for maintaining exist- ing conservation practices; (3) a one-time 2006–39 I.R.B.511September 25, 2006 new practice component for additional needed practices; and (4) an enhancement component for exceptional conservation effort and additional conservation prac- tices or activities that provide increased resource benefits beyond the prescribed level. Payments for practices included in the existing practice and new practice components are limited, under 16 U.S.C. § 3838c, to 75 percent (or, in the case of a beginning farmer or rancher, 90 percent) of the average county costs of the practices for the 2001 crop year. Payments under the stewardship component are not limited to the taxpayer’s costs but are instead a percentage of the rental rate applicable to the land, as determined by the NRCS. Pay- ments under the enhancement component may be based either on an activity’s cost or on its expected conservation benefits. The Secretary of Agriculture has deter- mined that payments under the CSP are primarily for the purpose of conserving soil and water resources or protecting and restoring the environment. In addition, the Secretary of Agriculture has informed the Treasury Department that USDA believes the CSP is a small watershed program. LAW AND ANALYSIS Under § 126(a), gross income does not include the excludable portion of pay- ments received under certain conservation programs set forth in § 126(a)(1) through (8). Section 126(a)(9) provides that a small watershed program administered by the Secretary of Agriculture also is eligi- ble for § 126 treatment if the Secretary of the Treasury determines that the program is substantially similar to the type of pro- grams described in § 126(a)(1) through (8). See § 16A.126–1(d) of the Temporary Income Regulations Relating To The Par- tial Exclusion For Certain Cost-Sharing Payments for rules permitting the Com- missioner to make these determinations and announce them in the Internal Rev- enue Bulletin and for the definition of “small watershed.” If the Commissioner has determined that a program is substantially similar to the types of programs described in § 126(a)(1) through (8), taxpayers re- ceiving cost-share payments under that program must determine what portion of the cost-share payments is excludable from gross income under § 126. Under § 126(b), the excludable portion of a pay- ment is limited to the portion that (1) is determined by the Secretary of Agricul- ture to be made primarily for the purpose of conserving soil and water resources, protecting or restoring the environment, improving forests, or providing a habitat for wildlife, (2) does not substantially increase the income derived from the property, and (3) is not properly associ- ated with a deductible expense. Payments in the nature of rent or compensation for services do not qualify for the exclusion. See § 126(b) and § 16A.126–1, relating to the partial exclusion of certain cost-share payments, to determine what portion of the cost-share payments is excludable from gross income under § 126. HOLDING The Internal Revenue Service accepts USDA’s conclusion that the CSP is a small watershed program. Accordingly, the CSP will be treated for purposes of § 126 as a small watershed program administered by the Secretary of Agriculture. In addition, the Commissioner has determined that the CSP is substantially similar to the type of programs described in § 126(a)(1) through (8). Payments for practices included in the existing practice and new practice com- ponents are limited to a percentage of the average county costsof the practices and qualify as cost-sharepayments. Thecost- share payments received under the exist- ing practice and new practice components of the CSP are eligible for exclusion from gross income to the extent permitted by § 126. Payments under the stewardship com- ponent are based on the rental rate applica- ble to the land and are not cost-share pay- ments that are excludable from gross in- come. Payments under the enhancement com- ponent qualify as cost-share payments if they are based on an activity’s cost rather than on its expected conservation benefits. The cost-share payments received under the enhancement component are eligible for exclusion from gross income to the ex- tent permitted by § 126. Payments under the enhancement component based on the activity’s expected conservation benefits rather than on its cost are not cost-share payments and are not excludable from gross income. See § 126(b) and § 16A.126–1 to de- termine the extent to which cost-share payments under the existing practice, new practice, and enhancement components are excludable from gross income under §126. DRAFTING INFORMATION The principal author of this revenue rul- ing is Jennifer C. Bernardini of the Office of Associate Chief Counsel (Passthroughs & Special Industries). For further informa- tion regarding this revenue ruling, contact Jennifer C. Bernardini at (202) 622–3120 (not a toll-free call). Section 162.—Trade or Business Expenses 26 CFR 1.162(k)–1: Disallowance of deduction for reacquisition payments. 26 CFR 1.404(k)–3: Disallowance of deduction for reacquisition payments. T.D. 9282 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 Dividends Paid Deduction for StockHeldinEmployeeStock Ownership Plan AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains final regulations under sections 162(k) and 404(k) of the Internal Revenue Code (Code) providing that a payment in re- demption of employer securities held by an employee stock ownership plan (ESOP) is not deductible. These regulations gen- erally affect administrators of, employers maintaining, participants in, and benefi- ciaries of ESOPs. In addition, they will affect corporations that make distributions in redemption of stock held in an ESOP. DATES:Effective Date:These regulations are effective on August 30, 2006. September 25, 20065122006–39 I.R.B. Applicability Dates:These regulations apply with respect to payments to reac- quire stock that are made on or after and amounts paid or incurred on or after Au- gust 30, 2006. See §§1.162(k)–1(c) and 1.404(k)–3, Q&A–2. FOR FURTHER INFORMATION CONTACT: John T. Ricotta at (202) 622–6060 with respect to section 404(k) or Jean R. Brenner at (202) 622–7790 with respect to section 162(k) (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background This document contains final regu- lations (26 CFR Part 1) under sections 162(k) and 404(k) of the Code. Section 162(k)(1) generally provides that no deduction otherwise allowable un- der chapter 1 of the Code is allowed for any amount paid or incurred by a corpora- tion in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). The legislative history of section 162(k) states that the phrase “in connection with” is “intended to be construed broadly.” H.R. Conf. Rep. No. 99–841, at 168 (1986). Section 404(k)(1) provides a deduction for an applicable dividend paid in cash by a C corporation with respect to applica- ble employer securities held by an ESOP, as defined in section 4975(e)(7). Section 404(k)(2) generally provides that the term applicable dividendmeans any dividend which, in accordance with the plan provi- sions,iseitherpaidincashtoplanpartic- ipants or beneficiaries or paid to the plan and distributed in cash to participants or beneficiaries not later than 90 days after the close of the plan year in which paid. An applicable dividend also includes a div- idend which, at the election of participants or their beneficiaries, is payable as pro- vided in the preceding sentence or paid to the plan and reinvested in qualifying em- ployer securities. Finally, an applicable dividend also includes a dividend that is used to make payments on a loan described in section 404(a)(9), the proceeds of which were used to acquire the employer secu- rities (whether or not allocated to partici- pants) with respect to which the dividend is paid. Under section 404(k)(4), the deduc- tion is allowable in the taxable year of the corporation in which the dividend is paid or distributed to the participant or benefi- ciary. Prior to 2002, section 404(k)(5)(A) pro- vided that the Secretary may disallow the deduction under section 404(k) for any dividend if the Secretary determines that such dividend constitutes, in substance, an evasion of taxation. Section 662(b) of the Economic Growth and Tax Relief Recon- ciliation Act of 2001 (115 Stat. 38, 2001) amended section 404(k)(5)(A) to provide that the Secretary may disallow a deduc- tion under section 404(k) for any divi- dend the Secretary determines constitutes, in substance, an avoidance or evasion of taxation. Rev. Rul. 2001–6, 2001–1 C.B. 491 (see §601.601(d)(2) of this chapter), states that distributions to participants of amounts paid by an employer to reacquire shares of its stock from the employer’s ESOP (redemption proceeds) are made in connection with the reacquisition of the employer’s stock and that section 162(k)(1) therefore bars the deduction under these circumstances regardless of whether the distributions to participants would otherwise be deductible under sec- tion 404(k). The revenue ruling also states that the treatment of redemption proceeds as “applicable dividends” under section 404(k) would produce such anomalous results that the section cannot reasonably be construed as encompassing such pay- ments. The revenue ruling states that the application of section 404(k) to redemp- tion proceeds not only would allow em- ployers to claim deductions for payments that do not represent true economic costs, but also, as further explained below, would vitiate important rights and protections for recipients of ESOP distributions. Finally, the ruling states that a deduction would be disallowed under section 404(k)(5)(A) because a deduction under these circum- stances would constitute, in substance, an evasion of taxation. These positions were reiterated in Notice 2002–2, Q&A–11, 2002–2 C.B. 285 (See §601.601(d)(2) of this chapter), which states that, in accordance with Rev. Rul. 2001–6, payments in redemption of stockheldbyanESOPthatareusedto make distributions to terminating ESOP participants constitute an evasion of tax- ation under section 404(k)(5)(A) and are not applicable dividends under section 404(k)(1). Moreover, the notice states that any deduction for such payments in re- demption of stock is barred under section 162(k). Notice 2002–2 (Q&A–7) also discusses the tax treatment of section 404(k) divi- dend distributions, stating that dividends paid in cash to a participant (rather than reinvested at the option of the partici- pant under section 404(k)(2)(A)(iii)) are taxable without regard to the return of basis provisions under section 72, and are not subject to the consent requirements of section 411(a)(11) or the distribution restrictions of section 401(k)(2)(B). In ad- dition, the notice provides that dividends paid to participants under section 404(k) are not eligible rollover distributions under section 402(c), even if the dividends are distributed at the same time as amounts that do constitute an eligible rollover dis- tribution (or are reported on Form 1099-R (Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc.) in accordance with Announcement 85–168). 1 See also § 1.402(c)–2, Q&A–4(e), under which dividends paid on employer securities un- der section 404(k) are not eligible rollover distributions under section 402(c). InBoise Cascade Corporation v. United States, 329 F.3d 751 (9 th Cir. 2003), the Court of Appeals for the Ninth Circuit held that payments made by the issuer of stock to redeem its stock held by its ESOP were deductible as dividends paid under section 404(k), and that the deduction was not precluded by section 162(k). The IRS issued Chief Coun- sel Notice 2004–038 (October 1, 2004) (available atwww.irs.gov/foiathrough the electronic reading room) to indicate that it disagreed with the Court’s interpretation and would continue to assert in any matter in controversy outside the Ninth Circuit that sections 162(k) and 404(k) disallow a deduction for payments to reacquire employer securities held by an ESOP. For 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.513September 25, 2006 Circuit, agents or district counsel attorneys are to consult the National Office. A notice of proposed rulemaking con- taining proposed regulations under sec- tions 162(k) and 404(k) was issued on Au- gust 25, 2005 (REG–133578–05, 2005–39 I.R.B. 610 [70 FR 49897]) to address two issues: 1) which corporation is entitled to the deduction for applicable dividends under section 404(k) where the payor and employer are different entities; and 2) whether a payment in redemption of employer securities held by an ESOP is deductible. The issue in the proposed regulations concerning which corporation is entitled to the deduction for applicable dividends under section 404(k) is expected to be addressed in future regulations. The notice of proposed rulemaking in- cluded proposed regulations under section 404(k) that would provide that payments made to reacquire stock held by an ESOP are not deductible under section 404(k) because such payments would not con- stitute applicable dividends under section 404(k)(2) and a deduction for such pay- ments would constitute, in substance, an avoidance or evasion of taxation within the meaning of section 404(k)(5) because itwouldallowacorporationtoclaim two deductions for the same economic cost. It also included proposed regula- tions under section 162(k) providing that section 162(k), subject to certain excep- tions, would disallow any deduction for amounts paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). Fi- nally, the proposed regulations provided that amounts paid or incurred in connec- tion with the reacquisition of stock include amounts paid by a corporation to reacquire its stock from an ESOP that are then dis- tributed by the ESOP to its participants (or their beneficiaries) or otherwise used in a manner described in section 404(k)(2)(A). A public hearing on the proposed reg- ulations was held on January 18, 2006. After consideration of the comments received, these final regulations adopt without material change the provisions of the proposed regulations concerning payments in redemption of employer se- curitiesheldbyanESOP. Explanation of Provisions With respect to the treatment of pay- ments in redemption of employer securi- ties, these final regulations adopt the rule of the proposed regulations under which payments made to reacquire stock held by an ESOP are not deductible under section 404(k) because such payments do not con- stitute applicable dividends under section 404(k)(2) and a deduction for such pay- ments would constitute, in substance, an avoidance or evasion of taxation within the meaning of section 404(k)(5). These final regulations also adopt the rule of the pro- posed regulations that explicitly provides that section 162(k) disallows any deduc- tion, including any deduction under sec- tion 404(k), for amounts paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). In addition, these final reg- ulations adopt the rule of the proposed reg- ulations providing that amounts paid or in- curred in connection with the reacquisition of stock include amounts paid by a corpo- ration to reacquire its stock from an ESOP that are then distributed by the ESOP to its participants (or their beneficiaries) or oth- erwise used in a manner described in sec- tion 404(k)(2)(A). These provisions aroused little opposi- tion and only two comments were received regarding the treatment of payments made to reacquire stock. A trade association rep- resenting companies that sponsor ESOPs supported the position of the proposed regulations that a repurchase of shares of ESOP stock from ESOP participants in a stock redemption does not qualify as a deductible dividend under section 404(k). The other commentator disagreed with the position in the proposed regulations, arguing that redemptions of stock held by an ESOP that are recharacterized as divi- dends under section 302 nevertheless are proper dividends that should be treated the same as ordinary dividends paid with re- specttostockheldbyanESOP.Thecom- mentator argued that, by enacting section 404(k), Congress intended to allow a dou- ble deduction for contributions to purchase employer stock because the value of stock purchased with employer contributions includes the present value of expected future dividends. Thus, the commentator argued, a deduction for redemptive pro- ceeds should not be characterized as an avoidance or evasion of taxation within the meaning of section 404(k)(5). Finally, the commentator argued that, because the legislative history to section 162(k) does not specifically refer to section 404(k) dividends and section 162(k) was enacted only two years after section 404(k), sec- tion 162(k) does not preclude a deduction for a redemptive dividend under section 404(k). These arguments are unpersuasive. Al- though the present value of expected fu- ture dividends is an element of the value of shares of stock at any point in time, and Congress did authorize a current deduc- tion for the value of stock contributions to qualified plans, as well as a later de- duction for certain dividends paid on those shares under section 404(k), these deduc- tions are carefully limited to dividends ac- tually paid in certain specified ways while thestockisheldbytheESOP.Thereis no evidence that Congress intended to au- thorize yet another deduction for the full value of the shares upon their redemption. To allow a deduction for redemption pro- ceeds would be to allow a second deduc- tion that includes the present value of div- idends that are paid out after the date of distribution from the ESOP, contrary to the intent of the statute. Moreover, the amount of the deduction with respect to a redemp- tion could be many times the amount that would be deducted for that year for a con- ventional dividend. (In fact, permitting a second deduction for the full value of the shares would allow a corporation to claim one deduction for a share of stock con- tributed to an ESOP and allocated to an employee early in a tax year and another deduction if the share is redeemed to make a distribution to the employee later in the same tax year.) There is a no indication that such a result was intended and there is no obvious purpose that would be served by such a result. Congress recognized that an arrange- ment that might be argued to come within the literal language of section 404(k) might nevertheless be inconsistent with its pur- pose. Congress therefore granted authority to the Secretary, in section 404(k)(5)(A), to disallow a deduction for any dividend that the Secretary finds to be, in substance, an evasion of taxation. The statute was clarified, for years beginning in 2002, to explicitly broaden that authority to permit September 25, 20065142006–39 I.R.B. the Service to disallow any deduction that is an avoidance or evasion of taxation. A deduction for redemption proceeds is both excessive in amount and inconsistent with the purpose of section 404(k), so that this is clearly an appropriate case for the author- ity under section 404(k)(5)(A) to be exer- cised. 2 The IRS and Treasury Department also continue to believe, as provided in Rev. Rul. 2001–6, that a deduction for redemption of benefit distributions is appropriately disallowed under section 404(k)(5)(A) because a deduction under these circumstances would constitute, in substance, anevasionof taxation. As stated in Rev. Rul. 2001–6, the treatment of redemption proceeds as “applicable dividends” under section 404(k) would produce such anomalous results that the section cannot reasonably be construed as encompassing such payments. As one example, if a redemption of a benefit distribution were an applicable dividend under section 404(k), there would be no reason why such a redemption could only occur once with respect to a participant, so that multiple redemptions (or theoretically even an unlimited number of redemp- tions 3 ) might be possible, a result that is clearly not consistent with the intent of section 404(k). Further, as described in Rev. Rul. 2001–6, the application of section 404(k) to redemption amounts also would viti- ate important rights and protections for recipients of ESOP distributions. These important rights and protections include the right to apply the return of basis pro- visions under section 72 (whereas an applicable dividend under section 404(k) is includible in gross income without re- gard to return of basis under section 72), and the protection against involuntary cash-outs (section 411(a)(11)). See sec- tion 72(e)(5)(D), and Q&A–7 of Notice 2002–2, 2002–1 C.B. 285. Similarly, if redemption amounts distributed as a nor- mal benefit distribution were treated as an applicable dividend under section 404(k), then a participant would not have the right to elect a direct or indirect rollover with respect to redemption proceeds that are distributed from the ESOP, and any notice provided to the employee as required by section402(f)wouldhavetoidentifythe loss of this valuable right to the partici- pant. See §1.402(c)–2, Q&A–4(e). Congress also provided for other spe- cial treatment for applicable dividends un- der section 404(k) that would be incon- sistent with redemption of a normal bene- fit distribution beingtreated as an applica- ble dividend under section 404(k). Section 72(t)(2)(A)(vi) provides for an exception to the 10 percent additional income tax for early distributions for dividends paid with respect to stock of a corporation which are described in section 404(k). Further, sec- tion 404(k)(5)(B) provides that a plan will not violate the requirements of sections 401, 409, or 4975(e)(7) or be engaging in a prohibited transaction merely by reason of distributing an applicable dividend under section 404(k). Thus, for example, a distri- bution of an applicable dividend under sec- tion 404(k) is not subject to the prohibition against in-service distributions of amounts attributable to elective deferrals under sec- tion 401(k)(2). Clearly, these broad ex- ceptions under section 72(t)(2)(A)(vi) and 404(k)(5)(B) were not intended to apply to normal benefit distributions from ESOPs, essentially at the election of the employer or distributee. Finally, even if the IRS declined to exercise its authority under section 404(k)(5)(A), the plain language of sec- tion 162(k) precludes the deduction for payments by a corporation to redeem its stock including deductions otherwise al- lowed under section 404(k). As described under theBackgroundsection of this pre- amble, section 162(k) provides that “no deduction otherwise allowable shall be allowedunder this chapterfor any amount paid or incurred by a corporation in con- nection with the reacquisition of its stock” (emphasis added) and section 404(k) is in the same chapter as section 162(k). The commentator’s attempt to avoid the effect of the plain language of the statute by ref- erence to a supposed negative inference in the legislative history is unavailing. Accordingly, these regulations adopt the rule in the proposed regulations with- out material change. Effective Date Section 1.162(k)–1 applies with respect to amounts paid or incurred on or after August 30, 2006. Section 1.404(k)–3 applies with respect to payments to reacquire stock that are made on or after August 30, 2006. Rev. Rul. 2001–6 remains in effect for all peri- ods, including periods before the effective date of this regulation. Special Analyses It has been determined that this Trea- sury decision is not asignificant regula- tory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been deter- mined that section 553(b) of the Admin- istrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to sec- tion 7805(f) of the Code, the proposed reg- ulations preceding these regulations were submitted to the Chief Counsel for Advo- cacy of the Small Business Administration for comment on its impact on small busi- ness. Drafting Information The principal authors of these reg- ulations are John T. Ricotta, Office of Division Counsel/Associate Chief Coun- sel (Tax Exempt and Government Entities) and Jennifer D. Sledge, Office of Asso- ciate Chief Counsel (Corporate). How- ever, other personnel from the IRS and the Treasury Department participated in the development of these regulations. ***** Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: 2 Given 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.515September 25, 2006 PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding entries in nu- merical order to read as follows: Authority: 26 U.S.C. 7805 * * * Section 1.162(k)–1 is also issued under section26U.S.C.162(k).*** Section1.404(k)–3isalsoissued under sections 26 U.S.C. 162(k) and 404(k)(5)(A). * * * Par. 2. Section 1.162(k)–1 is added to read as follows: §1.162(k)–1 Disallowance of deduction for reacquisition payments. (a)In general. Except as provided in paragraph (b) of this section, no de- duction otherwise allowable is allowed under Chapter 1 of the Internal Revenue Code for any amount paid or incurred by a corporation in connection with the reacquisition of its stock or the stock of any related person (as defined in section 465(b)(3)(C)). Amounts paid or incurred in connection with the reacquisition of stock include amounts paid by a corpora- tion to reacquire its stock from an ESOP that are used in a manner described in section 404(k)(2)(A). See §1.404(k)–3. (b)Exceptions. Paragraph (a) of this section does not apply to any— (1) Deduction allowable under section 163(relatingtointerest); (2) Deduction for amounts that are properly allocable toindebtedness and amortized over the term of such indebted- ness; (3) Deduction for dividends paid (within the meaning of section 561); or (4) Amount paid or incurred in connec- tion with the redemption of any stock in a regulated investment company that issues only stock which is redeemable upon the demand of the shareholder. (c)Effective date. This section applies with respect to amounts paid or incurred on or after August 30, 2006. Par. 3. Section 1.404(k)–3 is added to read as follows: §1.404(k)–3 Disallowance of deduction for reacquisition payments. Q–1: Are payments to reacquire stock held by an ESOP applicable dividends that are deductible under section 404(k)(1)? A–1: (a) Payments to reacquire stock held by an ESOP, including reacquisition payments that are used to make benefit dis- tributions to participants or beneficiaries, are not deductible under section 404(k) be- cause— (1) Those payments do not consti- tute applicable dividends under section 404(k)(2); and (2) The treatment of those payments as applicable dividends would constitute, in substance, an avoidance or evasion of taxation within the meaning of section 404(k)(5). (b) See also §1.162(k)–1 concerning the disallowance of deductions for amounts paid or incurred by a corporation in con- nection with the reacquisition of its stock from an ESOP. Q–2: What is the effective date of this section? A–2: This section applies with respect to payments to reacquire stock that are made on or after August 30, 2006. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved August 22, 2006. Eric Solomon, Acting Deputy Assistant Secretary oftheTreasury(TaxPolicy). (Filed by the Office of the Federal Register on August 29, 2006, 8:45 a.m., and published in the issue of the Federal Register for August 30, 2006, 71 F.R. 51471) Section 472.—Last-in, First-out Inventories 26 CFR 1.472–1: Last-in, first-out inventories. LIFO; price indexes; department stores.The July 2006 Bureau of Labor Statistics price indexes are accepted for use by department stores employing the retail inventory and last-in, first-out in- ventory methods for valuing inventories for tax years ended on, or with reference to, July 31, 2006. Rev. Rul. 2006–48 The following Department Store In- ventory Price Indexes for July 2006 were issued by the Bureau of Labor Statistics. The indexes are accepted by the Inter- nal Revenue Service, under § 1.472–1(k) of the Income Tax Regulations and Rev. Proc. 86–46, 1986–2 C.B. 739, for ap- propriate application to inventories of department stores employing the retail inventory and last-in, first-out inventory methods for tax years ended on, or with reference to, July 31, 2006. The Department Store Inventory Price Indexes are prepared on a national basis and include (a) 23 major groups of depart- ments, (b) three special combinations of the major groups — soft goods, durable goods, and miscellaneous goods, and (c) a store total, which covers all departments, including some not listed separately, ex- 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) GroupsJuly 2005July 2006 Percent Change from July 2005 to July 2006 1 1. PieceGoods .............................................495.0465.0-6.1 2. DomesticsandDraperies..................................517.7488.7-5.6 3. Women’sandChildren’sShoes ............................629.0655.74.2 4. Men’sShoes.............................................867.0875.41.0 5. Infants’Wear ............................................548.0557.71.8 September 25, 20065162006–39 I.R.B. BUREAU OF LABOR STATISTICS, DEPARTMENT STORE INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS (January 1941 = 100, unless otherwise noted) GroupsJuly 2005July 2006 Percent Change from July 2005 to July 2006 1 6. Women’sUnderwear......................................541.2546.81.0 7. Women’sHosiery ........................................339.7343.81.2 8. Women’sandGirls’Accessories ...........................580.5544.5-6.2 9. Women’sOuterwearandGirls’Wear .......................321.7327.31.7 10. Men’sClothing ..........................................520.6514.2-1.2 11. Men’sFurnishings........................................552.6550.3-0.4 12. Boys’ClothingandFurnishings............................386.1371.3-3.8 13. Jewelry..................................................870.2898.03.2 14. Notions .................................................809.2822.91.7 15. ToiletArticlesandDrugs..................................997.1995.1-0.2 16. FurnitureandBedding ....................................599.1602.40.6 17. FloorCoverings..........................................609.8614.10.7 18. Housewares..............................................712.2697.1-2.1 19. MajorAppliances.........................................203.5204.20.3 20. RadioandTelevision......................................38.935.8-8.0 21. Recreation and Education 2 .................................77.976.3-2.1 22. Home Improvements 2 .....................................137.6139.61.5 23. Automotive Accessories 2 ..................................115.1120.74.9 Groups1–15:SoftGoods .......................................537.3538.30.2 Groups16–20:DurableGoods...................................379.6373.2-1.7 Groups 21–23: Misc. Goods 2 .................................... 93.093.40.4 Store Total 3 ..............................................481.6480.8-0.2 1 Absence of a minus sign before the percentage change in this column signifies a price increase. 2 Inde xes 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 The principal author of this revenue ruling is Michael Burkom of the Office of Associate Chief Counsel (Income Tax and Accounting). For further informa- tion regarding this revenue ruling, contact Mr. Burkom at (202) 622–7924 (not a toll-free call). Section 882.—Tax on Income of Foreign Corporations Connected Wi th United States Business 26 CFR 1.882–5: Determination of interest deduc- tion. T.D . 9281 DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Parts 1 and 602 De termination of Interest Ex pense Deduction of Foreign C orporations AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final and temporary regula- tions. SUMMARY: This document contains re- vised Income Tax Regulations relating to the determination of the interest expense deduction of foreign corporations and applies to foreign corporations engaged in a trade or business within the United States. This action is necessary to conform the rules to subsequent U.S. Income Tax Treaty agreements and to adopt changes to facilitate improved administrability for taxpayers and the IRS. DATES:Effective Date:These regula- tions are effective starting the tax year end for which the original tax return due date (including extensions) is after August 17, 2006. Applicability Date:These regulations are applicable starting the tax year end 2006–39 I.R.B.517September 25, 2006 for which the original tax return due date (including extensions) is after August 17, 2006. FOR FURTHER INFORMATION CONTACT: Gregory Spring or Paul Epstein, (202) 622–3870 (not a toll-free number). SUPPLEMENTARY INFORMATION: Paperwork Reduction Act These temporary regulations are being issued without prior notice and public pro- cedure pursuant to the Administrative Pro- cedure Act (5 U.S.C. 553). For this reason, the collection of information contained in these regulations has been reviewed and pending receipt and evaluation of public comments, approved by the Office of Man- agement and Budget under control number 1545–2030. Responses to this collection of information are mandatory. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless the collection of information displays a valid control number. For further information concerning these collections of information, and where to submit comments on the col- lection of information and the accuracy of the estimated burden, and suggestions for reducing this burden, please refer to the preamble of the cross-referencing notice of proposed rulemaking (REG–120509–06) published in this issue of the Bulletin. Books and records relating to a collec- tion of information must be retained as long as their contents may become mate- rial in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as re- quired by 26 U.S.C. 6103. Background On December 30, 1980, the Treasury Department and the IRS published final regulations T.D. 7749, 1981–1 C.B. 390 [46 FR 16100 (see §601.601(d)(2) of this chapter)] under section 882(c) of the In- ternal Revenue Code (Code) regarding the determination of a foreign corpora- tion’s interest expense allocable to income effectively connected with the conduct of a trade or business within the United States. On March 8, 1996, the Treasury Department and the IRS published final regulations T.D. 8658, 1996–1 C.B. 161 [61 FR 15891 (see §601.601(d)(2) of this chapter)], and new proposed amendments INTL–0054–95, 1996–1 C.B. 844 [61 FR 28118) (see §601.601(d)(2) of this chapter)]. The 1996 amendments imple- mented certain statutory changes enacted in the Tax Reform Act of 1986, Public Law 99–514 (100 Stat. 2085), and took account of developments in international financial markets. Comments were received on both the final and proposed 1996 regula- tions. Since then, two new U.S. income tax treaties have entered into force that follow a different approach for determining the limit on profits attributable to a permanent establishment in a contracting state and for determining interest expense allowed incomputingsuchprofits. OnJuly14, 2005, the Treasury Department and the IRS published Notice 2005–53, 2005–2 C.B. 32, see §601.601(d)(2)), which de- scribed those new treaties and announced the intention to update the final §1.882–5 regulations to take account of changes in the international banking sector and to promote both ease of administration and certainty of application. These temporary regulations in this document implement Notice 2005–53, make effective one part of the 1996 pro- posed regulations, make miscellaneous clarifications to the 1996 final regu- lations, and modify the branch profits tax liability reduction regulations under §1.884–1(e)(3). Explanation of Provisions The following discussion is divided into several parts. Section 1 of the fol- lowing discussionsummarizes Notice 2005–53. Section 2 addresses the coordi- nation of §1.882–5 with U.S. tax treaties and discusses other modifications made by these temporary regulations to the three-step calculationof interest expense under §1.882–5. Section 3 addresses changes made to the branch profits tax regulations under section 884. Section 4 then addresses miscellaneous technical modifications made by these temporary regulations that clarify application of the existing final regulations. Section 5 describes the effective date of these regu- lations. 1.Notice 2005–53 Notice 2005–53 provided guidance re- garding the interaction of §1.882–5 and U.S. income tax treaties and explained that since the recent treaties with the United Kingdom and Japan entered into force, §1.882–5 no longer provides the exclusive rules for determining the interest expense attributable to the business profits of a U.S. permanent establishment. The no- tice also provided guidance and requested comments regarding certain potential modifications to certain elements of the three-step calculation of interest expense under §1.882–5. More specifically, the notice requested information regarding a possible increase to the existing 93-per- cent fixed ratio in Step 2 of the calculation and announced the intention to allow the use of a safe-harbor interest rate for deter- mining excess interest under the “adjusted U.S.-booked liabilities” method in Step 3. The notice also requested comments regarding the effect of intangibles on the Step–1 determination of U.S. assets under the elective fair market value method and the Step–2 determination of U.S. liabilities using the fixed or actual ratio. 2.Modifications to Three-Step Calculation Under §1.882–5 a.Introduction/background Section 1.882–5 generally requires a foreign corporation to use a three-step cal- culation to determine the amount of inter- est expense that is allocable under section 882(c) to income effectively connected (or treated as effectively connected) with the foreign corporation’s conduct of a trade or business within the United States. Step 1 determines the total value of a foreign corporation’s U.S. assets, which generally are the assets that produce (or would produce) income effectively con- nected with the foreign corporation’s con- duct of its U.S. trade or business. The value of the U.S. assets for this purpose is their adjusted basis, or, if the taxpayer makes an election, their fair market value. Step 2 determines the “U.S.-connected liabilities” of a foreign corporation as the product of the foreign corporation’s U.S. assets multiplied either by the actual ratio of the foreign corporation’s worldwide li- abilities to worldwide assets, or by a fixed September 25, 20065182006–39 I.R.B. ratio. In the case of a bank, the fixed ratio is 93 percent. If a taxpayer elects to value its assets at fair market value for purposes of Step 1, then the taxpayer must value worldwide assets at fair market value for purposes of Step 2, as well. Step 3 determines the allocable amount of interest expense under either the ad- justed U.S.-booked liabilities (AUSBL) method or the separate currency pools method. Under the AUSBL method, a foreign bank’s interest expense alloca- ble to effectively connected income is determined by comparing “U.S.-booked liabilities” with U.S.-connected liabilities and making appropriate adjustments as necessary. For this purpose, U.S.-booked liabilities generallyinclude liabilities that are both entered on books relating to an activity that produces effectively con- nected income before the close of the dayonwhichtheliabilityisincurredand are directly connected to that activity. In consequence, U.S.-booked liabilities are not limited to liabilities reflected on books within the United States. If a tax- payer’s U.S.-booked liabilities exceed its U.S.-connected liabilities, then its U.S-booked interest expense is propor- tionately disallowed under a “scale down” ratio. If a taxpayer’s U.S.-connected lia- bilities exceed its U.S.-booked liabilities, then interest expense in addition to the U.S.-booked interest expense is allocated in an amount equal to the product of the excess U.S.-connectedliabilities multi- plied by the borrowing rate on U.S.-dollar liabilities that are not U.S.-booked liabil- ities. Under the separate currency pools method, a foreign corporation’s interest expense allocable toincome effectively connected with the conduct of a trade or business within the United States is the sum of the separate interest deductions for each of the currencies in which the foreign corporation has U.S. assets. The separate interest deductions generally are deter- mined using a three-step calculation that multiplies the worldwide borrowing rate by the U.S.-connectedliabilities relevant to U.S. assets denominated in each foreign currency. Elections under §1.882–5T, as under the 1996 final regulations, generally are binding for a minimum of five years unless specifically provided otherwise. For ex- ample, consistent with the binding nature of a domestic corporation’s fair market value election under section 861, a fair market value election under §1.882–5T may be changed only with consent of the Commissioner. b.Treaty coordination — modification of §1.882–5 exclusivity rule The preamble to the 1996 final regula- tions states that §1.882–5 was fully consis- tent with all of the United States’ then-ex- isting treaty obligations, including Busi- ness Profits articles, and the 1996 final reg- ulations state that §1.882–5 provides the exclusive rules for determining the interest expense attributable to the business profits of a U.S. permanent establishment under a U.S. income tax treaty. However, the Trea- sury Department Technical Explanation to Article 7 of the United States-United King- dom income tax treaty which entered into force on March 31, 2003, and the Treasury Department Technical Explanation to Arti- cle 7 of the United States-Japan income tax treaty which entered into force on March 30, 2004, note that §1.882–5 may pro- duce an inappropriate result in some cases. As a result, the implementing documen- tation of these treaties provides that the 1995 Organization for Economic Co-Op- eration and Development (OECD) Trans- fer Pricing Guidelines will apply by anal- ogy for the purpose of determining the business profits attributable to a permanent establishment. Thus, as noted in Notice 2005–53, the exclusivity provision in the 1996 final regulations is no longer accu- rate. These temporary regulations modify the exclusivity provision by recognizing that express provision may be made by or pursuant to an income tax treaty or accom- panying documents (such as exchange of notes) that alternative principles will ap- ply by analogy to determine the business profits attributable to a permanent estab- lishment. Such treaty provisions may be used to determine the limit on the business profits attributable to a U.S. permanent es- tablishment, but taxpayers remain eligible to use §1.882–5, as explained in the Trea- sury Department Technical Explanations to Article 7(3) of the United States-United Kingdom and United States-Japan income tax treaties. The Treasury Department and the IRS believe that these treaties and agreements provide that a taxpayer must apply either the domestic law or the alternative rules expressly provided in the treaty in their entirety, in accordance with the consistency principle articulated in Rev. Rul. 84–17, 1984–1 C.B. 308 (see §601.601(d)(2) of this chapter), and described in the Treasury Department Technical Explanation to Article 1(2) of the United States-United Kingdom and United States-Japan income tax treaties. The Treasury Department and the IRS are continuing to consider the specific application of this consistency principle including the application of §1.882–5, the interaction of §1.882–5 with other U.S. in- come tax treaties (particularly those being renegotiated in whole or in part), and the application of the branch profits tax under alternative rules for determining interest expense attributable to business profits. c.Modifications to step one Consistency Requirement for Fair Market Value Election Under the 1996 final regulations, a taxpayer that uses the fair market value method for Step 1 must also use the fair market value method for Step 2. Notice 2005–53 clarified that this consistency rule applies only when the taxpayer has elected to use the actual ratio in Step 2, because assets are not valued when the fixed ratio is used. Accordingly, under the final regulations, electing the fair market value method under Step 1 does not ob- ligate a taxpayer to elect the actual ratio under Step 2. Notice 2005–53 also stated that the prevalence and significance of intangibles in the banking industry warrants reevalu- ating the right to elect both the fair market value method in Step 1 and the fixed ratio in Step 2. The Treasury Department and the IRS are concerned that applying the fixed ratio to intangibles when a Step 1 fair market value election is in place would have the effect of treating existing intan- gibles as highly leveraged assets when in fact such items often are more properly reflected in the taxpayer’s equity accounts under U.S. tax principles. Comments were requested. The single comment received in re- sponse to this request stated that distor- tions could result either by failing to take the value of intangibles into account when 2006–39 I.R.B.519September 25, 2006 revising the fixed ratio for banks or by ap- plying the fixed ratio to directly purchased intangibles that are valued at tax basis. As further discussed in this section in connection with modifications to Step 2, these temporary regulations adopt a fixed ratio that is believed to represent an ap- proximation of current average banking- industry balance-sheet ratios estimated un- der U.S. tax principles. Following due consideration of the comment, these tem- porary regulations require that the fair mar- ket value method may be elected in Step 1 only if a taxpayer is eligible to elect and in fact uses the actual ratio in Step 2. The consistency rule continues to require that the fair market value method, once elected, must be used in both Step 1 and Step 2. This consistency rule applies to all foreign corporations that are subject to §1.882–5. Conforming-Election Requirement A taxpayer that has both a valid fair market value method election for Step 1 and a valid fixed ratio method elec- tion for Step 2 in effect on the date these temporary regulations are effective must conform those elections to the new rules. Accordingly, such a taxpayer either may maintain the fixed ratio method for Step 2 and elect the adjusted basis method for Step 1, or may maintain the fair mar- ket value method for Step 1 and elect the actual ratio method for Step 2. Such conforming elections must be made for the first year these temporary regulations are effective, on either an original timely filed return (including extensions) or an amended return within 180 days after the extended due date. If a conforming election is not made by the extended due date for filing the amended return, the Director of Field Operations may make a binding conforming election on the tax- payer’s behalf. Conforming elections are subject to the minimum five-year period applicable to the adjusted basis method, fixed ratio and actual ratio method elec- tions. Elections with respect to Step 1 and Step 2, whether made by the taxpayer (either under the terms of the regulations or pursuant to the Commissioner’s grant of consent within what would otherwise be a five-year minimum period) or im- posed by the Commissioner, are separate. Thus, for example, the Commissioner may consent to a taxpayer’s request to move from the fair market value method to the adjusted basis method for Step 1 without granting consent to move from the actual ratio method to the fixed ratio method for Step 2. Average Value of Securities Subject to Section 475 or Section 1256 The 1996 proposed regulations provide that financial instruments that are subject to mark-to-market valuation under section 475orsection1256mustbevaluedfor purposes of §1.882–5 on each “determina- tion date” (as defined) within the taxable year. Taxpayers generally assess funding needs throughout the year, and this rule is intended to reflect such assessments more accurately than a single year-end valuation would do. These temporary regulations adopt this rule from the 1996 proposed regulations. The rule applies solely to determine the av- erage values of relevant assets for purposes of computing the average valuation of U.S. assets in Step 1 of the formula. The rule does not determine the actual tax basis of an asset for any other purpose. “Determi- nation dates” for purposes of the rule are defined as the most frequent regular inter- vals for which data are reasonably avail- able. These temporary regulations pro- vide that a taxpayer that has elected the ac- tualratioinStep2mustalsotakeinterim mark-to-market values into account using the most frequently available data but in no event less frequently than actual-ratio tax- payers are required to do. d.Modifications to step two New Fixed Ratio The 1996 final regulations revised the fixed ratio for banks downward to 93 per- cent. Since then, foreign bank taxpayers have commented that 93 percent is not rep- resentative of regulated banking industry capital structures. Foreign bank taxpay- ers also have commented that use of the actual ratio in Step 2 presents the poten- tial for significant tax risk and uncertainty of results, particularly when adjusting their books to conform to U.S. tax principles. It appears that many foreign banks have adopted the 93-percent fixed ratio despite indications that many operate on a smaller equity capital structure. Notice 2005–53 indicated that the Trea- sury Department and the IRS were con- sidering increasing the fixed ratio. In or- der to improve administration by aligning the fixed ratio more closely with an ap- proximation of current average banking in- dustry balance sheet ratios estimated un- der U.S. tax principles, these temporary regulations revise the fixed ratio for for- eign banks upward to 95 percent. The new fixed ratio may be adopted by for- eign banks for the first year in which the original tax return due date (including ex- tensions) is after August 17, 2006, or for any subsequent year. The ratio may be adopted, for example, for the 2005 calen- dar year even if the original return was filed before these regulations were pub- lished. Taxpayers that want to try to sup- port any further revision to the fixed ra- tio would have to submit detailed, specific, compelling evidence to that effect. Branch Profits Tax Consequences of Fixed-Ratio Election Use of the new 95-percent fixed ratio in Step 2 conceivably could give rise to branch profits tax consequences. For ex- ample, a taxpayer that elects the new fixed ratio and that had been using either the 93-percent fixed ratio or an actual ratio that is less than 95 percent could be viewed under the branch profits tax rules as hav- ing experienced a decrease in net equity, thus giving rise to a dividend equivalent amount. One comment received in re- sponse to Notice 2005–53 requested that regulations implementing the notice pro- vide special immunity from branch profits tax consequences except to the extent that a taxpayer benefited from the 1996 reduc- tion of the fixed ratio from 95 percent to 93 percent. Such consequences under the branch profits tax rules should arise only to the extent a taxpayer uses a 95-percent ra- tio that is substantially higher than the ra- tiousedintheprioryear,andthetax- payer’s asset base has not increased suf- ficiently in the ordinary course of busi- ness to cause current and accumulated ef- fectively connected earnings and profits to be treated as reinvested. The 1996 fi- nal regulations identify the actual ratio as the preferred method, and taxpayers have always been entitled to elect their actual ratio. Accordingly, the Treasury Depart- September 25, 20065202006–39 I.R.B. ment and the IRS believe that granting the commenter’s request is unnecessary and in some cases could produce an inappropri- ate windfall. In addition, considerable ad- ministrative difficulties would complicate efforts to identify and recapture prior tax benefits that may have resulted from the increase in net equity when the fixed ra- tio was reduced in the 1996 final regula- tions and to track the deferred component of the computation through the intervening years up to and including the effective date of the new fixed ratio. Further, a special rule of the type requested is inconsistent with the expectation of reduced effectively connected income through increased inter- est expense allocations that result from the higher ratio. Finally, any branch profits tax consequences of a new fixed-ratio elec- tion may be mitigated by applicable tax treaties and by the expanded availability of the liability-reduction election under sec- tion 884, as further discussed in Section 3. Accordingly, the comment is not adopted. Elections Taxpayers that currently have elected the fixed ratio for Step 2 may use the re- vised 95-percent ratiofor the first tax year for which the original tax return due date (including extensions) is after August 17, 2006. Remaining on the fixed ratio does not constitute the election of a new five- year minimum period. For example, a tax- payer that used the 93-percent fixed ratio for three years preceding the publication of these regulations and used the 95-percent fixed ratio for three more years would be entitled to elect the actual ratio method in the following year. Foreign bank taxpayers that currently use the actual ratio for Step 2 may make a binding five-year election to use the new 95-percent fixed ratio for the first year this amendment is effective, on either an orig- inal return or on an amended return filed within 180 days of the extended due date. An amended return election may not be made for any year where the extended due date for a timely filing is after December 31, 2006. If a fixed-ratio election is not made for the first year these regulations are effective, a taxpayer using the actual ratio may make the fixed-ratio election in any subsequent year, but only on a timely filed return. Eligibility Under the 1996 final regulations, the 93-percent fixed ratio is available to for- eign banks, which are defined for this purpose as banks within the meaning of section 585(a)(2)(B), without regard to the second sentence thereof. This definition excludes foreign banking corporations that are not engaged in a banking business within the United States. This has the effect of excluding aforeign corporation that is engaged in the banking business outside the United States but terminates its U.S. banking licenses and continues to engage in a nonregulated trade or business within the United States. The Treasury Department and the IRS intend that a taxpayer that meets the re- quirements of section 581 when consid- ered on a worldwide basis should be eli- gible to elect the fixed ratio applicable to banks under §1.882–5 without regard to whether it remains engaged in a banking business within the United States. There- fore, a taxpayer that is regulated as a bank in its home country, takes deposits, and makes loans as a substantial part of its business outside the United States will be eligible to elect the 95-percent fixed ratio. e.Modifications to step three Excess Interest A foreign bank that uses the AUSBL method to determine its allocable inter- est expense may be required to allocate interest expense in addition to its U.S.- booked interest expense if U.S.-connected liabilities exceed U.S.-booked liabilities. The 1996 final regulations provide that the interest rate required to be applied to excess U.S.-connected liabilities is gener- ally the foreign bank’s average U.S.-dollar borrowing rate outside the United States. This rule was a change from the 1981 regulations, which had allowed taxpayers to use published rates under certain con- ditions. Taxpayers have commented in- formally that using actual non-U.S. dollar borrowing costs in all circumstances im- poses significant administrative burdens. The Treasury Department and the IRS agree that the use of published data rather than the actual borrowing rate requirement would simplify administration of the ex- cess-interest computation both for taxpay- ers and for the IRS. Notice 2005–53 an- nounced the intention to permit the use of the published 30-day average London Interbank Offering Rate (LIBOR) for tax years beginning after the date the notice was published. In response to Notice 2005–53, two comments were received. One comment stated that the proposal to use published 30-day LIBOR rates would make sense if it has been difficult for banks to calculate their actual rate of interest and that con- sideration might be given to making such a rule available for prior years. The other comment stated that a small sample of available information suggested that the 90-day LIBOR rate rather than the 30-day ratemaybemorerepresentativeofthe sampled banks and suggested that the IRS review tax returns with excess interest. IRS experience in actual cases involv- ing excess interest supports the adoption of a 30-day LIBOR rate rather than a 90-day LIBOR rate. In view of IRS experience and the absence of contrary data, these temporary regulations allow an annual binding election to use a published 30-day average LIBOR rate beginning with the first tax year in which an original tax re- turn is due (including extensions) after August 17, 2006. Taxpayers may continue to use their actual U.S.-dollar borrowing rate in lieu of the 30-day LIBOR rate. Relevant excess U.S.-connected liabilities These temporary and proposed regu- lations provide that the determination of the actual U.S.-dollar borrowing rate ap- plicable to excess U.S.-connected liabil- ities is made with regard only to U.S.- dollar liabilities that are booked outside the United States and that do not con- stitute U.S.-booked liabilities as defined. The rate applicable to excess U.S.-con- nected liabilities is intended to reflect the rate applicable to relevant borrowings and book interest expense that has not other- wise been allocated. Because interest with respect to U.S.-booked liabilities is alloca- ble under Step 3 of the AUSBL method, including such interest expense in the de- termination of the rate applicable to excess U.S.-connected liabilities could distort the calculation. Elections The 30-day LIBOR election may be adopted on a year-to-year basis. For the 2006–39 I.R.B.521September 25, 2006 first tax year in which the original tax-re- turn due date (including extensions) is af- ter August 17, 2006 and not later than De- cember 31, 2006, taxpayers may make the 30-day LIBOR election on an original re- turn, or on an amended return within 180 days of the original extended due date. For subsequent years, the election must be made on an original tax return timely filed (including extensions). The election is made by attaching a statement to the return identifying the three-steps of the AUSBL calculation and the published rate used. An election to use a 30-day LIBOR rate is binding for such taxable year and may not bechangedonanamendedreturnforany year. Accordingly, a taxpayer is bound by the published rate used on its original re- turn. If a taxpayer does not timely file an income tax return, then the opportunity to make a timely 30-day LIBOR election will be forfeited for the tax year. Consistent with the general rules for untimely elec- tions, in such circumstances, the Director of Field Operations may require a taxpayer to use the actual U.S.-dollar borrowing rate or apply a published 30-day LIBOR rate for the year. 3.Liability Reduction Election Under Branch Profits Tax In general, the branch profits tax is imposed under section 884(a) in addition to the corporate income tax under section 882 and applies only to amounts that are treated as repatriated from the branch. These amounts are determined by refer- ence to a foreign corporation’s effectively connected earnings and profits for a year and accumulated effectively connected earnings and profits, adjusted upward to reflect decreases in U.S. net equity and adjusted downward to reflect increases in U.S. net equity. Adjustments to net equity generally are made by comparing U.S. net equity at the end of a taxable year to U.S. net equity at the beginning of a taxable year. The branch profits tax rules impute equity capital to a branch according to a formula that treats a portion of reinvested amounts as having been funded by in- debtedness. This generally reduces U.S. net equity and so gives rise to a dividend equivalent amount. Regulations provide that a taxpayer may elect to treat reinvested earnings as equity capital (rather than as debt-funded capital) by reducing U.S. lia- bilities as of the determination date. The amount of liabilities eligible for reduction under this election is limited to the ex- cess of U.S. liabilities (which is generally based on U.S.-connected liabilities, as de- fined under §1.882–5) over U.S.-booked liabilities (as defined under §1.882–5) as of the determination date. An election to reduce liabilities under §1.884–1 also reduces the interest deduction available under §1.882–5. Taxpayers have expressed uncertainty regarding the policy served by setting U.S.-booked liabilities as a floor for liabil- ity reduction and have requested greater latitude to treat earnings as reinvested. For example, taxpayers have noted that the amount of U.S.-booked liabilities is not relevant to the §1.882–5 allocation under the separate currency pools method. They have noted also that the amount of U.S.-booked liabilities taken into account under the AUSBL method is an average balance for the year that may differ signif- icantly from a year-end balance. The Treasury Department and the IRS believe that it is desirable to more nearly align the branch profits tax treatment of distributed earnings with the tax treatment of a subsidiary’s distributed earnings while retaining integration with the interest al- location rules provided in §1.882–5. In view of taxpayer comments, these tempo- rary regulations permit a taxpayer to re- duce U.S. liabilities to the extent neces- sary to prevent recognition of a dividend equivalent amount. However, this elec- tion may not reduce U.S. liabilities below zero. The other liability-reduction rules of §1.884–1(e)(3) continue to apply in their entirety. An example in the final regula- tions is amended in the temporary regula- tions to reflect the new limitation rule. The new liability reduction election is effective for the first year for which the original tax return due date (including extensions) is after August 17, 2006. For tax years for which the first original tax return due date (including extensions) is not later than De- cember 31, 2006, a liability reduction elec- tionmaybemadeonanamendedreturn within 180 days after the original extended due date for filing the original return. 4.Clarifications of 1996 Final Regulations Questions have arisen regarding the ap- plication of certain rules contained in the 1996 final regulations. These temporary regulations clarify the application of the 1996 final regulations with respect to cer- tain direct interest allocations, certain re- quirements applicable to elections gener- ally under §1.882–5, the definition ofU.S.- booked liability, and the treatment of cer- tain currency gain and loss for purposes of §1.882–5. a.Direct interest allocations The direct interest allocation rules un- der §1.882–5 provide generally that a for- eign taxpayer with both a U.S. asset and indebtedness that meet the requirements of both §1.861–10T(b) and (c) may treat the asset and the indebtedness as an inte- grated financial transaction and so may al- locate interest expense with respect to the indebtedness directly to income from the asset. In general, §1.861–10T(b) provides rules for certain nonrecourse indebtedness, and §1.861–10T(c) provides rules for cer- tain integrated financial transactions. Fi- nancial institutions may allocate interest directly only to the extent provided by the nonrecourse indebtedness rules. These temporary regulations clarify that a finan- cial institution is not disqualified from di- rect allocation treatment by satisfying only the rules provided in §1.861–10T(b) with respect to particular nonrecourse indebted- ness transactions. These temporary regu- lations also clarify that direct allocation is mandatory for eligible taxpayers if the re- quirements of either §1.861–10T(b) or (c) are satisfied. b.General election requirements The 1996 final regulations specify the time, place, and manner for making elections under each step of the formula. These temporary regulations clarify that a taxpayer eligible to change an election as of right after the minimum five-year pe- riodmaydosoonlyonanoriginaltimely filed return. These temporary regulations also clarify that the election procedures prohibit relief under §301.9100 for future elections as well as the elections in the first year a taxpayer is subject to the rules. These temporary regulations also clarify September 25, 20065222006–39 I.R.B. that after the minimum five-year period, a taxpayer may change an election on a timely filed return for any subsequent year. For example, leaving an election in place in the sixth year after the election was made does not constitute a new election subject to a new 5-year minimum period. The general election provision is updated to provide expressly that the elections to use the fair market value method elec- tion and the 30-day LIBOR rate election are subject to their own specific period requirements instead of the five-year min- imum period. c.U.S.-booked liabilities The definition ofU.S.-booked liability has changed over time. The 1981 final regulations defined U.S.-booked liabili- ties to include only liabilities shown on the books and records of the U.S. trade or business. This definition excluded as- sets that produced effectively connected income but were booked and maintained in a foreign branch. The 1996 final regu- lations modified the definition to include generally, for non banks, liabilities that are recorded reasonably contemporaneously with their acquisition on a set of books that has a direct relationship to an activity that gives rise to effectively connected in- come. For banks, liabilities generally must be recorded contemporaneously with their acquisition. These rules do not require tracing of specific borrowings to specific effectively connected uses. Whether there is a direct connection between the liability and an activity that produces effectively connected income is determined under all the facts and circumstances. These temporary regulations amend the definition of U.S.-booked liability and pro- vide an example to clarify that in the case of a bank, the liability must be recorded on a set of books before the end of the day on which it is incurred, and the liability relates to an activity that produces effec- tively connected income. The reasonably contemporaneous booking rule is retained for non banks and the language clarified to reassert that the liability must relate to an activity that produces effectively con- nected income. d.Currency gain and loss A foreign bank’s U.S. branch com- monly books third-party liabilities de- nominated in non-dollar currencies and uses the proceeds to make interbranch loans. Because interbranch transactions generally are not recognized for U.S. tax purposes, the third-party liability is treated as unhedged. As noted in the pream- ble to the 1996 final regulations, foreign currency gain or loss from an unhedged liability remains subject to the rules of sec- tion 988. As a result, the U.S. branch may have currency gain or loss with respect to the third-party borrowing but may not be entitled to recognize currency gain or loss with respect to the offsetting interbranch transaction. In addition, any scaling down of interest expense that might otherwise be required under the AUSBL method does not apply to foreign currency gain or loss. Some taxpayers have suggested infor- mally that, despite the absence of a gen- eral tracing principle in the interest allo- cation rules, currency gain and loss from such third-party liabilities should be trace- able to currency gains and losses with re- spect to specific interbranch and noneffec- tively connected assets. The Treasury De- partment and the IRS solicit comments re- garding the allocation, sourcing, and ap- portionment of currency gain or loss from unhedged third-party borrowings between effectively connectedand non-effectively connected income. Comments are specif- ically requested regarding the viability of a tracing principle for this purpose and the extent to which current booking prac- tices may provide an administrable basis for such rules in accordance with existing authority. 5.Effective Date The temporary regulations are applica- ble for the first tax year end for which the original tax return due date (includ- ing extensions) is after August 17, 2006. Accordingly, for calendar-year taxpayers, the applicability date is for the tax year ended December 31, 2005. The rules pro- vide an additional 180 days to make certain one-time special elections on an amended return for tax years for which the original tax return due date is not later than Decem- ber 31, 2006. Special Analyses It has been determined that this Treasury decision is not a significant regulatory ac- tion as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Pro- cedure Act (5 U.S.C. chapter 5) does not apply to these regulations. For applica- bility of the Regulatory Flexibility Act (5 U.S.C. chapter 6) please refer to the cross reference notice of proposed rule- making published elsewhere in this issue of the Bulletin. Pursuant to section 7805(f) of the Code, this regulation has been sub- mitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Drafting Information The principal authors of these regulations are Paul S. Epstein and Gregory A. Spring of the Office of As- sociate Chief Counsel (International). ***** Amendments to the Regulations Accordingly, 26 CFR parts 1 and 602 are amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 is amended by adding entries in nu- merical order to read in part as follows: Authority: 26 U.S.C. 7805 * * * Section 1.882–5 also issued un- der 26 U.S.C. 882, 26 U.S.C. 864(e), 26 U.S.C. 988(d), and 26 U.S.C. 7701(l). *** Section 1.884–1 is also issued under 26 U.S.C. 884. * * * Par. 2. Section 1.882–0 is amended by: 1. Revising the entries for §1.882– 5(a)(1), (a)(1)(i), (a)(1)(ii), (a)(1)(ii)(A), (a)(1)(ii)(B), (a)(2), (a)(7), (a)(7)(i), (a)(7)(ii), (b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4), (d)(2)(iii)(A), and (d)(5)(ii). 2. Removing the entry for §1.882– 5(b)(2)(iv). 3. Adding entries for §1.882–5T. The revisions and additions read as follows: §1.882–0 Table of contents. ***** §1.882–5 Determination of interest deduction. ***** (a)(1) through (a)(2) [Reserved]. 2006–39 I.R.B.523September 25, 2006 ***** (a)(7) through (a)(7)(iii) [Reserved]. ***** (b)(2)(ii)(A) [Reserved]. ***** (b)(3) [Reserved]. ***** (c)(2)(iv) [Reserved]. ***** (c)(4) [Reserved]. **** * (d)( 2)(iii)(A) [Reserved]. ***** (d)(5)(ii) [Reserved]. ***** §1.882–5T Determination of interest deduction (temporary). (a) [Reserved]. (1) Overview. (i) In general. (ii) Direct allocations. (A) In general. (B) Partnership interests. (2) Coordination with tax treaties. (3) through (6) [Reserved]. (7) Elections under §1.882–5. (i) In general. (ii) Failure to make the proper election. (iii) Step 2 special election for banks. (8) through (b)(2)(ii) [Reserved]. (A) In general. (b)(2)(ii)(B) through (b)(2)(iii)(B) [Re- served]. (3) Computation of total value of U.S. assets. (i) General rule. (ii) Adjustment to basis of financial in- struments. (c) through (c)(2)(iii) [Reserved]. (iv) Determination of value of world- wide assets. (c)(2)(v) through (c)(3) [Reserved]. (4) Elective fixed ratio method of deter- mining U.S. liabilities. (c)(5) through (d)(2)(iii) [Reserved]. (A) In general. (B) through (d)(5)(i) [Reserved]. (ii) Interest rate on excess U.S.-con- nected liabilities. (A) General rule. (B) Annual published rate election. (6) through (f)(2) [Reserved]. Par. 3. Section 1.882–5 is amended by: 1.Revising paragraphs (a)(1) through (a)(2), (a)(7) through (a)(7)(ii), (b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4), (d)(2)(ii)(A)(2),(d)(2)(ii)(A)(3), (d)(2)(iii)(A), and (d)(5)(ii). 2. Removing paragraph (b)(2)(iv). 3. Adding paragraph (d)(6)Example 5. The revisions and additions read as fol- lows: §1.882–5 Determination of interest deduction. (a)(1) through (a)(2) [Reserved]. For further guidance, see entry in §1.882–5T(a)(1) through (a)(2). ***** (a)(7)(ii) [Reserved]. For further guidance, see §1.882–5T(a)(7) through (a)(7)(ii). ***** (b)(2)(ii)(A) [Reserved]. For further guidance, see §1.882–5T(b)(2)(ii)(A). ***** (b)(3) [Reserved]. For further guid- ance, see §1.882–5T(b)(3). ***** (c)(2)(iv) [Reserved]. For further guid- ance, see §1.882–5T(c)(2)(iv). ***** (c)(4) [Reserved]. For further guid- ance, see §1.882–5T(c)(4). ***** (d)(2)(ii)(A)(2) through (3)[Re- served]. For further guidance, see §1.882–5T(d)(2)(ii)(A)(2) through (3). ***** (d)(2)(iii)(A) [Reserved]. For further guidance, see §1.882–5T(d)(2)(iii)(A). ***** (d)(5)(ii) [Reserved]. For further guid- ance, see §1.882–5T(d)(5)(ii). ***** (d)(6)Example 5[Reserved]. For fur- ther guidance, see §1.882–5T(d)(6)Exam- ple 5. Par. 4. Section 1.882–5T is added to read as follows: §1.882–5T Determination of interest deduction (temporary). (a) [Reserved]. For further guidance, see §1.882–5(a). (1)Overview—(i)In general.The amount of interest expense of a foreign corporation that is allocable under section 882(c) to income which is (or is treated as) effectively connected with the conduct of a trade or business within the United States (ECI) is the sum of the interest al- locable by the foreign corporation under the three-step process set forth in para- graphs (b), (c), and (d) of this section and the specially allocated interest expense determined under paragraph (a)(1)(ii) of this section. The provisions of this section provide the exclusive rules for allocating interest expense to the ECI of a foreign corporation under section 882(c). Un- der the three-step process, the total value of the U.S. assets of a foreign corpora- tion is first determined under paragraph (b) of this section (Step 1). Next, the amount of U.S.-connected liabilities is determined under paragraph (c) of this section (Step 2). Finally, the amount of interest paid or accrued on U.S.-booked liabilities, as determined under paragraph (d)(2) of this section, is adjusted for inter- est expense attributable to the difference between U.S.-connected liabilities and U.S.-booked liabilities (Step 3). Alterna- tively, a foreign corporation may elect to determine its interest rate on U.S.-con- nected liabilities by reference to its U.S. assets, using the separate currency pools method described in paragraph (e) of this section. (ii)Direct allocations—(A)In gen- eral. A foreign corporation that has a U.S. asset and indebtedness that meet the requirements of §1.861–10T(b) or (c), as limited by §1.861–10T(d)(1), shall di- rectly allocate interest expense from such indebtedness to income from such asset in the manner and to the extent provided in §1.861–10T. For purposes of paragraph (b)(1) or (c)(2) of this section, a foreign corporation that allocates its interest ex- pense under the direct allocation rule of this paragraph (a)(1)(ii)(A) shall reduce the basis of the asset that meets the re- quirements of §1.861–10T(b) or (c) by the principal amount of the indebtedness that meets the requirements of §1.861–10T(b) or (c). The foreign corporation shall also disregard any indebtedness that meets the requirements of §1.861–10T(b) or (c) in determining the amount of the foreign corporation’s liabilities under paragraphs (c)(2) and (d)(2) of this section and shall September 25, 20065242006–39 I.R.B. not take into account any interest expense paid or accrued with respect to such a lia- bility for purposes of paragraph (d) or (e) of this section. (B)Partnership interest. A foreign cor- poration that is a partner in a partnership that has a U.S. asset and indebtedness that meet the requirements of §1.861–10T(b) or (c), as limited by §1.861–10T(d)(1), shall directly allocate its distributive share of interest expense from that indebtedness to its distributive share of income from that asset in the manner and to the extent provided in §1.861–10T. A foreign corpo- ration that allocates its distributive share of interest expense under the direct allo- cation rule of this paragraph (a)(1)(ii)(B) shall disregard any partnership indebt- edness that meets the requirements of §1.861–10T(b) or (c) in determining the amount of its distributive share of part- nership liabilities for purposes of para- graphs (b)(1), (c)(2)(vi), and (d)(2)(vii) or (e)(1)(ii) of this section, and shall not take into account any partnership interest expense paid or accrued with respect to such a liability for purposes of paragraph (d) or (e) of this section. For purposes of paragraph (b)(1) of this section, a foreign corporation that directly allocates its dis- tributive share of interest expense under this paragraph (a)(1)(ii)(B) shall— (1) Reduce the partnership’s basis in such asset by the amount of such indebt- edness in allocating its basis in the partner- ship under §1.884–1(d)(3)(ii); or (2) Reduce the partnership’s income from such asset by the partnership’s inter- est expense from such indebtedness under §1.884–1(d)(3)(iii). (2)Coordination with tax treaties.Ex- cept as expressly provided by or pursuant to a U.S. income tax treaty or accompa- nying documents (such as an exchange of notes), the provisions of this section provide the exclusive rules for determin- ing the interest expense attributable to the business profits of a permanent establish- ment under a U.S. income tax treaty. (3) through (a)(6) [Reserved]. For fur- ther guidance, see §1.882–5(a)(3) through (a)(6). (7)Elections under §1.882–5—(i)In general. A corporation must make each election provided in this section on the corporation’s original timely filed Fed- eral income tax return for the first taxable year it is subject to the rules of this sec- tion. An amended return does not qualify for this purpose, nor shall the provisions of §301.9100–1 of this chapter and any guidance promulgated thereunder apply. Except as provided elsewhere in this sec- tion, each election under this section, whether an election for the first taxable year or a subsequent change of election, shall be made by the corporation calcu- lating its interest expense deduction in accordance with the methods elected. An elected method (other than the fair market value method under §1.882–5(b)(2)(ii), or the annual 30-day London Interbank Of- fered Rate (LIBOR) election in paragraph (d)(5)(ii) of this section) must be used for a minimum period of five years before the taxpayer may elect a different method. To change an election before the end of the requisite five-year period, a taxpayer must obtain the consent of the Commissioner or his delegate. The Commissioner or his delegate will generally consent to a taxpayer’s request to change its election only in rare and unusual circumstances. After the five-year minimum period, an elected method may be changed for any subsequent year on the foreign corpora- tion’s original timely filed tax return for the first year to which the changed election applies. (ii)Failure to make the proper election. If a taxpayer, for any reason, fails to make an election provided in this section in a timely fashion, the Director of Field Oper- ations may make any or all of the elections provided in this section on behalf of the taxpayer, and such elections shall be bind- ing as if made by the taxpayer. (iii)Step 2 special election for banks. For the first tax year for which an origi- nal income tax return is due (including ex- tensions) after August 17, 2006 and not later than December 31, 2006, in which a taxpayer that is a bank as described in §1.882–5(c)(4) is subject to the require- ments of this section, a taxpayer may make a new election to use the fixed ratio on ei- ther an original timely filed return, or on an amended return filed within 180 days after the original due date (including ex- tensions). A new fixed ratio election may be made in any subsequent year subject to the timely filing and five-year minimum period requirements of paragraph (a)(7)(i) of this section. A new fixed ratio election under this paragraph (a)(7)(iii) is subject to the adjusted basis or fair market value conforming election requirements of para- graph (b)(2)(ii)(A)(2)ofthissectionand may not be made if a taxpayer elects or maintains a fair market value election for purposes of §1.882–5(b). Taxpayers that already use the fixed ratio method under an existing election may continue to use the new fixed ratio at the higher percentage without having to make a new five-year election in the first year that the higher per- centage is effective. (8) through (b)(2)(ii) [Reserved]. For further guidance, see §1.882–5(a)(8) through (b)(2)(ii) . (A)In general—(1)Fair market value conformity requirement. A taxpayer may elect to value all of its U.S. assets on the basis of fair market value, subject to the requirements of§1.861–9T(g)(1)(iii), and provided the taxpayer is eligible and uses the actual ratio method under §1.882–5(c)(2) and the methodology pre- scribed in §1.861–9T(h). Once elected, the fair market value must be used by the taxpayer for both Step 1 and Step 2 de- scribed in §§1.882–5(b) and (c), and must be used in all subsequent taxable years unless the Commissioner or his delegate consents to a change. (2)Conforming election requirement. Taxpayers that as of the effective date of this paragraph (b)(2)(ii)(A)(2)have elected and currently use both the fair market value method for purposes of §1.882–5(b) and a fixed ratio for purposes of paragraph (c)(4) of this section must conform either the adjusted basis or fair market value methods in Step 1 and Step 2 of the allocation formula by making an adjusted basis election for §1.882–5(b) purposes while continuing the fixed ratio forStep2,orbymakinganactualratio election under §1.882–5(c)(2) while re- maining on the fair market value method under §1.882–5(b). Taxpayers who elect toconformStep1andStep2ofthefor- mula to the adjusted basis method must remain on both methods for the minimum five-year period in accordance with the provisions of paragraph (a)(7) of this sec- tion. Taxpayers that elect to conform Step 1 and Step 2 of the formula to the fair market value method must remain on the actual ratio method until the consent of the Commissioner or his delegate is obtained to switch to the adjusted basis method. If consent to use the adjusted basis method in Step 1 is granted in a later year, the 2006–39 I.R.B.525September 25, 2006 taxpayer must remain on the actual ratio method for the minimum five-year period unless consent to use the fixed ratio is independently obtained under the require- ments of paragraph (a)(7) of this section. For the first tax year for which an original income tax return is due (including exten- sions) after August 17, 2006 and not later than December 31, 2006, taxpayers that are required to make a conforming elec- tion under this paragraph (b)(2)(ii)(A)(2), maydosoeitheronatimelyfiledoriginal return or on an amended return within 180 days after the original due date (including extensions). If a conforming election is not made within the timeframe provided in this paragraph, the Director of Field Operations or his delegate may make the conforming elections in accordance with the provisions of paragraph (a)(7)(ii) of this section. (B) through (b)(2)(iii)(B) [Re- served].For further guidance, see §1.882–5(b)(2)(ii)(B) through (b)(2)(iii)(B). (3)Computation of total value of U.S. assets—(i)General rule.Thetotalvalue of U.S. assets for the taxable year is the average of the sums of the values (deter- mined under paragraph (b)(2) of this sec- tion) of U.S. assets. For each U.S. asset, value shall be computed at the most fre- quent regular intervals for which data are reasonably available. In no event shall the value of any U.S. asset be computed less frequently than monthly (beginning of taxable year and monthly thereafter) by a large bank (as defined in section 585(c)(2)) or a dealer in securities (within the mean- ing of section 475) and semi-annually (be- ginning, middle and end of taxable year) by any other taxpayer. (ii)Adjustment to basis of financial in- struments. For purposes of determining the total average value of U.S. assets in this paragraph (b)(3), the value of a se- curity or contract that is marked to mar- ket pursuant to section 475 or section 1256 will be determined as if each determina- tion date is the most frequent regular inter- val for which data are reasonably available that reflects the taxpayer’s consistent busi- ness practices for reflecting mark-to-mar- ket valuations on its books and records. (c) through (c)(2)(iii) [Reserved]. For further guidance, see §1.882–5(c) through (c)(2)(iii). (iv)Determination of value of world- wide assets. The value of an asset must be determined consistently from year to year and must be substantially in accordance with U.S. tax principles. To be substan- tially in accordance with U.S. tax princi- ples, the principles used to determine the value of an asset must not differ from U.S. tax principles to a degree that will ma- terially affect the value of the taxpayer’s worldwide assets or the taxpayer’s actual ratio. The value of an asset is the adjusted basis of that asset for determining the gain or loss from the sale or other disposition of that asset, adjusted in the same manner as the basis of U.S. assets are adjusted under paragraphs (b)(2)(ii) through (iv) of this section. The rules of §1.882–5(b)(3)(ii) apply in determining the total value of applicable worldwideassetsforthetax- able year, except that the minimum num- ber of determination dates are those stated in §1.882–5(c)(2)(i). (c)(2)(v) through (c)(3) [Reserved]. For further guidance, see §1.882–5(c)(2)(v) through (c)(3). (4)Elective fixed ratio method of deter- mining U.S. liabilities. A taxpayer that is a bank as defined in section 585(a)(2)(B) (without regard to the second sentence thereof or whether any such activities are effectively connected with a trade or busi- ness within the United States) may elect to use a fixed ratio of 95 percent in lieu of the actual ratio. A taxpayer that is neither a bank nor an insurance company may elect to use a fixed ratio of 50 percent in lieu of the actual ratio. (5) through (d)(2)(ii)(A)(1) [Reserved]. For further guidance, see §1.882–5(c)(5) through (d)(2)(ii)(A)(1). (2) The foreign corporation enters the liability on a set of books reasonably con- temporaneous with the time at which the liability is incurred and the liability relates to an activity that produces ECI. (3) The foreign corporation maintains a set of books and records relating to an ac- tivity that produces ECI and the Director of Field Operations determines that there is a direct connection or relationship between the liability and that activity. Whether there is a direct connection between the li- ability and an activity that produces ECI depends on the facts and circumstances of each case. (d)(2)(ii)(B) through (d)(2)(iii) [Re- served]. For further guidance, see §1.882–5(d)(2)(ii)(B) through (d)(2)(iii). (A)In general. A liability, whether interest bearing or non-interest bearing, is properly reflected on the books of the U.S. trade or business of a foreign corpo- ration that is a bank as described in section 585(a)(2)(B) (without regard to the second sentence thereof) if— (1) The bank enters the liability on a set of books before the close of the day on which the liability is incurred, and the liability relates to an activity that produces ECI; and (2) There is a direct connection or rela- tionship between the liability and that ac- tivity. Whether there is a direct connection between the liability and an activity that produces ECI depends on the facts and cir- cumstances of each case. For example, a liability that is used to fund an interbranch or other asset that produces non-ECI may have a direct connection to an ECI pro- ducing activity and may constitute a U.S.- booked liability if both the interbranch or non-ECI activity is the same type of activ- ity in which ECI assets are also reflected on the set of books (for example, lending or money market interbank placements), and such ECI activities are notde minimis. Such U.S. booked liabilities may still be subject to §1.882–5(d)(2)(v). (B)through(d)(5)(i)[Re- served]. For further guidance, see §1.882–5(d)(2)(iii)(B) through (d)(5)(i). (ii)Interest rate on excess U.S.-con- nected liabilities—(A)General rule. The applicable interest rate on excess U.S.-connected liabilities is determined by dividing the total interest expense paid or accrued for the taxable year on U.S.-dol- lar liabilities that are not U.S.-booked liabilities (as defined in §1.882–5(d)(2)) and that are shown on the books of the offices or branches of the foreign corpo- ration outside the United States by the average U.S.-dollar denominated liabili- ties (whether interest-bearing or not) that are not U.S.-booked liabilities and that are shown on the books of the offices or branches of the foreign corporation out- side the United States for the taxable year. (B)Annual published rate election. For each taxable year beginning with the first year end for which the original tax return due date (including extensions) is after August 17, 2006, in which a tax- September 25, 20065262006–39 I.R.B. payer is a bank within the meaning of section 585(a)(2)(B) (without regard to the second sentence thereof or whether any such activities are effectively con- nected with a trade or business within the United States), such taxpayer may elect to compute its excess interest by reference to a published average 30-day London Interbank Offering Rate (LIBOR) for the year. The election may be made for any eligible year by attaching a statement to a timely filed tax return (including exten- sions) that shows the 3-step components of the taxpayer’s interest expense allocation under the adjusted U.S.-booked liabilities method and identifies the provider (for example, International Monetary Fund statistics) of the 30-day LIBOR rate se- lected. Once selected, the provider and the rate may not be changed by the taxpayer. If a taxpayer that is eligible to make the 30-day LIBOR election either does not file a timely return or files a calculation that allocates interest expense under the scaling ratio in §1.882–5(d)(4) and it is determined by the Director of Field Oper- ations that the taxpayer’s U.S.-connected liabilities exceed its U.S.-booked liabili- ties, then the Director of Field Operations, and not the taxpayer, may choose whether to determine the taxpayer’s excess interest rate under paragraph (d)(5)(ii)(A) or (B) of this section and may select the published 30-day LIBOR rate. For the first taxable year for which an original tax return due date (including extensions) is after August 17, 2006 and not later than December 31, 2006, an eligible taxpayer may make the 30-day LIBOR election one time for the taxable year on an amended return within 180 days after the original due date (in- cluding extensions). (d)(6) through (d)(6)Example 4 [Reserved]. For further guidance, see §1.882–5(d)(6) through (d)(6)Example 4. Example 5.U.S. booked liabilities— direct rela- tionship.(i)Facts. Bank A, a resident of Country X maintains a banking office in the U.S. that records transactions on three sets of books for State A, an International Banking Facility (IBF) for its bank regulatory approved international transactions, and a shell branch licensed operation in Country C. Bank A records substantial ECI assets from its bank lending and placement activities and a mix of interbranch and non-ECI producing assets from the same or similar activities on the books of State A branch and on its IBF. Bank A’s Country C branch borrows substantially from third parties, as well as from its home office, and lends all of its funding to its State A branch and IBF to fund the mix of ECI, interbranch and non-ECI activities on those two books. The con- solidated books of State A branch and IBF indicate that a substantial amount of the total book assets constitute U.S. assets under §1.882–5(b). Some of the third-party borrowings on the books of the State A branch are used to lend directly to Bank A’s home office in Country X. These borrowings reflect the average borrowing rate of the State A branch, IBF and Country C branches as a whole. All third-party borrowings reflected on the books of State A branch, the IBF and Country C branch were recorded on such books before the close of business on the day the liabilities were acquired by Bank A. (ii)U.S. booked liabilities. The facts demonstrate that the separate State A branch, IBF and Country C branch books taken together, constitute a set of books within the meaning of (d)(2)(iii)(A)(1)ofthissec- tion. Such set of books as a whole has a direct rela- tionship to an ECI activity under (d)(2)(iii)(A)(2)of this section even though the Country C branch books standing alone would not. The third-party liabilities recorded on the books of Country C constitute U.S. booked liabilities because they were timely recorded and the overall set of books on which they were re- flected has a direct relationship to a bank lending and interbank placement ECI producing activity. The third-party liabilities that were recorded on the books of State A branch that were used to lend funds to Bank A’s home office also constitute U.S. booked liabili- ties because the interbranch activity the funds were used for is a lending activity of a type that also gives rise to a substantial amount of ECI that is properly reflected on the same set of books as the interbranch loans. Accordingly, the liabilities are not traced to their specific interbranch use but to the overall activ- ity of bank lending and interbank placements which gives rise to substantial ECI. The facts show that the liabilities were not acquired to increase artificially the interest expense of Bank A’s U.S. booked liabilities as a whole under §1.882–5(d)(2)(v). The third-party lia- bilities also constitute U.S. booked liabilities for pur- poses of determining Bank A’s branch interest under §1.884–4(b)(1)(i)(A) regardless of whether Bank A uses the Adjusted U.S. booked liability method, or the Separate Currency Pool method to allocate its in- terest expense under §1.882–5(e). (e) through (f)(2) [Reserved]. For fur- ther guidance, see §1.882–5(e) through (f)(2). (g)Effective date. (1) This section is applicable for the first tax year in which an original tax return due date (including extensions) is after August 17, 2006. (2) The applicability of this section ex- pires on or before August 14, 2009. Par. 5. Section 1.884–1 is amended by revising the entries for paragraphs (e)(3)(ii), (e)(3)(iv) and (e)(5)Example 2. §1.884–1 Branch profits tax. ***** (e)(3)(ii) [Reserved]. For further guid- ance, see entry in §1.884–1T(e)(3)(ii). ***** (e)(3)(iv) [Reserved]. For further guid- ance, see entry in §1.884–1T(e)(3)(iv). ***** (e)(5)Example 2[Reserved]. For further guidance, see entry in §1.884–1T(e)(5)Example 2. ***** Par. 6. Section 1.884–1T is added to read as follows: §1.884–1T Branch profits tax (temporary). (a) through (e)(3)(i) [Reserved]. For further guidance, see §1.884–1(a) through (e)(3)(i). (ii)Limitation. For any taxable year, a foreign corporation may elect to reduce the amount of its liabilities determined un- der paragraph §1.884–1(e)(1) of this sec- tion by an amount that does not exceed the lesser of the amount of U.S. liabilities as of the determination date, or the amount of U.S. liability reduction needed to reduce a dividend equivalent amount as of the de- termination date to zero. (iii) [Reserved]. For further guidance, see §1.884–1(e)(3)(iii). (iv)Method of election.Aforeigncor- poration that elects the benefits of this paragraph (e)(3) for a taxable year shall state on its return for the taxable year (or on a statement attached to the return) that it has elected to reduce its liabilities for the taxable year under this paragraph (e)(3) and that it has reduced the amount of its U.S.-connected liabilities as provided in §1.884–1(e)(3)(iii), and shall indicate the amount of such reductions on the return or attachment. An election under this para- graph (e)(3) must be made before the due date (including extensions) for the foreign corporation’s income tax return for the taxable year, except that for the first tax year for which the original tax return due date (including extensions) is after August 17, 2006 and not later than December 31, 2006, an election under this paragraph (e)(3)maybemadeonanamendedreturn within 180 days after the original due date (including extensions). (v) through (e)(5)Example 1[Re- served]. For further guidance, see §1.884–1(e)(3)(v) through (e)(5)Example 1. Example 2.Election made to reduce liabilities. (i) As of the close of 2007, foreign corporation A, a real estate company, owns U.S. assets with an E&P 2006–39 I.R.B.527September 25, 2006 basis of $1000. A has $800 of liabilities under para- graph (e)(1) of this section. A has accumulated ECEP of $500 and in 2008, A has $60 of ECEP that it in- tends to retain for future expansion of its U.S. trade or business. A elects under paragraph (e)(3) of this section to reduce its liabilities by $60 from $800 to $740. As a result of the election, assuming A’s U.S. assets and U.S. liabilities would otherwise have re- mained constant, A’s U.S. net equity as of the close of 1994 will increase by the amount of the decrease in liabilities ($60) from $200 to $260 and its ECEP will be reduced to zero. Under §1.884–1(e)(3)(iii), A’s interest expense for the taxable year is reduced by the amount of interest attributable to $60 of liabil- ities and A’s excess interest is reduced by the same amount. A’s taxable income and ECEP are increased by the amount of the reduction in interest expense at- tributable to the liabilities, and A may make an elec- tion under paragraph (e)(3) of this section to further reduce its liabilities, thus increasing its U.S. net eq- uity and reducing the amount of additional ECEP cre- ated for the election. (ii) In 2009, assuming A again has $60 of ECEP, A may again make the election under paragraph (e)(3) to reduce its liabilities. However, assuming A’s U.S. assets and liabilities under paragraph (e)(1) of this section remain constant, A will need to make an elec- tion to reduce its liabilities by $120 to reduce to zero its ECEP in 2009 and to continue to retain for expan- sion (without the payment of the branch profits tax) the $60 of ECEP earned in 2008. Without an election to reduce liabilities, A’s dividend equivalent amount for 2009 would be $120 ($60 of ECEP plus the $60 reduction in U.S. net equity from $260 to $200). If A makes the election to reduce liabilities by $120 (from $800 to $680), A’s U.S. net equity will increase by $60 (from $260 at the end of the previous year to $320), the amount necessary to reduce its ECEP to $0. However, the reduction of liabilities will itself create additional ECEP subject to section 884 because of the reduction in interest expense attributable to the $120 of liabilities. A can make the election to reduce liabil- ities by $120 without exceeding the limitation on the election provided in paragraph (e)(3)(ii) of this sec- tion because the $120 reduction does not exceed the amount needed to treat the 2009 and 2008 ECEP as reinvested in the net equity of the trade or business within the United States. (iii) If A terminates its U.S. trade or business in 2009 in accordance with the rules in §1.884–2T(a), A would not be subject to the branch profits tax on the $60 of ECEP earned in that year. Under paragraph §1.884–1(e)(3)(v) of this section, however, it would be subject to the branch profits tax on the portion of the $60 of ECEP that it earned in 2008 that became accumulated ECEP because of an election to reduce liabilities. (f) through (j)(2)(ii) [Reserved]. For further guidance, see §1.884–1(f) through (j)(2)(ii). PART 602—OMB CONTROL NUMBER UNDER THE PAPERWORK REDUCTION ACT Par. 7. The authority citation for part 602 continues to read as follows: Authority: 26 U.S.C. 7805. Par. 8. In §602.101, paragraph (b) is amended by adding an entry for “§1.882–5T” to the table to read as fol- lows: §601.101 OMB Control numbers. ***** (b) * * * CFR part or section where identified and described Current OMB Control No. ***** 1.882–5T........................................................... 1545–2030 ***** Mark E. Matthews, Deputy Commissioner for Services and Enforcement. Approved August 2, 2006. Eric Solomon, Acting Deputy Assistant Secretary oftheTreasury(TaxPolicy). (Filed by the Office of the Federal Register on August 15, 2006, 8:45 a.m., and published in the issue of the Federal Register for August 17, 2006, 71 F.R. 47443) September 25, 20065282006–39 I.R.B. Part III. Administrative, Procedural, and Miscellaneous Extensi on of Replacement Period f or Livestock Sold on Accoun t of Drought Notice 2006–82 SECTION 1. PURPOSE This not ice provides guidance regard- ing the replacement period under § 1033(e) of the I nternal Revenue Code for livestock sold on account of drought. SECTION 2. BACKGROUND .01Nonrecognition of Gain on Invol- untary Conversion of Livestock. Section 1033(a) generally provides for nonrecog- nition of gain when property is involun- tarily converted and replaced with prop- erty that is similar or related in service or use. Section 1033(e)(1) provides that a sale or exchange of livestock (other than poultry) held by a taxpayer for draft, breed- ing, or dairy purposes in excess of the num- ber that would be sold following the tax- payer’s usual business practices is treated as an involuntary conversion if the live- stock is sold or exchanged solely on ac- count of drought, flood, or other weather- related conditions. .02Replacement Period. Section 1033(a)(2)(A) generally provides that gain from an involuntary conversion is recognized only to the extent the amount realized on the conversion exceeds the cost of replacement property purchased during the replacement period. If a sale or exchange of livestock is treated as an involuntary conversion under § 1033(e)(1) and is solely on account of drought, flood, or other weather-related conditions that re- sult in the area being designated as eligible for assistance by the federal government, § 1033(e)(2)(A) provides that the replace- ment period ends four years after the close of the first taxable year in which any part of the gain from the conversion is realized. Section 1033(e)(2)(B) provides that the Secretary may extend this replacement pe- riod on a regional basis for such additional time as the Secretary determines appro- priate if the weather-related conditions that resulted in the area being designated as eligible for assistance by the federal government continue for more than three years. S ection 1033(e)(2) is effective for any taxa ble year with respect to which the due date (without regard to extensions) for a taxpay er’s return is after December 31, 2002. SECTION 3. EXTENSION OF REPLAC EMENT PERIOD FOR PERSIS TENT DROUGHT .01In G eneral. If a sale or exchange of live stock is treated as an involun- tary co nversion on account of drought and th e taxpayer’s replacement period is deter mined under § 1033(e)(2)(A), the repla cement period will be extended un- der § 1 033(e)(2)(B) until the end of the taxpa yer’s first taxable year ending after the f irst drought-free year for the appli- cabl e region. For this purpose, the first drou ght-free year for the applicable region is th e first 12-month period that— (1) E nds on August 31; (2) E nds in or after the last year of the taxp ayer’s 4-year replacement period de- term ined under § 1033(e)(2)(A); and (3) D oes not include any weekly period for w hich exceptional, extreme, or severe drou ght is reported for any location in the app licable region. .02A pplicable Region. The applicable reg ion with respect to a sale or exchange of liv estock on account ofdrought conditions is t he county that experienced the drought con ditions on account of which the live- sto ck was sold or exchanged and all coun- ti es that are contiguous to that county. .03 Exceptional, Extreme, or Severe Dr ought.(1)U.S. Drought Monitor Maps . At axpayer may determine whether ex- ce ptional, extreme, or severe drought is re ported for any location in the applica- bl e region by reference to U.S. Drought M onitor maps produced by the National D rought Mitigation Center. In determin- i ng whether a 12-month period ending on A ugust 31 of a calendar year includes any p eriod for which exceptional, extreme, o r severe drought is reported, all maps with dates before September 8 of that year and after August 31 of the preced- ing calendar year are taken into account. U.S. Drought Monitor maps are archived athttp://www.drought.unl.edu/dm/ archive.html. (2)Publ ication of List of Drought Countie s. Taxpayers can generally deter- mine on t he basis of a visual inspection of U.S. D rought Monitor maps whether excepti onal, extreme, or severe drought is repo rted for all or part of a county. In some ca ses, however, on the borders of a droug ht zone, it may not be clear on the bas is of a visual inspection whether a count y is within or partly within the zone. Accor dingly, the Internal Revenue Ser- vice, after consultation with the National Droug ht Mitigation Center, will publish in Septe mber of each year a list of counties for w hich exceptional, extreme, or severe drou ght was reported during the preceding 12 mo nths. Taxpayers may use this list inst ead of U.S. Drought Monitor Maps to de termine whether a 12-month period end ing on August 31 of a calendar year inc ludes any period for which exceptional, ext reme, or severe drought is reported for alo cation in the applicable region. SEC TION 4. EXAMPLE The following example illustrates the app lication of the rules in this notice. Dr ought conditions and designations of el igibility for federal assistance are de- sc ribed in this example solely for illus- tr ative purposes and are not intended to re flect actual conditions and designations. Example. (i) Taxpayer A, a calendar year tax- payer, raises cattle in Keith County, Nebraska. In 20 02, all of A’s cattle held for breeding purposes are sold solely on account of drought conditions in Keith County. Under A’s normal business practices, only 2 5 percent of A’s cattle held for breeding purposes would have been sold in 2002. In 2003, the Secre- tary of Agriculture designates Keith County as eligi- b le for federal assistance on account of the drought conditions. (ii) Under § 1033(e)(1), the sale of 75 percent o f the cattle held for breeding purposes is treated as an involuntary conversion. Section 1033(a) provides that the gain from this portion of A’s sale is not rec- ognized except to the extent it exceeds the cost of replacement property (property that is related in ser- vice or use) purchased during the replacement period. Because the Secretary of Agriculture has designated Keith County as being eligible for federal assistance on account of the drought conditions, A’s replace- ment period is determined under § 1033(e)(2)(A) and ends on December 31, 2006. (iii) Under § 1033(e)(2) and this notice, A’s re- placement period is extended until the end of A’s first taxable year ending after the first drought-free year for the applicable region. For this purpose, the applicable region is the county that experienced the drought conditions on account of which the livestock 2006–39 I.R.B.529September 25, 2006 was sold (Keith County) and all counties contiguous to Keith County (Deuel, Garden, Arthur, McPher- son, Lincoln, and Perkins Counties, Nebraska, and Sedgwick County, Colorado). Sedgwick County is contiguous even though it is in a different state and touches Keith County only at Keith County’s south- west corner. (iv) For the 12-month period ending on August 31, 2006, severe drought conditions are reported on U.S. Drought Monitor maps for all counties in the ap- plicable region, and all of those counties are included on the list published by the IRS. For the 12-month period ending on August 31, 2007, the only drought conditions reported for the applicable region on U.S. Drought Monitor maps are severe drought conditions for Sedgwick County for the first week in Septem- ber 2006. A is unable to determine from the maps whether drought conditions have been reported for the applicable region, but the list published by the IRS for the 12-month period ending on August 31, 2007, includes Sedgwick County. For the 12-month period ending August 31, 2008, U.S. Drought Monitor maps do not report drought conditions for any county in the applicable region and none of the counties are in- cluded on the list published by the IRS. (v) Neither the 12-month period ending on Au- gust 31, 2006, nor the 12-month period ending on August 31, 2007, is a drought-free year for the ap- plicable region because, in each of the 12-month periods, severe drought conditions have been re- ported for at least one county in the applicable region for a part of the 12-month period. Accordingly, the 12-month period ending on August 31, 2008, is the first drought-free year for the applicable region. Under § 1033(e)(2) and this notice, A’s replacement period is extended through December 31, 2008 (the last day of A’s first taxable year ending after the first drought-free year for the applicable region). SECTION 5. EFFECTIVE DATE This notice applies to taxable years end- ing after September 25, 2006. SECTION 6. DRAFTING INFORMATION The principal author of this notice is Jeffrey Marshall of the Office of Associate Chief Counsel (Income Tax and Account- ing). For further information regarding this notice, contact Mr. Marshall at (202) 622–7287 (not a toll-free call). 26 CFR 601.105: Examination of returns and claims for refund, credit, or abatement; determination of correct tax liability. (Also Part I, § 42; 1.42–14.) Rev. Proc. 2006–38 SECTION 1. PURPOSE This revenue procedure publishes the amounts of unused housing credit carry- overs allocated to qualified states under § 42(h)(3)(D) of the Internal Revenue Code for calendar year 2006. SECTION 2. BACKGROUND Rev. Proc. 92–31, 1992–1 C.B. 775, provides guidance tostate housing credit agencies of qualified states on the pro- cedure for requesting an allocation of unused housing credit carryovers under § 42(h)(3)(D). Section 4.06 of Rev. Proc. 92–31 provides that the Internal Rev- enue Service will publish in the Internal Revenue Bulletin the amount of unused housing credit carryovers allocated to qualified states for a calendar year from a national pool of unused credit authority (the National Pool). This revenue proce- dure publishes these amounts for calendar year 2006. SECTION 3. PROCEDURE The unused housing credit carryover amount allocated from the National Pool by the Secretary to each qualified state for calendar year 2006 is as follows: Qualified StateAmount Allocated Alabama $119,717 Arizona156,003 California949,059 Connecticut92,203 Delaware22,156 Flori da 467,2 74 Georgia238,303 Illinois335,247 Indiana164,742 Kansas72,093 Kentucky109,620 Mai ne 34, 711 Maryland147,102 Massachusetts168,072 Michigan265,838 Minnesota134,820 Missouri152,353 N ebraska 4 6,197 New Jersey228,988 New York505,748 North Dakota16,723 Oregon95,637 Pennsylvania326,480 Rhode Island28,268 September 25, 20065302006–39 I.R.B. Qualified StateAmount Allocated Tennessee156,625 Texas600,447 Utah64,867 Vermont16,365 Virginia198,770 Washington165,156 Wisconsin145,416 SECTION 4. EFFECTIVE DATE This revenu e procedure is effective for alloca tions of housing credit dollar amounts at tributable to the National Pool component of a qualified state’s housing credit cei ling for calendar year 2006. DRAFTING INFORMATION The princip al author of this revenue procedure is Christopher J. Wilson of the Office of Associate Chief Counsel (Passthro ughs and Special Industries). For further in formation regarding this revenue procedure, contact Mr. Wilson at (202) 622–3040 (not a toll-free call). 2006–39 I.R.B.531September 25, 2006 Part IV. Items of General Interest Notice of Proposed Rulemaking and Notice of Public Hearing Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property REG–168745–03 AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking and notice of public hearing. SUMMARY: This document contains proposed regulations that explain how section 263(a) of the Internal Revenue Code (Code) applies to amounts paid to acquire, produce, or improve tangible property. The proposed regulations clarify and expand the standards in the current regulations under section 263(a), as well as provide some bright-line tests (for ex- ample, a 12-month rule for acquisitions and a repair allowance for improvements). The proposed regulations will affect all taxpayers that acquire, produce, or im- prove tangible property. This document also provides a notice of public hearing on the proposed regulations. DATES: Written or electronic comments must be received by November 20, 2006. Requests to speak and outlines of topics to be discussed at the public hearing sched- uled for Tuesday, December 19, 2006, at 10:00 a.m., must be received by Novem- ber 28, 2006. ADDRESSES: Send submissions to: CC:PA:LPD:PR(REG–168745–03), room 5203, Internal Revenue Ser- vice, POB 7604, Ben Franklin Sta- tion, Washington, DC 20044. Alter- natively, comments may be sent elec- tronically, via the IRS Internet site at www.irs.gov/regsor via the Federal eRule- making Portal atwww.regulations.gov (IRS–REG–168745–03). The public hear- ing will be held in the auditorium of the New Carrollton Federal Building, 5000 Ellin Road, Lanham, MD 20706 at 10:00 a.m. FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, Kimberly L. Koch, (202) 622–7739; concerning submission of comments, the hearing, and/or to be placed on the building access list to at- tend the hearing, Richard A. Hurst at Richard.A.Hurst@irscounsel.treas.govor at (202) 622–7180 (not toll-free numbers). SUPPLE MENTARY INFORMATION: Background In recent years, much debate has fo- cused on the extent to which section 263(a) of the Code requires taxpayers to capital- izeasanimprovementamountspaidtore- store property to its former working con- dition; that is, whether, or the extent to which, the amounts paid to restore or im- prove the property are capital expenditures or deductible ordinary and necessary re- pair and maintenance expenses. There has been controversy, for example, regard- ing what tests to apply for determining capitalization or expensing, how to ap- ply the tests, and the appropriate unit of property with respect to which to apply the tests. On January 20, 2004, the IRS and Treasury Department published No- tice 2004–6, 2004–1 C.B. 308, announc- ing an intention to propose regulations pro- viding guidance in this area. The notice identified issues under consideration by the IRS and Treasury Department and in- vited public comment on whether these or other issues should be addressed in the reg- ulations and, if so, what specific rules and principles should be provided. To respond to various comments and provide a more comprehensive set of rules regarding tan- gible property, the proposed regulations in- clude the treatment of amounts paid to ac- quire or produce tangible property. Explanation of Provisions I.Introduction The proposed regulations under section 263(a) of the Code set forth the general statutory principles of capitalization and provide that capital expenditures generally include amounts paid to sell, acquire, pro- duce, or improve tangible property. The proposed regulations, if promulgated as final regulations, would replace current §§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3 of the Income Tax Regulations. The treat- ment of amounts paid to acquire or create intangibles was addressed with the pub- lication of §§1.263(a)–4 and 1.263(a)–5 in theFederal Registeron January 5, 2004 (T.D. 9107, 2004–1 C.B. 447 [69 FR 436]). Certain sections of the current regula- tions under section 263(a) are proposed to be removed entirely and are not re- stated in the proposed regulations. Section 1.263(a)–1(c) of the current regulations lists several Code and regulation sections to which the capitalization provisions do not apply. Section 1.263(a)–3 (election to deduct or capitalize certain expenditures) lists several Code sections under which a taxpayer may elect to treat certain cap- ital expenditures as either deductible or deferred expenses, or to treat deductible expenses as capital expenditures. These two sections have not been carried over to the proposed regulations because the lists of items in these sections are outdated. This language is intended to have the same general effect as current §§1.263(a)–1(c) and 1.263(a)–3, without citing to specific Code and regulation sections that may have been repealed and without omitting specific Code and regulation sections that may have been added. Certain portions of §1.263(a)–2 of the current regulations(examples of capital expenditures) also are not restated in the proposed regulations, or are incorporated into other sections of the proposed regu- lations. Section 1.263(a)–2(a) of the cur- rent regulations (the cost of acquisition of property with a useful life substantially be- yond the taxable year) is incorporated into and expanded upon in §1.263(a)–2 of the proposed regulations (amounts paid to ac- quire or produce tangible property). Sec- tion 1.263(a)–2(b) ofthe current regula- tions (amounts expended for securing a copyright and plates) is proposed to be removed because these amounts are now addressed by §1.263(a)–4(d)(5) and sec- tion 263A. The rules in §1.263(a)–2(c) of the current regulations (the cost of defend- ing or perfecting title to property) are ad- dressed in §1.263(a)–4(d)(9) of the current regulations with regard to intangibles and September 25, 20065322006–39 I.R.B. in §1.263(a)–2(d)(2) of the proposed reg- ulations with regard to tangible property. Section 1.263(a)–2(d) of the current regu- lations (amounts expended for architect’s services) is proposed to be removed be- cause those amounts are now included in section 263A. The rules in §1.263(a)–2(f) and (g) of the current regulations (relating to certain capital contributions) essentially are restated in §1.263(a)–1(b) of the pro- posed regulations. Finally, §1.263(a)–2(h) of the current regulations (the cost of good- will in connection with the acquisition of the assets of a going concern) is proposed to be removed because this cost is now ad- dressed by §1.263(a)–4(c)(1)(x). Taking into account the provisions that are proposed to be removed and other modifications to the current regulations noted above, the remaining guidance in the current regulations is contained in §1.263(a)–1(a) and (b) of the proposed regulations. Section 1.263(a)–1(a) of the current regulations restates the statutory rules from section 263(a), which are car- ried over in §1.263(a)–1(a) of the proposed regulations. The rules in §1.263(a)–1(b) of the current regulations address amounts paid to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, and amounts paid to adapt property to a new or different use. They also address the treatment of those cap- italized expenditures, for example, as a charge to capital account or basis. These rules are incorporated into and expanded upon in §1.263(a)–3 of the proposed reg- ulations. The proposed regulations also revise §1.162–4 of the current regulations (allowing a deduction for the cost of inci- dental repairs) to provide rules consistent with §1.263(a)–3 of the proposed regula- tions (requiring capitalization of amounts paid to improve property). The proposed regulations do not ad- dress amounts paid to acquire or cre- ate intangible interests in land, such as easements, life estates, mineral interests, timber rights, zoning variances, or other intangible interests in land. The IRS and Treasury Department request comments on whether these and similar amounts, or certain of these amounts, should be ad- dressed in the final regulations and, if so, what rules should be provided. The pro- posed regulations also do not address the treatment of software development costs. II.General Principle of Capitalization A.Overview The proposed regulations require capi- talization of amounts paid to acquire, pro- duce, or improve tangible real and personal property, including amounts paid to facil- itate the acquisition of tangible property. The proposed regulations do not address amounts paid to facilitate an acquisition of a trade or business because those amounts are addressed in §1.263(a)–5 of the current regulations. The proposed regulations clarify that they do not change the treatment of any amount that is specifically provided for under any provision of the Code or regula- tions other than section 162(a) or section 212 and the regulations under those sec- tions. This rule applies regardless of whether that specific provision is more or less favorable to the taxpayer than the treatment in the proposed regula- tions. Thus, where another section of the Code or regulations prescribes a specific treatment of an amount, the provisions of that section apply and not the rules contained in the proposed regulations. This rule is the same as that contained in §§1.263(a)–4(b)(4) and 1.263(a)–5(j) of the current regulations. The proposed regulations, for example, do not preclude taxpayers from deducting the cost of cer- tain depreciable business assets under sec- tion 179. On the other hand, the proposed regulations do not exempt taxpayers from applying the uniform capitalization rules under section 263A when applicable, nor do they exempt taxpayers from complying with the timing rules regarding incurring a liability under section 461 (including economic performance). The rule clarifying that the proposed regulations do not change the treatment of any other amount that is specifically pro- vided for under any other provision of the Code or regulations provides an excep- tion for the treatment of any amount that is specifically provided for under section 162(a) or section 212 or the regulations under those sections. Thus, the proposed regulations override any conflicting pro- visions in the regulations under sections 162(a) and 212. For this reason, the pro- posed regulations amend the current rule for deductible repairs under §1.162–4 to provide that amounts paid for repairs and maintenance to tangible property are de- ductible if the amounts paid are not re- quired to be capitalized under §1.263(a)–3 of the proposed regulations. The proposed regulations, however, do not amend or re- move any other provisions of the current regulations under section 162(a), includ- ing §§1.162–6 (regarding professional ex- penses) and 1.162–12 (regarding certain expenses of farmers). Section 1.162–6 permits a deduction for amounts paid for books, furniture, and professional instru- ments and equipment, the useful life of which is short, while §1.162–12 permits a deduction for the cost of ordinary tools of short life or small cost. The rules in cur- rent §§1.162–6 and 1.162–12 are consis- tent with the rules in the proposed regula- tions and are not revised. B.Amounts paid to sell property The proposed regulations provide that, except in the case of dealers in property, commissions and other transaction costs paid to facilitate the sale of property gen- erally must be capitalized and treated as a reduction in the amount realized. Dealers in property include taxpayers that main- tain and sell inventories and taxpayers that produce property for sale in the ordinary course of business, for example, the home construction business. The language in this section is slightly broader than the current language of §1.263(a)–2(e), which refers only to commissions paid in sell- ing securities. However, the language in the proposed regulations is consistent with case law that generally treats all trans- action costs paid in connection with the sale of any property as capitalized and offset against the amount realized. See, Wilson v. Commissioner,49T.C.406,414 (1968); rev’d on other grounds, 412 F.2d 314 (6 th Cir. 1969) (“The rule is thor- oughly engrained that commissions and similar charges must be treated as capi- tal expenditures which reduce the selling price when gain or loss is computed on the transaction”);Frick v. Commissioner, T.C. Memo 1983–733, aff’d without opin- ion, 774 F.2d 1168 (7 th Cir. 1985) (“Fees paid in connection with the disposition of real property are capital expenditures and are deductible from the selling price in de- termining gain or loss on the ultimate dis- position”);Hindes v. United States,246 F. Supp. 147, 150 (W.D. Tex. 1965); affd. 2006–39 I.R.B.533September 25, 2006 in part, revd. in part on other grounds, 371F.2d650(5 th Cir. 1967) (“Fees and expenses paid in connection with the ac- quisition or disposition of property, real or personal, are capital expenditures, and, in the case of a taxpayer not engaged in the business of buying and selling real es- tate, are deductible from the selling price in determining gain or loss on the ulti- mate disposition”). The sales cost rule in the proposed regulations, however, applies only to transaction costs and does not in- clude other amounts that might be paid for the purpose of selling property, such as amounts paid to repair or improve the property in preparation for a sale. The treatment of those amounts is governed by the general rules under §1.263(a)–3 of the proposed regulations relating to improve- ments. III.Amounts Paid to Acquire or Produce Tangible Property A.In general The current regulations under section 263(a) require capitalization of amounts paid for the acquisition, construction, or erection of buildings, machinery and equipment, furniture and fixtures, and similar property having a useful life sub- stantially beyond the taxable year. See §1.263(a)–2(a) of the current regulations. The proposed regulations are consistent with this rule, but treat amounts paid to construct or erect property as production costs. Specifically, the proposed regu- lations require capitalization of amounts paid for property having a useful life sub- stantially beyond the taxable year, includ- ing land and land improvements, build- ings, machinery and equipment, and fur- niture and fixtures, and a unit of property (as determined under §1.263(a)–3(d)(2)), having a useful life substantially beyond the taxable year. See §1.263(a)–2(d) of the proposed regulations. Thus, §1.263(a)–2 of the proposed regulations requires cap- italization of amounts paid for property that is not itself a unit of property, such as property (not treated as a material or supply under §1.162–3) that is intended to be used as a component in the repair or improvement of a unit of property. Additionally, the current regulations at §1.263(a)–1(b) list inventory costs as cap- ital expenditures under §1.263(a)–1(a). Therefore, §1.263(a)–2 of the proposed regulations also requires capitalization of amounts paid to acquire real or personal property for resale and to produce real or personal property for sale. The proposed regulations provide that the termsamounts paidandpayment mean, in the case of a taxpayer using an accrual method of accounting, a li- ability incurred (within the meaning of §1.446–1(c)(1)(ii)). The definitions of real and tangible personal property are intended to be the same as the defini- tions used for depreciation purposes as derived from the language in the regula- tions at §1.48–1. Thus, for purposes of the proposed regulations, tangible personal property means any tangible property except land and improvements thereto, such as buildings or other inherently per- manent structures (including items that are structural components of buildings or structures). See,Whiteco Indus., Inc. v. Commissioner, 65 T.C. 664 (1975) (ap- plying six factors in determining whether property is an inherently permanent struc- ture). Under the proposed regulations, the definitions of building and structural components are the definitions provided in §1.48–1(e). The IRS and Treasury De- partment considered other definitions of real and tangible personal property, in- cluding the definitions in the regulations under section 263A(f), but believe that the definitions used for depreciation purposes are the definitions most consistent with the purposes of the proposed regulations. The definition of produce in §1.263(a)–2(b)(4) of the proposed reg- ulations is intended to be the same as the definition used for purposes of sec- tion 263A(g)(1) and §1.263A–2(a)(1)(i), except that improvements are separately defined in §1.263(a)–3 of the proposed regulations. The costs that are required to be capitalized to property produced or to any improvement are the costs that must be capitalized under section 263A. Thus, for example, all direct materials and direct labor, and all indirect costs that directly benefit or are incurred by reason of production/improvement activities are required to be capitalized to the property being produced or improved. The proposed regulations require tax- payers to capitalize an amount paid to de- fend or perfect title to tangible property. This rule is consistent with the current reg- ulations at §1.263(a)–2(c) and parallels the rule in §1.263(a)–4(d)(9) with regard to in- tangible property. The proposed regula- tions also require capitalization of amounts paid to facilitate the acquisition of real or personal property. The IRS and Treasury Department request comments on whether any specific guidance is needed with re- gard to employee compensation and over- head costs that facilitate the acquisition of tangible property and, if so, what that guid- ance should provide. The proposed reg- ulations do not address transaction costs related to the production or improvement of tangible property because those costs are subject to capitalization under section 263A. B.Materials and supplies As noted in section II.A. above, the proposed regulations generally do not change the treatment of any amount that is specifically provided for under any provi- sion of the Code or regulations other than section 162(a) or section 212 and the reg- ulations under those sections. However, with regard to section 162(a), the pro- posed regulations provide an exception for amounts paid for materials and supplies that are properly treated as deductions or deferred expenses, as appropriate, under §1.162–3. Thus, the proposed regulations do not change the treatment of materials and supplies under §1.162–3, including property that is treated as a material and supply that is not incidental under Rev. Proc. 2002–28, 2002–1 C.B. 815 (regard- ing the use of the cash method by certain qualifying small business taxpayers), Rev. Proc. 2002–12, 2002–1 C.B. 374 (regard- ing smallwares), and Rev. Proc. 2001–10, 2001–1 C.B 272 (regarding inventory of certain qualifying taxpayers). C.12-month rule The current regulations under sec- tions 263(a), 446, and 461 require tax- payers to capitalize amounts paid to ac- quire property having a useful life sub- stantially beyond the taxable year. See §§1.263(a)–2(a), 1.446–1(c)(1)(ii), and 1.461–1(a)(2)(i) of the current regulations. Section 1.263(a)–2(d) of the proposed reg- ulations retains this general rule. Some courts have adopted a 12-month rule for determining whether property has a use- ful life substantially beyond the taxable September 25, 20065342006–39 I.R.B. year. SeeMennuto v. Commissioner,56 T.C. 910 (1971), acq. (1973–2 C.B. 2); Zelco, Inc. v. Commissioner, 331 F.2d 418 (1 st Cir. 1964);International Shoe Co. v. Commissioner, 38 B.T.A. 81 (1938). Under the 12-month rule adopted by some courts, a taxpayer may deduct currently an amount paid for a benefit or paid for property having a useful life that does not extend beyond one year. This rule was adopted in the regulations relating to intangibles. See §1.263(a)–4(f). The proposed regulations provide a similar 12-month rule for amounts paid to acquire or produce certain tangible property. The proposed regulations generally provide that an amount (including trans- action costs) paid for the acquisition or production of a unit of property with an economic useful life of 12 months or less is not a capital expenditure. The unit of property and economic useful life determi- nations are made under the rules described in §1.263(a)–3 for improved property. The 12-month rule generally applies un- less the taxpayer elects not to apply the 12-month rule, which election may be made with regard to each unit of property that the taxpayer acquires or produces. An election not to apply the 12-month rule may not be revoked. Taxpayers that have elected to use the original tire capitaliza- tion method of accounting for the cost of certain tires under Rev. Proc. 2002–27, 2002–1 C.B. 802, must use that method for the original and replacement tires of all their qualifying vehicles. See section 5.01 of Rev. Proc. 2002–27. Therefore, taxpayers that use that method cannot use the 12-month rule provided under the pro- posed regulations to deduct amounts paid to acquire original or replacement tires. The proposed regulations clarify the in- teraction of the 12-month rule with the tim- ing rules contained in section 461 of the Code. Nothing in the proposed regula- tions is intended to change the application of section 461, including the application of the economic performance rules in sec- tion 461(h). This coordination rule is the same as that provided in the regulations under section 263(a) relating to intangi- bles. See §1.263(a)–4(f). In the case of a taxpayer using an accrual method of ac- counting, section 461requires that an item be incurred before it is taken into account through capitalization or deduction. For example, under §1.461–1(a)(2), a liabil- ity generally is not incurred until the tax- able year in which all the events have oc- curred that establish the fact of the liabil- ity, the amount of the liability can be deter- mined with reasonable accuracy, and eco- nomic performance has occurred with re- spect to the liability. Thus, the 12-month rule provided by the proposed regulations does not permit an accrual method tax- payer to deduct an amount paid for tan- gible property if the amount has not been incurred under section 461 (for example, if the taxpayer does not have a fixed lia- bility to acquire the property). The pro- posed regulations contain examples illus- trating the interaction of the 12-month rule with section 461. The proposed regulations provide that, upon a sale or other disposition, property to which a taxpayer applies the 12-month rule is not treated as a capital asset under sec- tion 1221 or as property used in the trade or business under section 1231. Thus, 12-month property is not of a character subject to depreciation and any amount re- alized upon disposition of 12-month prop- erty is ordinary income to the taxpayer. The IRS and Treasury Department do not believe that it is appropriate to apply the 12-month rule to certain types of prop- erty. Thus, the proposed regulations pro- vide that the 12-month rule does not apply to property that is or will be included in property produced for sale or property ac- quired for resale, improvements to a unit of property, land, or a component of a unit of property. D.De minimis rule In Notice 2004–6, the IRS and Trea- sury Department requested comments on whether the regulations should provide ade minimisrule. Because the notice refers to the application of section 263(a) to amounts paid to repair, improve, or rehabilitate tangible property, most com- mentators focused on ade minimisrule for the cost of repairs rather than the cost to acquire property. However, one com- mentator requested that the regulations specifically provide ade minimisrule for acquisition costs, but allow taxpayers to continue to use their current method if they have reached a working agreement with their IRS examining agent regarding ade minimisrule. The IRS and Treasury Department rec- ognize that for regulatory or financial ac- counting purposes, taxpayers often have a policy for deducting an amount paid below a certain dollar threshold for the acquisi- tion of tangible property (de minimisrule). For Federal income tax purposes, the tax- payer generally would be required to capi- talize the amount paid if the property has a useful life substantially beyond the taxable year. However, in this context some courts have permitted the use of ade minimis rule for Federal income tax purposes. See Union Pacific R.R. Co. v. United States, 524 F.2d 1343 (Ct. Cl. 1975) (permitting the use of the taxpayer’s $500de minimis rule, which was in accordance with the Interstate Commerce Commission (ICC) minimum rule and generally accepted ac- counting principles);Cincinnati, N.O. & Tex. Pac. Ry. v. United States,424 F.2d 563 (Ct. Cl. 1970) (same). But seeAlacare Home Health Services, Inc. v. Commissioner, T.C. Memo 2001–149 (dis- allowing the taxpayer’s use of a $500de minimisrule because it distorted income). The proposed regulations do not in- clude ade minimisrule for acquisition costs. However, the IRS and Treasury Department recognize that taxpayers often reach an agreement with IRS examining agents that, as an administrative matter, based on risk analysis and/or materiality, the IRS examining agents do not select certain items for review such as the ac- quisition of tangible assets with a small cost. This often is referred to by taxpayers and IRS examining agents as ade minimis rule. The absence of ade minimisrule in the proposed regulations is not intended to change this practice. The IRS and Treasury Department con- sidered including ade minimisrule in the proposed regulations. Thede minimisrule considered would have provided that tax- payers are not required to capitalize cer- tainde minimisamounts paid for the acqui- sition or production of a unit of property. Under the rule considered, if a taxpayer had written accounting procedures in place treating as an expense on its applicable fi- nancial statement (AFS) amounts paid for property costing less than a certain dollar amount, and treated the amounts paid dur- ing the taxable year as an expense on its AFS in accordance with those written ac- counting procedures, the taxpayer would not have been required to capitalize those 2006–39 I.R.B.535September 25, 2006 amounts if they did not exceed a certain dollar threshold. A taxpayer that did not meet these criteria (for example, a taxpayer that did not have an AFS) would not have been required to capitalize amounts paid for a unit of property that did not exceed the established dollar threshold. Because taxpayers without an AFS generally are smaller than taxpayers with an AFS, the dollar threshold for thede minimisrule that would have applied to them would have been lower than the threshold for taxpay- ers with an AFS (although thede minimis rule for taxpayers with an AFS also would have been limited to the amount treated as an expense on their AFS). Thede minimis rule considered by the IRS and Treasury Department would not have applied to in- ventory property, improvements, land, or a component of a unit of property. Thede minimisrule considered also would have provided that property to which a taxpayer applies thede minimis rule is treated upon sale or disposition similar to section 179 property. Thus,de minimisproperty would have been prop- erty of a character subject to depreciation and amounts paid that were not capital- ized under thede minimisrule would have been treated as amortization subject to recapture under section 1245. Thus, gain on disposition of the property would have been ordinary income to the taxpayer to the extent of the amount treated as amorti- zation for purposes of section 1245. The IRS and Treasury Department de- cided to not include ade minimisrule in the proposed regulations but instead to request comments on whether such a rule should be included in the final regu- lations or whether to continue to rely on the current administrative practice of IRS examining agents. Therefore, the IRS and Treasury Department request comments on whether ade minimisrule for acquisi- tion costs should be included in the final regulations, and, if so, whether thede minimisrule should be the rule described above and what dollar thresholds are ap- propriate. The IRS and Treasury Department also request comments on the scope of costs that should be included in ade minimis rule if one is provided in the final regula- tions and on the character ofde minimis rule property. For example, thede min- imisrule considered by the IRS and Trea- sury Department would have applied to the aggregate of amounts paid for the acquisi- tion or production (including any amounts paid to facilitate the acquisition or produc- tion)ofaunitofpropertyandincluding amounts paid for improvements prior to the unit of property being placed in service. If ade minimisrule should be provided in the final regulations, the IRS and Treasury Department request comments on what, if any, type of rule should be provided to pre- vent a distortion of income when taxpay- ers acquire a large number of assets, each of which individually is within thede min- imisrule (for example, the purchase by a taxpayer of 2,000 personal computers). If ade minimisrule for acquisition costs should be provided in the final regulations, the IRS and Treasury Department request comments on whether the rule should per- mit IRS examining agents and taxpayers to agree to the use of higherde minimis thresholds on the basis of materiality and risk analysis and, if so, under what circum- stances a higher threshold should be al- lowed. The IRS and Treasury Department also request comments on whether, if ade minimisrule should be provided in the fi- nal regulations, changes to begin using ade minimisrule or changes to a higher dollar amount within ade minimisrule should be treated as changes in a method of account- ing. E.Recovery of costs when property is used in a repair AsnotedinsectionIII.A.ofthispre- amble, §1.263(a)–2 of the proposed regu- lations generally requires capitalization of amounts paid for the acquisition or produc- tion of property having a useful life sub- stantially beyond the taxable year. Thus, §1.263(a)–2(d) of the proposed regulations applies to property that is not itself a unit of property, such as property (not treated as a material or supply under §1.162–3) that is intended to be used as a component in the repair or improvement of a unit of property. It must be determined whether the subsequent use of the component prop- erty results in an improvement to the unit of property under §1.263(a)–3 or an oth- erwise deductible repair or maintenance cost under §1.162–4. Even if the subse- quent use of the component is an otherwise deductible expense under §1.162–4, the amount paid nonetheless may be required to be capitalized. For example, it must be determined whether the amount paid for the component property is required to be capitalized under section 263A as an indi- rect cost that directly benefits or is incurred by reason of property produced or acquired for resale. The proposed regulations illus- trate this concept in an example of a man- ufacturer that replaces one window in a building. The taxpayer initially must cap- italize under §1.263(a)–2(d) amounts paid to acquire the window. The replacement of the window subsequently is determined to be a repair to the building rather than an improvement. Amounts paid for the re- pair (or an allocable portion thereof) must then be capitalized under section 263A to the inventory that the taxpayer produces to the extent that the repair directly benefits or is incurred by reason of the taxpayer’s production activities. IV.Amounts Paid to Improve Tangible Property A.In general In response to Notice 2004–6, the IRS and Treasury Department received several comments on the issues that should be ad- dressed in the proposed regulations to pro- vide guidance on amounts paid to repair, improve, and rehabilitate tangible prop- erty. These comments have been taken into account in drafting §1.263(a)–3 of the proposed regulations. That section ad- dresses amounts paid to improve tangible property and includes the following pro- visions: (1) rules for determining the ap- propriate unit of property to which the im- provement provisions apply; (2) general rules for improvements; (3) rules for de- termining whether an amount paid mate- rially increases the value of the unit of property; (4) rules for determining whether an amount paid restores the unit of prop- erty; and (5) an optional repair allowance method. B.Unit of property rules 1.In general A threshold issue in applying the im- provement rules under §1.263(a)–3 of the proposed regulations is determining the appropriate unit of property to which the rules should be applied. For example, to determine whether an amount paid ma- terially increases the value of property, it September 25, 20065362006–39 I.R.B. is necessary to know what property is at issue. The smaller the unit of property, the more likely it is that amounts paid in connection with that unit of property will materially increase the value of, or restore, the property. Taxpayers and the IRS frequently disagree on the unit of property to which thecapitalization rules should be applied. Thus, the unit of prop- erty rules in the proposed regulations are intended to provide guidance in deter- mining whether an amount paid improves the unit of property under §1.263(a)–3. The unit of property rules also apply for purposes of §1.263(a)–1 of the proposed regulations (which references the rules in §§1.263(a)–2 and 1.263(a)–3 of the pro- posed regulations) and §1.263(a)–2 of the proposed regulations (for example, with regard to the 12-month rule). The unit of property rules in the proposed regula- tions apply only for purposes of section 263(a) and §§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3 of the proposed regulations, and not any other Code or regulation sec- tion. For example, no inference is intended that these unit of property rules have any application for section 263A(f) interest capitalization purposes. The current regulations under section 263(a) do not provide any guidance on de- termining the appropriate unit of property. Some courts have addressed the unit of property issue under section 263(a), but their holdings are based on the particu- lar facts of each case and do not contain rules that are generally applicable for pur- poses of section 263(a). See,FedEx Corp. v. United States, 291 F. Supp. 2d 699 (W.D. Tenn. 2003), aff’d, 412 F.3d 617 (6 th Cir. 2005) (concluding that an aircraft, and not the aircraft engine, was the appro- priate unit of property);Smith v. Commis- sioner, 300 F.3d 1023 (9 th Cir. 2002) (con- cluding that an aluminum reduction cell, rather than entire cell line, was the ap- propriate unit of property);Ingram Indus- tries, Inc. v. Commissioner, T.C. Memo 2000–323 (concluding that a towboat, and not the towboat engine, was the appropri- ate unit of property);LaSalle Trucking Co. v. Commissioner, T.C. Memo 1963–274 (concluding that truck engines, tanks, and cabs were each separate units of property). InFedEx, the court ruled on whether an aircraft engine or the entire aircraft was the appropriate unit of property for deter- mining whether the costs of engine shop visits (ESVs) must be treated as capital expenditures. Relying on the opinions in IngramandSmith, the court concluded that the following four factors were relevant in determining the appropriate unit of prop- erty: (1) whether the taxpayer and the in- dustry treat the component part as a part of a larger unit of property for regulatory, market, management, or accounting pur- poses; (2) whether theeconomic useful life of the component part is coextensive with theeconomicusefullifeofthelargerunit of property; (3) whether the larger unit of property and the smaller unit of property can function without each other; and (4) whether the component part can be and is maintained while affixed to the larger unit of property. Applying these factors to air- craft engines, the court concluded that the engines should not be considered a unit of property separate and apart from the air- plane. In Notice 2004–6, the IRS and Trea- sury Department requested comments on the relevance of various unit of property factors derived fromFedExand other cases that addressed the unit of property issue. The factors listed in Notice 2004–6 in- cluded: (1) whether the property is man- ufactured, marketed,or purchased sepa- rately; (2) whether the property is treated as a separate unit by a regulatory agency, in industry practice, or by the taxpayer in its books and records; (3) whether the property is designed to be easily removed from a larger assembly, is regularly or pe- riodically replaced, or is one of a fungi- ble set of interchangeable or rotable assets; (4) whether the property must be removed from a larger assembly to be fixed or im- proved; (5) whether the property has a dif- ferent economic life than the larger assem- bly; (6) whether the property is subject to a separate warranty;(7) whether the prop- erty serves a discrete purpose or functions independently from a larger assembly; or (8) whether the property serves a dual pur- pose function. The IRS and Treasury Department received nine comments on the unit of property issue, fourof which specifically recommended that the proposed regula- tions adopt the factors used by the court inFedEx. These factors essentially are containedinfactors1,2,4,5,and7of Notice 2004–6. Several of the factors listed in Notice 2004–6 have been in- corporated into the proposed regulations. However, the IRS and Treasury Depart- ment determined that some factors were not relevant for certain types of property. For example, the factors listed in Notice 2004–6 primarily derive from case law that addresses tangible personal property; therefore, the factors were not as help- ful in determining the appropriate unit of property for real property, such as land. Further, some types of property lend them- selves to specific unit of property rules, such as buildings and property owned by taxpayers in a regulated industry. The IRS and Treasury Department believe that the administrative burden associated with determining the appropriate unit of property can be reduced for both the IRS and taxpayers by identifying specific rules reflecting an approach appropriate for the taxpayer’s industry and the type of property at issue. Therefore, the proposed regulations provide different unit of prop- erty rules for four categories of property, rather than prescribing one rule for all types of property. The unit of property rules in the pro- posed regulations apply to all real and personal property other than network assets. For purposes of the unit of prop- erty rules,network assetsmeans railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective in- dustries. Network assets include, for example, trunk and feeder lines, pole lines, and buried conduit. They do not include property that would be included as a structural component of a building un- der §1.263(a)–3(d)(2)(iv) of the proposed regulations, nor do they include separate property that is adjacent to, but not part of a network asset, such as bridges, culverts, or tunnels. The proposed regulations do not affect current guidance that addresses the unit of property or capitalization rules for network assets, such as Rev. Proc. 2001–46, 2001–2 C.B. 263 (track main- tenance allowance method for Class I railroads); Rev. Proc. 2002–65, 2002–2 C.B. 700 (track maintenance allowance method for Class II and III railroads); and Rev. Proc. 2003–63, 2003–2 C.B. 304 (safe harbor unit of property rule for ca- ble television distribution systems). The IRS and Treasury Department request comments on the relevant rules for deter- 2006–39 I.R.B.537September 25, 2006 mining the appropriate unit of property for network assets. Additionally, the IRS and Treasury Department request comments on whether to include rules for network assets in final regulations, or whether to develop for network assets industry-spe- cific guidance that is similar to the above referenced revenue procedures. With the exception of network assets, the four categories of property in the pro- posed regulations are intended to cover all real and personal property. In addition to the four categories of property, the unit of property rules provide for an initial unit of property determination, which, except with regard to buildings and structural components, is made prior to categorizing the property. The initial unit of property determination is based on the functional interdependence test in §1.263A–10(a)(2), relating to the capitalization of interest. The initial unit of property determina- tion is intended to be a common-sense approach to defining the largest possible unit of property as a starting point for analyzing the rules under one of the four relevant unit of property categories. After the initial unit of property is determined, the additional unit of property rules are intended to result in a determination that either confirms the initial unit of property as the unit of property, or that separates one or more components of the initial unit of property into separate units of property. Some commentators suggested that the functional interdependence test un- der §1.263A–10(a)(2) regarding interest capitalization should be the sole test for determining the appropriate unit of prop- erty. The IRS and Treasury Department believe that the functional interdepen- dence test is a relevant, but not dispositive factor. The purpose of that test under §1.263A–10(a)(2) is to calculate the ap- propriate unit of property for determining the accumulated production expenditures at the beginning and end of the production period. The preamble that accompanied the promulgation of §1.263A–10 discusses the reasoning for adopting a broad formu- lation of the unit of property definition and states that “this concept of single property may differ from the concept of single or separate property that taxpayers use for other purposes (e.g., for comput- ing amounts of depreciation deductions or separately tracking the bases of assets).” T.D. 8584, 1995–1 C.B. 20, 25; [59 FR 67, 187] Dec. 29, 1994). In contrast to the unit of property rules in §1.263A–10(a)(2), the purpose of the unit of property rules under section 263(a) is to provide a starting point for determin- ing whether an amount paid materially in- creases the value of, or restores, the unit of property. Thus, §1.263A–10(a)(2) has a different purpose than the proposed reg- ulations under section 263(a). Further, in determining the appropriate unit of prop- erty for purposes of section 263(a), the functional interdependence test does not always produce appropriate results. For example, a taxpayer might argue that ap- plication of that test results in an entire complex of structures and machinery, such as an entire power plant, being treated as a single unit of property. The IRS and Trea- sury Department do not believe that result is correct for purposes of section 263(a). After the initial unit of property deter- mination is made, the unit of property anal- ysis continues with determining the ap- propriate category of property and apply- ing the rules in that category. The pro- posed regulations provide specific rules for four categories of property: (1) prop- erty owned by taxpayers in a regulated in- dustry; (2) buildings and structural com- ponents; (3) other personal property; and (4) other real property. The unit of prop- erty determination made under the appli- cable category is then subject to an ad- ditional rule in §1.263(a)–3(d)(2)(vii) re- garding treatment for other Federal income tax purposes. The rules for each of the four categories are explained below. 2.Category I: Taxpayers in regulated industries The first unit of property category in the proposed regulations is property owned by taxpayers in a regulated industry. The pro- posed regulations provide that if the tax- payer is in an industry for which a Federal regulator has a uniform system of accounts (USOA) identifying a particular unit of property, the taxpayer must use the same unit of property for Federal income tax purposes, regardless of whether the tax- payer is subject to the regulatory account- ing rules of the Federal regulator and re- gardless of whether the property is par- ticular to that industry. This rule derives from one of the factors cited by the court in FedExfor determining the appropriate unit of property — whether the taxpayer and the industry treat the component part as part of the larger unit of property for regu- latory, market, management, or accounting purposes. Thus, this rule ties into the reg- ulatory accounting element of theFedEx factor, as well as the general concept of in- dustry practice. The IRS and Treasury De- partment are aware of three Federal regula- tors that provide a USOA: (1) the Federal Energy Regulatory Commission (FERC); (2) the Federal Communications Commis- sion (FCC); and (3) the Surface Trans- portation Board (STB). Accordingly, this unit of property category applies to taxpay- ers such as power companies, telecommu- nications companies, and railroads. The IRS and Treasury Department de- termined that the regulatory accounting rule should be applied similarly to all tax- payers in industries for which a Federal regulator provides a USOA, regardless of whether the taxpayer is subject to the regulatory accounting rules of the Federal regulator. This rule is consistent with the general standard of using industry prac- tice to determine the appropriate unit of property. Further, it results in all taxpayers within a specific industry being treated the same for Federal income tax purposes, without regard to whether a particular tax- payer is subject to the accounting rules of the Federal regulator. The rule is limited to the regulator’s USOA and does not ap- ply to other Federal regulatory rules, such as rules concerning safety or health. The proposed regulations apply only to USOA provided by Federal regulators and do not apply to USOA issued by any state or local agencies. Rules of state and local agencies may be different than Federal regulatory rules and can vary widely within an indus- try depending on the taxpayer’s location. Four of the commentators on this aspect of Notice 2004–6 recommended adopting the four factors cited inFedEx,fromwhich the regulated industry rule was derived. None of the commentators specifically ob- jected to a regulatory accounting rule, al- though one commentator suggested that where cost recovery is determined for non- tax purposes by a Federal or state agency, the regulations should provide a special election that may be made on an annual ba- sis under which the taxpayer may use the same unit of property for tax purposes as it must use for regulatory purposes. The IRS September 25, 20065382006–39 I.R.B. and Treasury Department believe the unit of property inquiry should result in one clear determination that will be used con- sistently by the taxpayer unless the under- lying facts change and, therefore, do not believe an annual election is appropriate. 3.Category II: Buildings and structural components In general, a building and its struc- tural components must be treated as one unit of property. This rule is based on the definitions ofbuildingandstructural componentin the regulations under sec- tion 48. The repair allowance regulations under the Class Life Asset Depreciation Range (CLADR) system also provide that a building and its structural components generally are a single unit of property. See §1.167(a)–11(d)(2)(vi). The IRS and Treasury Department believe that these definitions are useful in determining the appropriate unit of property for buildings and structural components. One com- mentator specifically requested that the proposed regulations use the definition of building under §1.48–1(e) to determine a unit of property. The proposed regu- lations rely on the definition of building under §1.48–1(e). Property located inside a building that is not a structural com- ponent of the building must be analyzed under one of the other three unit of prop- erty categories; for example, machinery and equipment inside a factory must be analyzed under Category III (the other personal property category). This Category II is the only category to which the initial unit of property de- termination does not apply. Applying the functional interdependence test to a building would raiseissues in cases where certain floors or portions of a building are placed in service independently of an- other. The IRS and Treasury Department believe that, unless the additional rule in §1.263(a)–3(d)(2)(vii) of the proposed regulations (regarding treatment for other Federal income tax purposes) applies to require a component of a building to be treated as a separate unit of property, the building and its structural components should be the unit of property. The IRS and Treasury Department recognize, how- ever, that it is not always appropriate to treat the entire building as the unit of prop- erty. For example, a taxpayer who owns a unit in a condominium building, whether the unit is used for personal or investment purposes, should not treat the entire build- ing as the unit of property. Therefore, the IRS and Treasury request comments on how the unit of property rules should apply to condominiums, cooperatives, and similar types of property. 4.Category III: Other personal property The unit of property determination for personal property not included in Category I (taxpayers in a regulated industry) is a facts and circumstances test, based on four exclusive factors, none of which is dispos- itive or weighs more heavily than the oth- ers. a. Factor 1: Marketplace treatment factor The first exclusive factor is whether the component is (1) marketed separately to or acquired or leased separately by the taxpayer (from a party other than the seller/lessor of the property of which the component is a part) at the time it is ini- tially acquired or leased; (2) subject to a separate warranty contract (from a party other than the seller/lessor of the property of which the component is a part); (3) sub- ject to a separate maintenance manual or written maintenance policy; (4) appraised separately; or (5) sold or leased separately by the taxpayer to another party. This factor contains a number of items intended to determine the treatment in the market- place of the component as a separate unit of property. Whether the component is acquired separately was a factor addressed by the courts inFedExandIngram,andisalso part of the CLADR repair allowance reg- ulations under section 167 and the unit of property determination for interest capi- talization in §1.263A–10. InFedEx,the court discussed this issue in the context of whether the taxpayer and the industry treat the component part as part of the larger unit of property for regulatory, market, management, or accounting purposes. In finding that the aircraft engines were not purchased separately, the court relied on the fact that the engines and aircraft were designed to be compatible and were gen- erally acquired by the taxpayer at the same time. The court disregarded the fact that the taxpayer purchased the engines and airframes from different sellers when the aircraft were initially acquired. The IRS and Treasury Department believe that the acquisition of a component from a differ- ent seller at the time the larger property is acquired should be a relevant factor, and that the same rule should apply if the taxpayer leases the component from a different party than the seller of the larger property. The IRS and Treasury Department rec- ognize that this factor may produce differ- ent results depending on whether the prop- erty is new or used. When a taxpayer ac- quires or leases used property, it is possible that items that were separate units of prop- erty when purchased new will be treated as one unit of property because the ini- tial purchaser has assembled the units into one functional item that it sells or leases. The IRS and Treasury Department consid- ered whether it was appropriate to have a factor that could treat new and used prop- erty differently, and decided that the differ- ence reasonably reflects the substance of the transactions — where the taxpayer ac- quires or leases a component from a differ- ent party from whom it acquires or leases the larger property, the taxpayer typically is conducting different, but related, trans- actions with separately negotiated terms. Whether the component is subject to a separate warranty contract, maintenance manual, or written maintenance policy was cited as a factor inFedExand is adopted as part of the marketplace treatment factor in the proposed regulations. The warranty contract factor applies only to a warranty that is provided by a party other than the seller/lessor of the larger property. It is not intended to apply to a warranty provided by the sellor/lessor that may contain sepa- rate warranties (for example, for different time periods) on various components of the larger property. Whether the property is manufactured separately was a possi- ble factor cited in Notice 2004–6. The proposed regulations do not specifically adopt this factor because components that are subject to a separate warranty or main- tenance procedures also are likely to be manufactured separately. TheFedExcase used as a factor whether the component was appraised or valued separately and the CLADR repair allowance regulations under section 167 addressed whether the component was sold separately to another party. The proposed regulations adopt 2006–39 I.R.B.539September 25, 2006 these tests as part of the marketplace fac- tor. The IRS and Treasury Department be- lieve that it is important that all the crite- ria in this factor be taken into account to- gether when weighing this factor with the other three factors. Some criteria may be stronger indicators warranting treatment of the component as a separate unit of prop- erty than others. The IRS and Treasury Department acknowledge that several of the criteria within this factor do not work well for property produced by the taxpayer, and request comments regarding how and whether a marketplace factor should apply to self-constructed property. b. Factor 2: Industry practice and financial accounting factor The second exclusive factor in this Category III is whether the component is treated as a separate unit of property in industry practice or by the taxpayer in its books and records. This factor was citedbythecourtinFedEx.TheIRS and Treasury Department believe that the taxpayer’s treatment of the component as separate in its books and records is a relevant factor in determining whether the component should be treated as a separate unit of property in the proposed regula- tions. In particular, if the taxpayer’s books and records assign different economic use- ful lives to the component and the larger property, this factorwould weigh heavily toward treating the component as a sepa- rate unit of property. The IRS and Treasury Department con- sidered whether to use as a factor whether the component has a different economic useful life than the property of which it is a part. This factor was cited by the courts inSmith,Ingram,andFedEx. However, for this factor to be useful, the regula- tions would need to define economic useful life. The proposed regulations at §1.263(a)–3(f) (with regard to restoration of a unit of property) provide a definition of economic useful life, which has dif- ferent meanings depending on whether a taxpayer has an AFS. If the unit of property rules adopted this definition, the economic useful life test under this factor would produce different results depending on whether the taxpayer has an AFS. These different results are not justified in this context. Further, a taxpayer’s treatment of the component in its books and records under this Factor 2 includes any useful life determinations of the component and the property of which the component is a part in the books and records. Therefore, the economic useful life factor was not specifically adopted as a separate factor. c. Factor 3: Rotable part factor The third exclusive factor in the other personal property category is whether the taxpayer treats the component as a rotable part. A rotable part is defined as a part that is removeable from property, repaired or improved, and either immediately rein- stalled on other property or stored for later installation. This factor was cited by the courts inSmithandLaSalle. The court in FedExignored this factor, but considered as a separate concept whether the compo- nent can be and is maintained while affixed to the larger unit. The IRS and Treasury Department considered this separate con- cept as well, but believe that the rotable part factor incorporates this concept from FedEx. As the examples in the proposed regulations illustrate, this factor focuses on the particular taxpayer’s treatment of the property as a rotable part in determining whether the rotable is a separate unit of property. Therefore, for example, if the rotable part is a separate unit of property to the taxpayer and the taxpayer incorpo- rates the rotable into other property for re- sale, the rotable part will not necessarily be a separate unit of property to the purchaser. Two commentators stated that the treat- ment of a component as a rotable part is of limited or no relevance. While treatment of minor parts as rotable would not weigh heavily toward separate unit of property treatment, the IRS and Treasury Depart- ment believe that the treatment of major components as rotable is a relevant factor in determining whether a component is a separate unit of property, particularly when the economic useful life of the larger prop- erty is limited by the expected useful life of the rotable part. Many taxpayers do not maintain an inventory of rotable spares for their major components. Although it is un- derstood that the purpose for maintaining an inventory of rotables is to minimize the time that the larger property is out of ser- vice, treatment of a major component as a rotable has consequences that tend to be indicative of a separate unit of property. For example, in the case of a taxpayer that does not maintain an inventory of rotable spare parts, if a major component of the larger property breaks down, then the en- tire larger property must be taken out of service while the major component is be- ing repaired. This is indicative of the larger property and the component collectively being treated as one unit of property. Con- versely, a taxpayer that does maintain an inventory of rotable spare parts for a ma- jor component is able to continue to use the larger property without regard to the time required to repair the broken down compo- nent. In this instance, the IRS and Treasury Department believe that continued use of the larger property is indicative of separate unit of property treatment for the rotable part. In addition, rotables being depre- ciated as rotable spare parts is indicative of separate treatment because the compo- nents are depreciated separately from the larger property. In the request for comments, Notice 2004–6 combined several other factors with the rotables factor, including whether a component is designed to be easily re- moved from a larger assembly, is regularly or periodically replaced, or is one of a fungible set of interchangeable assets. These factors are broader than the rota- bles factor in the proposed regulations and would sweep in many minor components that rarely, if ever, would be appropriately considered a separate unit of property. Further, these factors are duplicative of the rotables part factor, because a rotable generally meets all of these factors. The IRS and Treasury Department believe that these factors are not more helpful in deter- mining whether a component is a separate unit of property than the rotables factor described in the proposed regulations. Therefore, the proposed regulations do not include these other factors. d. Factor 4: Function factor The fourth and final factor in Category III is whether the property of which the component is a part generally functions for its intended use without the compo- nent property. This factor was cited by the court inFedExand is similar to the dis- crete purpose test under the CLADR re- pair allowance regulations. It is also simi- lar to the functional interdependence test under §1.263A–10(a)(2) and the rules in September 25, 20065402006–39 I.R.B. these proposed regulations regarding the initial unit of property determination. As noted in the discussion of the initial unit of property determination, the IRS and Trea- sury Department agree with commentators that the functional interdependence test is a relevant, although not dispositive, factor in the unit of property analysis. Although the proposed regulations use the functional interdependence test to determine the ini- tial unit of property, the functional inter- dependence test in that context is merely a starting point in determining the appro- priate unit of property, rather than a spe- cific factor to be considered. Providing this version of the functional interdepen- dence test as a specific factor gives appro- priate weight to that test in the unit of prop- erty analysis for other personal property. 5.Category IV: Other real property The unit of property determination for real property not included in Category I or II is based on a facts and circumstances test. The property subject to this category is primarily land and land improvements owned or leased by taxpayers not in a reg- ulated industry. This category does not list specific factors because land and land improvements are such unique assets that specific factors cannot uniformly provide appropriate results. Thus, the unit of prop- erty determination for property in this cat- egory may be based on some, all, or none of the factors listed in Category III for per- sonal property, or may be based on other factors. The IRS and Treasury Depart- ment request comments on whether addi- tional guidance is needed for this category of property and, if so, what unit of property guidance would be appropriate. 6.Additional rule for unit of property After determining the initial unit of property and applying the unit of property rules under the appropriate category, the additional rule in §1.263(a)–3(d)(2)(vii) must be applied. Under this rule, if a taxpayer properly treats a component as a separate unit of property for any Federal income tax purpose, the taxpayer must treat the component as a separate unit of property for purposes of §1.263(a)–3. The purpose of this rule is to prevent taxpay- ers from taking inconsistent positions by arguing that a component of property is a unit of property for one tax purpose and that it is not a separate unit of property for capitalization purposes. For example, if a taxpayer does a cost segregation study on a building and properly identifies separate section 1245 property, the taxpayer must treat that separate property as the unit of property for capitalization purposes. As a further example, if a taxpayer properly recognizes a loss under section 165, or under another applicable provi- sion, from a retirement of a component of property or from the worthlessness or abandonment of a component of property, the taxpayer must treat the component as a separate unit of property. A loss arising under another applicable provision in this context includes a loss arising under (1) §1.167(a)–8 or 1.167(a)–11, as applica- ble, from a retirement of a component of property if the component is not sub- ject to section 168 (MACRS property) or former section 168 (ACRS property); (2) §1.167(a)–8(a) from a retirement of a component of property if the component is MACRS or ACRS property (applying §1.167(a)–8(a) as though the retirement is a normal retirement from a single as- set account) unless the component is a structural component or the component is in a mass asset account (ACRS prop- erty) or a general asset account (MACRS property); or (3) §1.168(i)–1(e) from the disposition of a component of property if the component is MACRS property and in a general asset account. No inference is intended that this rule in the proposed reg- ulations requires or allows taxpayers that are using a unit of property for purposes of the proposed regulations to use the same unit of property for purposes of any Code or regulation section other than section 263(a) and §§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3 of the proposed regulations. This rule is intended to prevent tax- payers from taking a loss deduction on a component of a unit of property, and then deducting the cost of the replaced com- ponent as a repair. The application of this rule results in the replacement com- ponent being treated as a separate unit of property, thus requiring capitalization un- der §1.263(a)–2 of amounts paid to acquire or produce the replacement component. The IRS and Treasury Department believe that taxpayers must be consistent in the treatment of a unit of property for capital- ization (other than interest capitalization), depreciation, and loss deduction purposes. The IRS and Treasury Department recog- nize that the language of this consistency rule is very broad, and request comments regarding circumstances in which this rule should not apply. V.Improvements in General Section 1.263(a)–1(b) of the current regulations provides that an amount must be capitalized if it (1) adds to the value, or substantially prolongs the useful life, of property owned by the taxpayer, or (2) adapts the property to a new or different use. Notice 2004–6 requested comments on what general principles of capitaliza- tion should apply to amounts paid to repair or improve tangible property. Commenta- tors were almost unanimous in their sug- gestion that the current principles of value, useful life, and new or different use be re- tained. The IRS and Treasury Department agree with the commentators that the cur- rent guidelines generally are appropriate. However, the current regulations require a subjective inquiry into the application of the particular facts at issue, which often results in disagreements between taxpay- ers and the IRS. Accordingly, the proposed regulations attempt to clarify and expand the standards in the current regulations by setting forth rules to determine whether there has been a material increase in value (including adapting property to a new or different use) and to determine whether there has been a restoration of property (the useful life rules). In addition, the pro- posed regulations provide objective rules for improvements in an optional repair allowance method. The proposed regulations generally provide that a taxpayer must capitalize the aggregate of related amounts paid that improve a unit of property, whether the improvements are made by the taxpayer or a third party. The aggregate of related amounts does not encompass otherwise deductible repair costs unless those costs directly benefit or are incurred by reason of a capital improvement. Instead, the aggregation language is intended to in- clude amounts paid for an entire project, including removal costs and other project costs, regardless of whether amounts are paid to more than one party or whether the work spans more than one taxable year. The proposed regulations do not affect the treatment of amounts paid to retire and 2006–39 I.R.B.541September 25, 2006 remove a unit of property in connection with the installation or production of a replacement asset. See Rev. Rul. 2000–7, 2000–1 C.B. 712. Several commentators suggested that the proposed regulations provide that the relevant distinction between capital improvements and deductible repairs is whether the amounts were paid to put the property in ordinarily efficient operating condition or to keep the property in ordi- narily efficient operating condition. See Estate of Walling v. Commissioner,373 F.2d 190 (3d Cir. 1967);Illinois Mer- chants Trust Co. v. Commissioner,4 B.T.A. 103 (1926), acq. (V–2 C.B. 2); Rev. Rul. 2001–4, 2001–1 C.B. 295. The improvement rules in the proposed regu- lations are consistent with the put versus keep standard, to the extent that standard is relevant. An amount paid may be a capital expenditure even if it does not put the property in ordinarily efficient oper- ating condition because not all repair or improvement costs affect the functional- ity of the property. Thus, amounts paid that keep property in ordinarily efficient operating condition are not necessarily deductible repair costs, particularly if the useful life is extended. On the other hand, amounts that put property in ordinarily efficient operating condition are likely to be amounts paid prior to the property’s being placed in service or to ameliorate a pre-existing condition or defect. Amounts paid in these later situations would be capital expendituresunder either the value rule or the restoration rule in the proposed regulations. Some commentators suggested that the frequency of the expenditure should be considered, noting that an expenditure be- ing regularly incurred on a cyclical basis should be a strong indication of deductible maintenance. The IRS and Treasury De- partment considered this comment but concluded that the frequency of the ex- penditure was too vague a standard to be administrable. Further, the IRS and Trea- sury Department believe that the proposed regulations provide appropriate guidance on cyclical maintenance by clarifying other rules, such as the appropriate com- parison rule for adding value and the rules relating to prolonging economic useful life. In accordance with several comments received in response to Notice 2004–6, the proposed regulations provide that a Fed- eral, state, or local regulator’s requirement that a taxpayer perform certain repairs or maintenance is not relevant in determin- ing whether the amount paid improves the unit of property. Several courts have held that amounts paid to bring property into compliance with government regu- lations were capital expenditures, in part because they made the taxpayer’s prop- erty more valuable for use in its trade or business. See,Swig Investment Co. v. United States, 98 F.3d 1359 (Fed. Cir. 1996) (replacing cornices and parapets on hotel to comply with city earthquake ordinance);Teitelbaum v. Commissioner, 294F.2d541(7 th Cir. 1961) (converting electrical system from direct current to alternating current to comply with city ordinance);RKO Theatres, Inc. v. United States, 163 F. Supp. 598 (Ct. Cl. 1958) (installing fire-proof doors and fire es- capes to comply with city code);Hotel Sulgrave, Inc. v. Commissioner,21T.C. 619 (1954) (installing sprinkler system to comply with city code). In each case, however, the court did not rely entirely on regulatory compliance as a basis for requiring capitalization. For example, in Hotel SulgraveandRKO Theatres, both involving the installation of certain equip- ment to comply with city fire codes, the courts emphasized that the work involved the addition of property with a useful life extending beyond the taxable year. Moreover, bothSwigandTeitelbaumin- volved expenditures for the replacement of major structural components of a build- ing (parapets and cornices inSwigand an electrical system inTeitelbaum)with upgraded components. Thus, in all these cases, even without the legal compulsion to make these changes, the taxpayers’ amounts paid would have constituted cap- ital expenditures. In contrast to the cases discussed above, both the courts and the IRS have permitted a current deduction for some government mandated expenditures. For example, in Midland Empire Packing Co. v. Commis- sioner, 14 T.C. 635 (1950), acq. (1950–2 C.B. 3), the court allowed the taxpayer to deduct the costs of applying a concrete liner to its basement walls to satisfy Fed- eral meat inspectors. Similarly, the IRS has permitted taxpayers to treat as other- wise deductible repairs amounts paid to re- mediate certain environmental contamina- tion and to replace certain waste storage tanks to comply with applicable state and Federal regulations. See Rev. Rul. 94–38, 1994–1 C.B. 35; Rev. Rul. 98–25, 1998–1 C.B. 998. The IRS specifically recognized in Rev. Rul. 2001–4, 2001–1 C.B. 295 that the requirement of a regulatory authority to make certain repairs or to perform certain maintenance on an asset to continue oper- ating the asset does not mean that the work performed must be capitalized. Thus, the proposed regulations reiterate that state- ment in Rev. Rul. 2001–4 and provide that a legal compulsion to repair or main- tain tangible property is not a relevant fac- tor in the repair versus improvement anal- ysis. The IRS and Treasury Department further believe that a new government re- quirement for existing property that man- dates certain expenditures with respect to the property does not create an inherent de- fect in the property. In response to several comments, the proposed regulations provide that if a taxpayer needs to replace part of a unit of property that cannot practicably be replaced with the same type of part, the replacement of the part with an improved but comparable part does not, by itself, result in an improvement to the unit of property. This rule is intended to apply in cases where the same replacement part is no longer available, generally because of technological advancements or product enhancements. This rule, however, is not intended to apply if, instead of replacing an obsolete part with the most similar comparable part available, the taxpayer replaces the part with one of a better qual- ity than what would have sufficed. The proposed regulations do not pre- scribe a plan of rehabilitation doctrine as traditionally described in the case law. That judicially-created doctrine provides that a taxpayer must capitalize otherwise deductible repair costs if they are incurred as part of a general plan of rehabilitation to the property. See,Norwest Corp. v. Commissioner, 108 T.C. 265 (1997);Moss v. Commissioner, 831 F.2d 833 (9 th Cir. 1987);United States v. Wehrli,400F.2d 686 (10 th Cir. 1968). Specifically, if an expenditure is made as part of a general plan of rehabilitation, modernization, and improvement of the property, the expen- diture must be capitalized, even though, standing alone, the item may be classified as one of repair or maintenance.Wehrli, September 25, 20065422006–39 I.R.B. 400 F.2d at 689. Whether a general plan of rehabilitation exists, and whether a par- ticular repair or maintenance item is part of it, are questions of fact to be determined based upon all the surrounding facts and circumstances, including, but not limited to, the purpose, nature, extent, and value of the work done.Id.at 690. The issue of whether an amount paid must be capitalized under the plan of re- habilitation doctrine has been the subject of much litigation, with varying results. For example, some cases have limited ap- plication of the plan of rehabilitation doc- trine to buildings that are not suitable for their intended use in the taxpayer’s trade or business. SeeSchroeder v. Commissioner, T.C. Memo 1996–336;Koanis v. Commis- sioner, T.C. Memo 1978–184, aff’d mem., 639F.2d788(9 th Cir. 1981);Keller Street Dev. Co. v. Commissioner,37T.C.559 (1961); acq., 1962–2 C.B. 5, aff’d in part, rev’dinpartonothergrounds,323F.2d 166 (9 th Cir. 1963). Other courts, as well astheIRS,haveviewedtheplanofrehabil- itation doctrine more broadly, emphasiz- ing the planned aspect of the work done by the taxpayer, rather than the condition of the property. SeeMountain Fuel Supply Co.v.UnitedStates, 449 F.2d 816 (10 th Cir. 1971);Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1 (1979); Rev. Rul. 88–57, 1988–2 C.B. 36. In Rev. Rul. 2001–4, 2001–1 C.B. 295, the IRS clarified its view of the plan of re- habilitation doctrine. In applying the plan of rehabilitation doctrine to the facts in Sit- uation 3 of that ruling, the IRS noted that (1) the taxpayer planned to perform sub- stantial capital improvements to upgrade the unit of property; (2) the repairs were in- cidental to the taxpayer’s plan to upgrade the unit of property; and (3) the effect of all the work performed on the unit of prop- erty, including the repairs and maintenance work, was to materially increase the value or prolong the useful life of the unit of property. The ruling also notes that the ex- istence of a written plan, by itself, is not sufficient to trigger the plan of rehabilita- tion doctrine. The ruling’s interpretation of the plan of rehabilitation doctrine is con- sistent with the majority of cases apply- ing that doctrine. SeeCalifornia Casket Co. v. Commissioner, 19 T.C. 32 (1952), acq., 1953–1 C.B. 3;Stoeltzing v. Com- missioner, 266 F.2d 374 (3d Cir. 1959); Bank of Houston v. Commissioner, T.C.M. 1960–110. The IRS and Treasury Department do not believe it is appropriate to capitalize as an improvement otherwise deductible re- pair costs solely because the taxpayer has a plan (written or otherwise) to perform periodic repairs or maintenance or solely because the taxpayer performs several re- pairs to the same property at one time. The IRS and Treasury Department believe that it is appropriate to capitalize otherwise de- ductible repair costs as part of an improve- ment only if the taxpayer improves a unit of property and the otherwise deductible repair costs directly benefit or are incurred by reason of the improvement to the prop- erty. Section 263A applies to these expen- ditures. Section 263A requires that all di- rect costs of an improvement and all in- direct costs that directly benefit or are in- curred by reason of the improvement must be capitalized. This application of section 263A to otherwise deductible repair costs in this context is consistent with the appli- cation of the plan of rehabilitation doctrine described in Rev. Rul. 2001–4. The pro- posed regulations provide that repairs that aremadeatthesametimeasanimprove- ment, but that do not directly benefit or are not incurred by reason of the improve- ment, are not required to be capitalized un- der section 263(a). VI.Value A.In general The proposed regulations provide that a taxpayer must capitalize amounts paid that materially increase the value of a unit of property and provide an exclusive list of five tests for determining whether an amount paid materially increases value. An amount paid must be capitalized if it meets any of the five tests. The first test is whether the amount paid ameliorates a condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of property. SeeUnited Dairy Farmers, Inc. v. United States, 267 F.3d 510 (6 th Cir. 2001);Dominion Resources, Inc. v. United States, 219 F.3d 359 (4 th Cir. 2000);Jones v. Commissioner,242 F.2d 616 (5 th Cir. 1957). This rule is con- sistent with the concept that amounts paid to put property into ordinarily efficient op- erating condition must be capitalized. This pre-existing defect rule applies regardless of whether the taxpayer was aware of the condition or defect at the time of acqui- sition or production. The IRS and Trea- sury Department considered but rejected as too subjective the idea of providing dif- ferent treatment based on the taxpayer’s prior knowledge of the condition or defect. The IRS and Treasury Department request comments on whether, and in what circum- stances, the pre-existing defect rule should take into account the condition of the prop- erty in the hands of a transferor. For ex- ample, if an individualtransfers property to a corporation in exchange for stock in a transaction under section 351, should the pre-existing defect rule take into ac- count the condition of the property when acquired by the individual, rather than the condition of the property when received by the corporation? The second test for materially increas- ing value is whether the work was per- formed prior to the date the property is placed in service by the taxpayer. This test essentially restates the concept that amounts paid to put property into ordinar- ily efficient operating condition must be capitalized. The IRS and Treasury Depart- ment believe that if the property cannot be placed in service prior to work being per- formed, that work necessarily increases the value of the property. Thethirdvaluetestiswhetherthe amounts paid adapt the property to a new or different use. The commentators agreed that this factor should remain a standard for capitalization. The new or different use standard is unchanged from the current regulations, but it is included in the value section of the proposed regulations, rather than as its own standard. The new or dif- ferent use test is not intended to apply to amounts paid to prepare a unit of property for sale (for example, painting a house). The fourth value test is whether the amount paid results in a betterment or material addition to the unit of property. The betterment language is consistent with the statutory language of section 263(a)(1) as well as the current regulations at §1.263(a)–1(a)(1). A betterment is an improvement that does more than restore to a former good condition. The better- ment test is intended to capture amounts paid that are qualitative improvements to the property that make the property bet- 2006–39 I.R.B.543September 25, 2006 ter and more valuable than mere repairs would do, such as using upgraded mate- rials when materials comparable to the original were available and would have sufficed. However, the betterment test is not intended to be a fair market value test. The fifth test in the value section of the proposed regulations is whether the amount paid results in a material increase in capacity, productivity, efficiency, or quality of output of the unit of property. These standards are consistent with case law under the current regulations. The proposed regulations provide an exception to the value tests if the original economic useful life of the unit of property is 12 months or less and the taxpayer does not elect to capitalize amounts paid for the property. The purpose of this rule is to not require capitalization under the value rules for improvements made to 12-month prop- erty. This exception, however, does not ap- ply to the restoration rule for determining whether an amount paid improves prop- erty. Thus, for example, if a taxpayer per- forms work on 12-month property that pro- longs the economic useful life of the prop- erty, the amount paid must be capitalized. The proposed regulations do not adopt an increase in fair market value as a stan- dard for capitalization. In response to Notice 2004–6, most commentators stated that value means fair market value. How- ever, in practice, taxpayers generally do not measure, and would have no reason to measure, the fair market value of a unit of property prior to some condition necessi- tating the expenditure. Further, taxpayers generally have no reason to measure the fair market value of a unit of property after the work is performed. The IRS and Treasury Department did not want to propose regulations with a standard that required taxpayers to have property appraised solely for the purpose of apply- ing a capitalization standard. In fact, the courts rarely have applied a strict increase in fair market value standard. Usually, the courts rely on some surrogate for fair market value to determine whether value is increased. For example, courts have looked to the amount of the expenditure versus (1) the cost of the property (see Stoeltzing v. Commissioner, 266 F.2d 374 (3d Cir. 1959)); (2) the cost of comparable new property (seeLaSalle Trucking Co. v. Commissioner, T.C. Memo 1963–274); and (3) the cost of comparable used prop- erty (seeIngram Industries, Inc. v. Com- missioner, T.C. Memo 2000–323). Courts have considered fair market value only in a few cases when property has been appraised for some other purpose (see Jones v. United States, 279 F. Supp. 772, 774 (D. Del. 1968)), or when property has been appraised in the course of the litigation (seeFedEx, 291 F. Supp. 2d at 706–707). Additionally, the fair market value of property may change over time without re- gard to the use, upkeep, or improvements made by the taxpayer, due to other factors such as supply and demand or changes in style, trends, technologies, etc. For ex- ample, land may increase in fair market value over time without the taxpayer per- forming any activities to improve it. Con- versely, amounts paid to make substantial improvements to a unit of property may not always increase fair market value, or may not increase the fair market value by the full amount paid for the improvements. See,Harrah’s Club v. United States,661 F.2d 203 (Ct. Cl. 1981) (amount paid to restore antique automobiles must be capi- talized even though restoration did not in- crease fair market value by the amount paid for the restoration). Attempting to ad- just fair market value for factors like these further complicates any possible compar- ison. The IRS and Treasury Department believe that the fair market value standard is too subjective and impractical, particu- larly because most repairs also increase the fair market value of property if the value is compared immediately before and after the work is performed. Therefore, the IRS and Treasury Department do not believe that fair market value is an appropriate stan- dard. The value factors in the proposed regulations are intended to be objective in- dications of work performed that generally would increase the fair market value of the unit of property. Whether amounts paid materially increase the value of a unit of property requires an analysis of the pur- pose, the physical nature, and the effect of the work for which the amounts were paid, and not an analysis of the fair market value of the property or the level of monetary ex- penditures. Some commentators requested that the regulations provide a bright line rule defin- ing a material increase in value with re- spect to a specified percentage increase, for example a twenty-five percent increase in capacity. The IRS and Treasury De- partment do not believe that providing a fixed percentage as a presumption of what is a material increase would be an ap- propriate safe harbor. Although perhaps measurable, the same fixed percentage in- crease in capacity would not work well as a rule applicable to all types of property. A twenty-five percent increase in capacity may be a reasonable litmus test for deter- mining whether there has been a material increase in value for certain types of prop- erty. However, for many types of property, a much smaller increase in capacity may be an extraordinary, or in some cases im- possible, improvement. For example, an increase in the square footage of a 50,000 square foot building by 5 percent would be a rather large improvement that should be capitalized. Therefore, the determination of whether an increase in capacity, produc- tivity, efficiency, or quality is a material in- crease in value should be based on all the facts and circumstances. B.Appropriate comparison Notice 2004–6 requested comments on the proper starting point for compar- ing whether an expenditure materially increases the value of property. Almost all the commentators suggested that the pro- posed regulations adopt the test set forth inPlainfield-Union Water Co. v. Commis- sioner, 39 T.C. 333 (1962), nonacq. on other grounds (1964–2 C.B. 8) (the Plain- field-Union test). In that case, the court noted that almost any properly performed repair adds value as compared with the situation existing immediately prior to that repair. The proper test, the court said, is whether the expenditure materially enhances the value of the property as com- pared with the status of the property prior to the condition necessitating the expen- diture. The court also noted that the test is appropriate even when the expenditure does not arise from a sudden, unexpected, or unusual external circumstance. The IRS and Treasury Department agree with this application of the Plain- field-Union test and believe that the test is appropriately applied to cases of normal wear and tear as well as cases when the expenditure arises from a sudden, unex- pected, or unusual external circumstance. The proposed regulations adopt the Plain- field-Union test for cases in which a partic- September 25, 20065442006–39 I.R.B. ular event necessitates the expenditure and clarify that when the event necessitating the expenditure is normal wear and tear, the condition of the property immediately prior to the event necessitating the ex- penditure is the condition of the property after the last time the taxpayer corrected the effects of normal wear and tear or, if the taxpayer has not previously corrected the effects of normal wear and tear, the condition of the property when placed in service by the taxpayer. This comparison rule for wear and tear is intended to apply when a taxpayer engages in regular, cycli- cal maintenance of a unit of property to correct the effects of normal wear and tear. Although wear and tear begins affecting the condition of property as soon as it is placed in service, the proposed regulations do not adopt the placed-in-service date as the appropriate comparison point. Al- though the placed-in-service date would be the appropriate comparison point when the taxpayer first corrects the effects of normal wear and tear, the IRS and Trea- sury Department believe that the condition of the property after the previous mainte- nance cycle is the appropriate comparison point for each subsequent maintenance cycle. The Plainfield-Union test works well when the amount paid is necessitated by a specific event (like amounts paid to repair damage or amounts paid to maintain prop- erty by correcting the effects of wear and tear). However, the test does not work in a pure improvement setting; that is, when a taxpayer decides to improve property without any event causing the taxpayer to perform the work to restore the prop- erty to a former good condition. There- fore, the proposed regulations do not ap- ply the Plainfield-Union test to the first three value factors (pre-existing defects, work performed prior to the property being placed in service, and adapting the prop- erty to a new or different use). These fac- tors are more appropriately analyzed on an absolute, rather than relative basis. Sim- ilarly, the test does not work well for bet- terments, which by definition are improve- ments that do more than restore property to a former good condition. VII.Restoration The proposed regulations provide that a taxpayer must capitalize amounts paid to restore property. The restoration lan- guage is from section 263(a)(2) and §1.263(a)–1(a)(2) of the current regu- lations and generally has been viewed as a rule requiring the capitalization of amounts paid that substantially pro- long the useful life of the property. See §1.263(a)–1(b). This section of the pro- posed regulations defines economic useful life and what it means to substantially prolong economic useful life. The comments received in response to Notice 2004–6 varied greatly with re- gard to useful life, with two commentators specifically suggesting that the concept of useful life be eliminated from the regula- tions. The other commentators suggested that economic useful life be defined as the period of time over which the property is expected to be useful to the taxpayer, taking into account the various factors listed in §1.167(a)–1(b). The proposed regulations adopt this definition of eco- nomic useful life for taxpayers that do not have an AFS. Economic useful life is not determined by reference to the recovery period under section 168 for the property. For a taxpayer that has an AFS, the eco- nomic useful life of the property is pre- sumed to be the same as the useful life used by the taxpayer for purposes of deter- mining depreciation in its AFS. The IRS and Treasury Department believe that the economic useful life definition is subjec- tive and difficult to apply; therefore, this rule provides certainty for taxpayers with an AFS. The regulations provide an excep- tion to this rule for situations in which a taxpayer does not assign a useful life to certain property in its AFS, even though thepropertyhasausefullifeofmorethan one year. For example, a taxpayer may treat amounts paid for a unit of property as an expense in its AFS if the property is used in a specific research project and has no alternative future uses. Additionally, many taxpayers have a policy of treating as an expense in their AFS an amount paid for tangible property below a certain dol- lar threshold, despite the fact that the prop- erty has a useful life of more than one year. This type of property does not have a use- ful life for purposes of determining depre- ciation in the taxpayer’s AFS, even though itmayhaveausefullifeofmorethanone year. Therefore, the IRS and Treasury De- partment believe that in these situations it is appropriate for taxpayers to use the eco- nomic useful life definition that applies to taxpayers without an AFS. One commentator stated that the useful life used for book depreciation purposes is not appropriate fortax purposes because the book useful life takes into account fac- tors that do not measure the inherent useful life, but rather the period over which the property is expected to be useful (on av- erage) to the taxpayer. The IRS and Trea- sury Department believe it is appropriate to take into account the period over which the property may reasonably be expected to be useful to the taxpayer, as required by taxpayers without an AFS, rather than the inherent useful life of the property. The proposed regulations also provide four rules for determining when an amount paid substantially prolongs economic use- ful life. The first rule requires capitaliza- tion when the amount paid extends the pe- riod over which the property may reason- ably be expected to be useful to the tax- payer beyond the end of the taxable year immediately succeeding the taxable year in which the economic useful life of the property was originally expected to cease. One commentator suggested that the reg- ulations provide a safe harbor bright line rule to define whether an amount substan- tially prolongs the useful life. The IRS and Treasury Department believe that a one year rule is an appropriate bright line. Therefore, the regulations require capital- ization when the amount paid extends the original useful life of the property by more than one taxable year. The IRS and Trea- sury Department believe that a one year rule is a more appropriate bright line than a rule based on a percentage of the useful life, because the one-year rule corresponds with the 12-month safe harbor rule for the acquisition or production of property. The second rule requires capitalization if a major component or a substantial struc- tural part of the unit of property is replaced and notes that the replacement of a rela- tively minor portion of the physical struc- ture of the unit of property or a relatively minor portion of any of its major parts does not constitute the replacement of a major component or substantial structural part of the unit of property. It is possible, how- ever, for amounts paid to replace a rela- tively minor portion of the physical struc- ture of the unit of property or a relatively minorportionofanyofitsmajorparts to substantially prolong the economic use- 2006–39 I.R.B.545September 25, 2006 ful life of the property if the property is near the end of its economic useful life, in which case the amounts paid neverthe- less must be capitalized. The rule is not in- tended to require capitalization if a major component is replaced with a similar, used component that has not been rebuilt, for example, if the engine in a car is replaced with a used engine with similar mileage obtained from a junkyard, or a component of property subject to a warranty or main- tenance agreement is replaced with a used part that has been repaired. Although the replacement of minor parts does not usually prolong the eco- nomic useful life of most property, the replacement of most or all minor parts for some types of property may be the equiva- lent of rebuilding the property, particularly in cases in which the property consists al- most entirely of minor parts. Therefore, the third rule provides that amounts paid that restore a unit of property (or a major component or substantial structural part of the unit of property) to a like-new condi- tion substantially prolong the useful life. The IRS and Treasury Department intend that this test be applied to situations in which the property undergoes the equiva- lent of being rebuilt. Merely recondition- ing a property by dismantling the property, and cleaning and inspecting components, is not the equivalent of rebuilding. All or almost all major and minor parts of the unit of property (or the major component or substantial structural part of the unit of property) must be returned to the original manufacturers’ specifications. The fourth rule relates to the restoration of a unit of property after the taxpayer has properly deducted a casualty loss under section 165 with respect to the property. Section 165(a) allows a taxpayer to deduct any loss sustained during the taxable year and not compensated for by insurance or otherwise. Generally, any loss arising from a fire, storm, shipwreck, or other casualty is allowable as a deduction under section 165(a). Section 1.165–7(a)(1). The amount of the deduction is the dif- ference between the fair market value of the property before and after the casualty, to the extent the amount does not exceed the property’s adjusted basis. Section 1.165–7(b)(1). A casualty loss deduction under section 165(a) results in a decrease in the taxpayer’s basis in the property. The courts have distinguished between losses that are deductible as casualties under section 165(a) and incidental repair costs that are deductible under section 162(a) as ordinary and necessary business expenses. In general, if property is lost, destroyed, or abandoned as a result of a casualty, a loss deduction under section 165(a) is appropriate; however, if property is simply damaged in a casualty and ex- penditures are made to repair the property in a manner that does not permanently im- proveorbetteritorprolongitsusefullife, those expenditures are business expenses deductible under section 162(a).Hensler v. Commissioner, 73 T.C. 168, 179 (1979); see alsoHubinger v. Commissioner,36 F.2d 724, 726 (2d Cir. 1929) (expenses resulting from “trifling accidental causes” are deductible only under section 162(a) and not under section 165(a));Atlantic Greyhound Corp. v. United States,111 F. Supp. 953 (1953) (“the provisions for deductions of ‘ordinary and necessary ex- penses’ and ‘casualty losses’ would seem to be mutually exclusive, for the normal connotation of one negates, at least by implication, the idea of the other”). Thus, the mere fact that the damage results from a casualty is not controlling; instead, the nature of the damage resulting from the ca- sualty is relevant in determining whether the expenditure should be treated as a loss or deduction. The IRS and Treasury Department believe that when a taxpayer properly deducts a casualty loss, the nature of the damage resulting from the casualty is such that any repairs done to restore the property after the casualty should not be treated as ordinary and necessary repair costs. Thus, the proposed regulations provide that any amounts paid to repair property after a casualty loss must be cap- italized. Commentators stated that amounts paid at any point during the property’s eco- nomic useful life that do not change the function, design, etc., but enable prop- erty to be used for itsexpected useful life should not be determined to extend the useful life. The IRS and Treasury Depart- ment believe that there are circumstances in which amounts paid that merely restore property to a former good condition may properly be capitalized as substantially prolonging useful life, for example, when repairs are made to property after a ca- sualty loss. As another example, work performed at the end of the economic use- ful life of the unit of property may extend the property’s useful life. Additionally, replacement of a major component or a substantial structural part of a unit of prop- erty extends the useful life, particularly when the expected life of the component is coterminous with the economic useful life of the unit of property, and the economic useful life of the unit of property is in fact limited by the period over which the component is expected to be useful. Thus, the proposed regulations do not adopt the commentators’ suggestion. VIII.Repair Allowance Method A.In general The primary focus of the proposed regulations is to provide guidance that dis- tinguishes deductible repair expenses from capital expenditures. However, because this remains inherently a facts-and-cir- cumstances based determination, the IRS and Treasury Department requested com- ments in Notice 2004–6 on whether the regulations should provide a repair al- lowance. Six commentators suggested the regulations should provide a repair allowance or otherde minimisrules for repair expenditures. Two commentators specifically proposed a repair allowance system modeled on the former CLADR re- pair allowance system. The proposed reg- ulations adopt these suggestions and pro- vide an optional repair allowance method, similar to the CLADR repair allowance, to create objective rules in this area. Al- though some commentators additionally requested otherde minimisrules for re- pair expenditures as well, the IRS and Treasury Department believe that a repair allowance is an appropriate safe harbor for repair expenditures. Therefore, the proposed regulations do not provide a safe harbor other than the repair allowance. Under the repair allowance in the pro- posed regulations, the taxpayer compares the amounts paid for materials and labor during the taxable yearto repair, maintain, or improve repair allowance property to the repair allowanceamount. The amounts paid are deductible under section 162 to the extent of the repair allowance amount, and any excess amounts paid are capital- ized. Under the proposed repair allowance September 25, 20065462006–39 I.R.B. method, a repair allowance amount is determined separately for each MACRS class. The repair allowance amount for a particular class is determined by multi- plying the repair allowance percentage in effect for that class by the average unad- justed basis of repair allowance property in that class. For buildings that are repair allowance property, the repair allowance method is applied separately to each build- ing. This rule is consistent with the rule for buildings under the CLADR repair allowance system. B.Capitalized amount The excess of amounts paid to re- pair, maintain, or improve all the repair allowance property in a MACRS class over the repair allowance amount for the class must be capitalized (the capital- ized amount). The capitalized amount includes the taxpayer’s direct costs of re- pairing, maintaining, or improving repair allowance property in a particular MACRS class. In addition, the taxpayer must add to the capitalized amount any allocable indirect costs of producing the repair al- lowance property in the MACRS class, which must be capitalized in accordance with the taxpayer’s method of accounting for section 263A costs. Except with re- gard to repair allowance property that is depreciated under section 168(g) or repair allowance property that is public utility property (for which separate rules are pro- vided), the proposed regulations permit taxpayers to choose one of two methods of treating the capitalized amount. The first method is to treat the capitalized amount as a separate single asset and to depreciate the asset in accordance with that MACRS class. The second method is to allocate the capitalized amount for a particular MACRS class to all repair allowance property in the particular MACRS class in proportion to the unadjusted basis of thepropertyinthatMACRSclassasof the beginning of the taxable year. Under either the single asset method or the allo- cation method, the capitalized amount is treated as a section 168(i)(6) improvement and is treated as placed in service by the taxpayer on the last day of the first half of the taxable year in which the amount is paid, before application of the convention under section 168(d). For example, the capitalized amount for a calendar year tax- payer would be treated as placed in service on June 30 of the taxable year. Because the single asset treatment does not permit taxpayers to recognize a gain or loss on the disposition of repair allowance property, the IRS and Treasury Depart- ment request comments on whether, in the final regulations, taxpayers should be per- mitted to change to the allocation treat- ment for the taxable year of disposition and if so, what record keeping rules or other rules should be required for taxpayers to make that change. With regard to the allo- cation treatment, the IRS and Treasury De- partment request comments on whether the allocation should be based on an amount other than the unadjusted basis as of the beginning of the taxable year, such as the unadjusted basis at the end of the taxable year or the average unadjusted basis. C.Repair allowance property Repair allowance property is defined in the proposed regulations as real or per- sonal property subject to MACRS that is used in the taxpayer’s trade or busi- ness or for the production of income. It also includes certain tangible property not otherwise subject to MACRS if the taxpayer, solely for purposes of the repair allowance method, classifies the property in the appropriate MACRS class in which the property would be included if the prop- erty were subject to MACRS. Taxpayers arenotrequiredtoclassifynon-MACRS property (property placed in service be- fore the effective date of section 168 and property for which the taxpayer properly elected out of section 168). Non-classi- fied property will not be repair allowance property eligible for the repair allowance method. Certain types of property are not included in repair allowance prop- erty, including any property for which the taxpayer has elected to use the CLADR repair allowance method and property for which the taxpayer uses the method of ac- counting provided in Rev. Proc. 2001–46, 2001–2 C.B. 263, or Rev. Proc. 2002–65, 2002–2 C.B. 700 (both with regard to rail- road track). Thus, the repair allowance in the proposed regulations does not repeal the CLADR repair allowance, nor does it prohibit taxpayers from using the repair allowance method in these regulations for repair allowance property, while contin- uing to use the CLADR repair allowance for other property. D.Excluded additions Repair allowance property also does not include excluded additions, the cost of which must be capitalized. The CLADR repair allowance system has a similar rule. Under the CLADR repair allowance sys- tem, excluded additions are defined as any expenditures (1) that increase by 25% or more the productivity or capacity of an existing identifiable unit of property over its productivity or capacity when first acquired; (2) that modify an existing iden- tifiable unit of property for a substantially different use; (3) for an additional iden- tifiable unit of property or a replacement of an identifiable unit of property that was retired; (4) for a replacement of a part in or a component or portion of an existing identifiable unit of property if such part, component, or portion is for replacement of a part, component or portion which was retired in a retirement upon which gain or loss was recognized; (5) in the case of a building or other structure, for additional cubic or linear space; and (6) in the case of those units of property of pipelines, elec- tric utilities, telephone companies, and telegraph companies consisting of lines, cables, and poles, for replacement of 5% or more of the unit of property with respect to which the replacement is made. One commentator suggested that the proposed regulations should not have excluded additions similar to those in the CLADR repair allowance because they are too qualitative and difficult to administer. The IRS and Treasury Department agree that some of the items listed as excluded additions under the CLADR system are too subjective and do not provide the kind of objective determination the proposed repair allowance is intended to provide. For this reason, the proposed regulations limit the excluded additions to amounts paid (1) for the acquisition or produc- tion of a specific unit of property; (2) for work that ameliorates a condition or defect that either existed prior to the tax- payer’s acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production; (3) for work performed prior to the date the 2006–39 I.R.B.547September 25, 2006 unit of property is placed in service by the taxpayer (without regard to any applicable convention under section 168(d)); (4) that adapts the unit of property to a new or dif- ferent use; or (5) that increases the cubic or square space of a building. Thus, the proposed regulations adopt excluded additions 2, 3, and 5 in the CLADR repair allowance. These ex- cluded additions are also listed in §1.263(a)–3(e)(1) of the proposed reg- ulations as factors that indicate a material increase in value. The regulations do not adopt excluded addition 1 in the CLADR repair allowance because an increase in productivity or capacity of 25% or more may be too difficult to measure. The reg- ulations do not specifically cite excluded addition 4 from the CLADR repair al- lowance; however, if a part, component, or portion of a unit of property is retired in a retirement upon which gain or loss properly was recognized, the replacement of that component is a separate unit of property under §1.263(a)–3(d)(2) of the proposed regulations and thus is addressed by excluded addition 1 of the proposed regulations. Excluded addition 6 in the CLADR repair allowance addresses net- work assets and was not adopted in the proposed regulations pending comments on how the final regulations should ad- dress the unit of property rules relating to network assets. In addition to the three excluded addi- tions that the proposed regulations carry over from the CLADR repair allowance, the excluded additions in the proposed reg- ulations include amounts paid for work that ameliorates a pre-existing condition or defect and for work performed prior to the date the unit of property is placed in service by the taxpayer. These two ex- cluded additions also are listed as factors in §1.263(a)–3(e)(1) of the proposed reg- ulations that indicate a material increase value. The IRS and Treasury Department believe that the excluded additions pro- vided in the repair allowance in the pro- posed regulations are more objective than those in the CLADR regulations and are easier to verify. E.Leased property Like the repair allowance under CLADR, repair allowance property does not include property leased by the tax- payer from another party. One commen- tator suggested that the repair allowance apply to leased property. The IRS and Treasury Department recognize that tax- payers that lease property confront the same issues as owners in distinguishing deductible repairs from capital improve- ments. However, the application of the re- pair allowance method to leased property raises several difficult issues. The IRS and Treasury Department request comments on whether the repair allowance method should be extended toleased property and, if so, how the following issues should be resolved: (1) How should the unadjusted basis of leased property be determined? Should fair market value be used instead of unadjusted basis and, if so, how and when should fair market value be deter- mined? (2) How should the regulations be drafted to prevent abuse between related lessors and lessees? (3) How should the regulations be drafted to prevent both the lessor and lessee from using the repair allowance method for the same property? (4) How should the regulations address qualified lessee construction allowances for short-term leases under section 110? (5) What is the proper treatment of the capitalized amount for leased property under the repair allowance? (6) Should lessees be permitted to classify the leased property to a MACRS class and use one of the treatments of the capitalized amount in the proposed regulations? (7) Should the capitalized amount be allocated to individual leases and amortized over the remaining term of each lease and, if so, how should that allocation be made? (8) If the taxpayer has a number of leases with varying lease terms, should the capitalized amount be allocated to certain groups of leases and amortized over the average re- maining term of the leases and if so, how should the leases be grouped? (9) Are there any other issues with regard to the application of a repair allowance to leased property that need to be addressed? F.Network assets The definition of repair allowance prop- erty in the proposed regulations does not specifically exclude network assets. How- ever, application of the repair allowance requires a determination of the appropriate unit of property, in particular with regard to identifying excluded additions. The unit of property determination with regard to network assets is not addressed in the pro- posed regulations and is an issue on which the IRS and Treasury Department have re- quested comments. Therefore, the IRS and Treasury Department anticipate that final regulations specifically will include net- work assets as repair allowance property if appropriate unit of property rules can be determined. If appropriate unit of property rules cannot be determined for network as- sets, the IRS and Treasury Department re- quest comments on whether to develop in- dustry-specific guidance on how the repair allowance method should apply (in partic- ular, how excluded additions should be de- termined) with regard to network assets in a particular industry. G.Repair allowance percentages The repair allowance percentages un- der the CLADR repair allowance were determined by the Treasury Department’s Office of Industrial Economics, which is no longer in existence. The percent- ages were published in various revenue procedures (most recently in Rev. Proc. 83–35, 1983–1 C.B. 745), made obsolete by Rev. Proc. 87–56, 1987–2 C.B. 674, with regard to property subject to section 168, and were revised and supplemented periodically. The proposed regulations create a new repair allowance percent- age for each MACRS class. These rates are based on the principle that a taxpayer will spend 50% of the property’s unad- justed basis on repairs over the property’s MACRS recovery period. Thus, the re- pair allowance percentages for a particular MACRS class in the proposed regulations were computed by: (1) dividing 100% by the number of years in the recovery period for the MACRS class, which represents the portion of the property’s unadjusted basis that is allocable to each year of the recovery period, and; (2) multiplying the result by 50%. For example, if a tax- payer has repair allowance property in a MACRS class with a 5 year recovery period, 100% divided by 5 is 20%, which represents the portion of the property’s unadjusted basis that is allocable to each year of the recovery period. Multiplying the 20% amount by 50% results in a re- pair allowance percentage of 10% for that MACRS class. September 25, 20065482006–39 I.R.B. The IRS and Treasury Department re- quest comments on whether the repair allowance percentages should be different than those provided in the proposed reg- ulations, whether the rates in Rev. Proc. 83–35 should be used, and whether the final regulations should permit taxpay- ers to choose between repair allowance percentages in Rev. Proc. 83–35 and the final regulations. The IRS and Trea- sury Department also request comments on whether a separate repair allowance percentage should be provided for certain types of property, such as repair allowance property subject to section 168(g) (for example, a percentage that reflects the recovery period under the alternative de- preciation system in section 168(g) rather than the MACRS recovery period under section 168). Finally, the IRS and Trea- sury Department request comments on whether industries should be permitted to request guidance through the Industry Issue Resolution program to establish dif- ferent repair allowance percentages for their particular industry. H.Manner of electing and manner of revoking election The proposed regulations reserve the is- sue of how a taxpayer will elect the re- pair allowance method. Two commenta- tors suggested that taxpayers be permitted to elect the repair allowance on a year by year basis. The IRS and Treasury Depart- ment disagree with this suggestion. The repair allowance method is a method of ac- counting under section 446(e) and should be used consistently by taxpayers. Allow- ing a year by year election would com- plicate a taxpayer’s record keeping and would create a burden on IRS examining agents when auditing a taxpayer’s com- pliance with the repair allowance method. Therefore, the IRS and Treasury Depart- ment do not expect to permit a year by year election. However, even though the repair allowance method is a method of accounting under section 446(e), the IRS and Treasury Department expect to pro- vide that taxpayers may elect the repair allowance method prospectively without having to file an application for change in accounting method and that the election be done on a cutoff basis. Procedures for electing the repair allowance method will be provided either in the final regulations or in published guidance in the Internal Revenue Bulletin. The proposed regulations provide that the repair allowance method, if elected, must be elected for all repair allowance property. A taxpayer may revoke an elec- tion made under the repair allowance method only by obtaining the Commis- sioner’s consent. Procedures for obtaining the Commissioner’s consent to revoke an electionwillbeprovidedeitherinthefinal regulations or in published guidance in the Internal Revenue Bulletin. The IRS and Treasury Department expect to provide that a taxpayer that revokes an election may not re-elect the repair allowance method for a period of at least five tax- able years, beginning with the year of the revocation unless, based on a showing of unusual and compelling circumstances, consent is specifically granted by the Commissioner to re-elect the repair al- lowance at an earlier time. The IRS and Treasury Department request comments on the appropriateness of the five year waiting period, as well as on the circum- stances that should be considered unusual and compelling so that the Commissioner would grant consent to re-elect the repair allowance prior to expiration of the five year waiting period. I.Record keeping The proposed regulations do not impose any specific record keeping requirements. However, under section 6001, taxpayers are required to keep books and records suf- ficient to establish the amounts used to compute a deduction under the repair al- lowance method. For example, taxpayers must maintain books and records reason- ably sufficient to determine (1) the total amounts paid (other than amounts paid for excluded additions) during the taxpayer year for the repair, maintenance, or im- provement of repair allowance property in the specific MACRS class; (2) the unad- justed basis of all repair allowance prop- erty in the specific MACRS class at the beginning and the end of the taxable year; (3) the repair allowance percentages used for the specific MACRS class for the tax- able year; and (4) the treatment of the cap- italized amounts (whether capitalized as a single asset or allocated to all repair al- lowance property in the specific MACRS class). Proposed Effective Date These regulations are proposed to ap- ply to taxable years beginning on or af- ter the date the final regulations are pub- lished in theFederal Register.Thefinal regulations will provide rules applicable to taxpayers that seek to change a method of accounting to comply with the rules con- tained in the final regulations. Taxpay- ers may not change a method of account- ing in reliance upon the rules contained in the proposed regulations until the rules are published as final regulations in theFed- eral Register. The IRS and Treasury Department an- ticipate that, except as otherwise provided (for example, in the repair allowance sec- tion), the final regulations will provide that a taxpayer seeking to change to a method of accounting provided in the fi- nal regulations mustfollow the applicable procedures for obtaining the Commis- sioner’s automatic consent to a change in accounting method. Generally, a change in method of accounting is made using an ad- justment under section 481(a). However, the IRS and Treasury Department are con- cerned about the potential administrative burden on taxpayers and the IRS that may result from section 481(a) adjustments that originate many years prior to the effective date of the final regulations. The IRS and Treasury Department request comments on whether there are circumstances in which it is appropriate to permit a change in method of accounting to be made using a cut-off basis instead of a section 481(a) adjustment. Finally, the IRS and Treasury Department request comments on any ad- ditional terms and conditions for changes in methods of accounting that would be helpful to taxpayers in adopting the rules contained in these proposed regulations. Special Analyses It has been determined that this notice of proposed rulemaking is not a signifi- cant regulatory action as defined in Exec- utive Order 12866. Therefore, a regula- tory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regu- lations, and, because the regulation does not impose a collection of information on small entities, the Regulatory Flexibility 2006–39 I.R.B.549September 25, 2006 Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this notice of proposed rulemaking will be submitted to the Chief Counsel for Advo- cacy of the Small Business Administration for comment on its impact on small busi- ness. Comments and Public Hearing Before the proposed regulations are adopted as final regulations, consideration will be given to any written comments (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. Comments are requested on all aspects of the proposed regulations. In addition, the IRS and Treasury Depart- ment specifically request comments on the clarity of the proposed rules and how they may be made easier to understand. All comments will be available for public inspection and copying. A public hearing has been scheduled for Tuesday, December 19, 2006, at 10:00 a.m., in the auditorium of the New Car- rollton Federal Building, 5000 Ellin Road, Lanham, MD 20706. Due to building se- curity procedures, visitors must enter at the main front entrance. In addition, all visitors must presentphoto identification to enter the building. Because of access restrictions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For information about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER IN- FORMATION CONTACT” section of this preamble. The rules of 26 CFR 601.601(a)(3) ap- ply to the hearing. Persons who wish to present oral comments at the hearing must submit electronic or written comments and an outline of the topics to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by Novem- ber 28, 2006. A period of 10 minutes will be allotted to each person for making com- ments. An agenda showing the scheduling of the speakers will be prepared after the deadline for receiving outlines has passed. Copies of the agenda will be available free of charge at the hearing. Drafting Information The principal author of these regula- tions is Kimberly L. Koch, Office of the Associate Chief Counsel (Income Tax and Accounting), IRS. However, other person- nel from the IRS and Treasury Department participated in their development. ***** Proposed Amendments to the Regulations Accordingly, 26 CFR part 1 is proposed to be amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C. 7805 * * * Par. 2. Section 1.162–4 is revised to read as follows: §1.162–4 Repairs. Amounts paid for repairs and mainte- nance to tangible property are deductible if the amounts paid are not required to be capitalized under §1.263(a)–3. Par. 3. Section 1.263(a)–0 is amended by revising the entries for §1.263(a)–1 through §1.263(a)–3 to read as follows: §1.263(a)–0 Table of contents. * * * §1.263(a)–1 Capital expenditures; in general. (a) General rule for capital expendi- tures. (b) Examples of capital expenditures. (c) Amounts paid to sell property. (1) In general. (2) Treatment of capitalized amount. (3) Examples. (d) Amount paid. (e) Effective date. (f) Accounting method changes. §1.263(a)–2 Amounts paid to acquire or produce tangible property. (a) Overview. (b) Definitions. (1) Amount paid. (2) Personal property. (3) Real property. (4) Produce. (c) Coordination with other provisions of the Internal Revenue Code. (1) In general. (2) Materials and supplies. (d) Acquired or produced tangible prop- erty. (1) In general. (i) Requirement of capitalization. (ii) Examples. (2) Defense or perfection of title to tan- gible property. (i) In general. (ii) Examples. (3) Transaction costs. (i) In general. (ii) Examples. (4) 12-month rule. (i) In general. (ii) Coordination with section 461. (iii) Exceptions to 12-month rule. (iv) Character of property subject to 12-month rule. (v) Election to capitalize. (vi) Examples. (e) Treatment of capital expenditures. (f) Recovery of capitalized amounts. (1) In general. (2) Examples. (g) Effective date. (h) Accounting method changes. §1.263(a)–3 Amounts paid to improve tangible property. (a) Overview. (b) Definitions. (1) Amount paid. (2) Personal property. (3) Real property. (c) Coordination with other provisions of the Internal Revenue Code. (1) In general. (2) Example. (d) Improved property. (1) Capitalization rule. (2) Determining the appropriate unit of property. (i) In general. (ii) Initial unit of property determina- tion. (iii) Category I: Taxpayers in regulated industries. (iv) Category II: Buildings and struc- tural components. (v) Category III: Other personal prop- erty. (vi) Category IV: Other real property. (vii) Additional rule. (viii) Examples. (3) Compliance with regulatory re- quirements. (4) Unavailability of replacement parts. September 25, 20065502006–39 I.R.B. (5) Repairs performed during an im- provement. (i) In general. (ii) Exception for individuals. (e) Value. (1) In general. (2) Exception. (3) Appropriate comparison. (4) Examples. (f) Restoration. (1) In general. (2) Economic useful life. (i) Taxpayers with an applicable finan- cial statement. (ii) Taxpayers without an applicable fi- nancial statement. (iii) Definition of “applicable financial statement.” (3) Substantially prolonging economic useful life. (i) In general. (ii) Replacements. (iii) Restoration to like-new condition. (iv) Restoration after a casualty loss. (4) Examples. (g) Repair allowance method. (1) In general. (2) Election of repair allowance method. (3) Application of repair allowance method. (4) Repair allowance amount. (i) In general. (ii) Average unadjusted basis. (iii) Unadjusted basis. (iv) Buildings. (5) Capitalized amount. (i) In general. (ii) Single asset treatment of capitalized amount. (iii) Allocation treatment of capitalized amount. (iv) Section 168(g) repair allowance property. (v) Section 168(g) election. (vi) Public utility property. (6) Repair allowance property. (i) In general. (ii) Certain property not subject to sec- tion 168. (iii) Exclusions from repair allowance property. (7) Excluded additions. (i) In general. (ii) Treatment of excluded additions. (8) Repair allowance percentage. (9)Mannerofelection. (10) Manner of revoking election. (11) Examples. (h) Treatment of capital expenditures. (i) Recovery of capitalized amounts. (j) Effective date. (k) Accounting method changes. ***** Par. 4. Sections 1.263(a)–1 through 1.263(a)–3 are revised to read as follows: §1.263(a)–1 Capital expenditures; in general. (a)General rule for capital expendi- tures. Except as provided in chapter 1 of the Internal Revenue Code, no deduction is allowed for— (1) Any amount paid for new buildings or for permanent improvements or better- mentsmadetoincreasethevalueofany property or estate, or (2) Any amount paid in restoring prop- erty or in making good the exhaustion thereof for which an allowance is or has been made in the form of a deduction for depreciation, amortization, or depletion. (b)Examples of capital expenditures. The following amounts paid are examples of capital expenditures: (1) An amount paid to acquire or produce real or personal property. See §1.263(a)–2. (2) An amount paid to improve real or personal property. See §1.263(a)–3. (3) An amount paid to acquire or create intangibles. See §1.263(a)–4. (4) An amount paid or incurred to facil- itate an acquisition of a trade or business, a change in capital structure of a business entity, and certain other transactions. See §1.263(a)–5. (5) An amount assessed and paid un- der an agreement between bondholders or shareholders of a corporation to be used in a reorganization of thecorporation or vol- untary contributions by shareholders to the capital of the corporation for any corporate purpose. See section 118 and §1.118–1. (6) An amount paid by a holding com- pany to carry out a guaranty of dividends at a specified rate on the stock of a sub- sidiary corporation for the purpose of se- curing new capital for the subsidiary and increasing the value of its stockholdings in the subsidiary. This amount must be added to the cost of the stock in the subsidiary. (c)Amounts paid to sell property—(1) In general. Commissions and other trans- action costs paid to facilitate the sale of property generally must be capitalized. However, in the case of dealers in property, amounts paid to facilitate the sale of prop- erty are treated as ordinary and necessary business expenses. See §1.263(a)–5(g) for the treatment of amounts paid to facilitate the disposition of assets that constitute a trade or business. (2)Treatment of capitalized amount. Amounts capitalized under paragraph (c)(1) of this section are treated as a reduc- tion in the amount realized and generally are taken into account either in the taxable year in which the sale occurs or in the taxable year in which the sale is aban- doned if a loss deduction is permissible. The capitalized amount is not added to the basis of the property and is not treated as an intangible under §1.263(a)–4. (3)Examples. The following examples, which assume the sale is not an installment sale under section 453, illustrate the rules of this paragraph (c): Example 1.Sales costs of real property.Xowns a parcel of real estate. X sells the real estate and pays legal fees, recording fees, and sales commissions to facilitate the sale. X must capitalize the fees and com- missions and, in the taxable year of the sale, offset the fees and commissions against the amount realized from the sale of the real estate. Example 2.Sales costs of dealers. Assume the same facts as inExample 1, except that X is a dealer in real estate. The commissions and fees paid to facil- itate the sale of the real estate are treated as ordinary and necessary business expenses under section 162. Example 3.Sales costs of personal property used in the trade or business. X is a farmer and owns a truck for use in X’s trade or business. X decides to sell the truck and on November 15, 2008, X pays to advertise the sale of the truck in the local news media. On February 15, 2009, X sells the truck to Y. X is required to capitalize in 2008 the amount paid to advertise the sale of the truck and, in 2009, is required to offset the amount paid against the amount realized from the sale of the truck. Example 4.Costs of abandoned sale of personal property used in a trade or business. Assume the same facts as inExample 3, except that, instead of selling the truck on February 15, 2009, X decides on that date not to sell the truck and takes the truck off the market. X is required to capitalize in 2008 the amount paid to advertise the sale of the truck. However, X may treat the amount paid as a loss under section 165 in 2009 when the sale is abandoned. Example 5.Sales costs of personal property not used in a trade or business.Assumethesamefactsas inExample 3, except that X does not use the truck in X’s trade or business, but instead uses it for personal purposes. X decides to sell the truck and on Novem- ber 15, 2008, X pays to advertise the sale of the truck in the local news media. On February 15, 2009, X sells the truck to Y. X is required to capitalize in 2008 the amount paid to advertise the sale of the truck and, in 2009, is required to offset the amount paid against the amount realized from the sale of the truck. 2006–39 I.R.B.551September 25, 2006 Example 6.Costs of abandoned sale of personal property not used in a trade or business. Assume the samefactsasinExample 5, except that, instead of selling the truck on February 15, 2009, X decides on that date not to sell the truck and takes the truck off the market. X is required to capitalize in 2008 the amount paid to advertise the sale of the truck. Although the sale is abandoned in 2009, X may not treat the amount paid as a loss under section 165 because the truck was not used in X’s trade or business or in a transaction entered into for profit. (d)Amount paid. For purposes of this section, the termsamounts paidandpay- mentmean, in the case of a taxpayer us- ing an accrual method of accounting, a liability incurred (within the meaning of §1.446–1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liabil- ity is incurred. (e)Effective date.Therulesinthissec- tion apply to taxableyears beginning on or after the date of publication of the Treasury decision adopting these rules as final reg- ulations in theFederal Register. (f)Accounting method changes.[Re- served] §1.263(a)–2 Amounts paid to acquire or produce tangible property. (a)Overview. This section provides rules for applying section 263(a) to amounts paid to acquire or produce real or personal property. See §1.263(a)–3 for the treatment of amounts paid to im- prove tangible property, §1.263(a)–4 for the treatment of amounts paid to acquire or create intangibles, and §1.263(a)–5 for the treatment of amounts paid to facilitate an acquisition of a trade or business, a change in capital structure of a business entity, and certain other transactions. (b)Definitions. For purposes of this section, the following definitions apply: (1)Amount paid. In the case of a tax- payer using an accrual method of account- ing, the termsamounts paidandpayment mean a liability incurred (within the mean- ing of §1.446–1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred. (2)Personal property.Personal prop- ertymeans tangible personal property as defined in §1.48–1(c). (3)Real property.Real propertymeans land and improvements thereto, such as buildings or other inherently permanent structures (including items that are struc- tural components of such buildings or structures) that are not personal prop- erty as defined in paragraph (b)(2) of this section. Local law is not controlling in determining whether property is real prop- erty for purposes of this section. (4)Produce.Producemeans construct, build, install, manufacture, develop, cre- ate, raise, or grow. See §1.263(a)–3 for capitalization rules applicable to amounts paid to improve property. (c)Coordination with other provisions of the Internal Revenue Code—(1)In gen- eral. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the In- ternal Revenue Code or regulations other than section 162(a) or section 212 and the regulations under those sections. (2)Materials and supplies. Nothing in this section changes the treatment of amounts paid for materials and supplies that are properly treated as deductions or deferred expenses, as appropriate, under §1.162–3. (d)Acquired or produced tangible property—(1)In general—(i)Require- ment of capitalization. A taxpayer must capitalize amounts paid to acquire or produce real or personal property hav- ing a useful life substantially beyond the taxable year, including land and land im- provements, buildings, machinery and equipment, and furniture and fixtures, and a unit of property (as determined under §1.263(a)–3(d)(2)), having a useful life substantially beyond the taxable year. A taxpayer also must capitalize amounts paid to acquire real or personal property for resale and to produce real or personal property for sale. See section 263A for the scope of costs required to be capitalized to property produced by the taxpayer or to property acquired for resale. (ii)Examples. The following examples illustrate the rule of this paragraph (d)(1): Example 1.Acquisition of personal property — coordination with §1.162–3. X, an airline, operates a fleet of aircraft. X purchases and maintains in stock for repairs to its aircraft a great number of differ- ent expendable flight equipment spare parts (includ- ing cartridges, canisters, cylinders, and disks), based in part on the manufacturer’s recommendations and in part on the airline’s experience. The expendable flight equipment spare parts are carried on hand by X until they are installed in the particular type of aircraft for which purchased. The expendable flight equip- ment spare parts are of a type normally not repaired and reused. As these parts are taken from stock and used to repair aircraft, the stock supply is replenished by X purchasing new parts. In 2008, X purchases expendable flight equipment spare parts. X prop- erly treats the amount paid for the expendable flight equipment spare parts as a deferred expense under §1.162–3. Nothing in this section changes the treat- ment of the original acquisition cost as a deferred ex- pense. Example 2.Acquisition of personal property — coordination with §1.162–3.X,anindustriallaundry business, leases many products, including garments, linens, shop towels, continuous roll towels, and mops (rental items). X maintains a supply of rental items on hand to replace worn or damaged items. The rental items have useful lives of 12 months or less. In 2008, X purchases a large quantity of rental items. The amount paid for the rental items is properly treated by X as a deferred expense under §1.162–3. Nothing in this section changes the treatment of the original acquisition cost as a deferred expense. Example 3.Acquisition of personal property.In 2008, X purchases new cash registers, which have a useful life substantially beyond the taxable year, for use in its retail store located in a leased space in a shopping mall. X must capitalize under this para- graph (d)(1) the amount paid to purchase each cash register. Example 4.Relocation and installation of per- sonal property.AssumethesamefactsasinExample 3, except that X’s lease expires in 2009 and X decides to relocate its retail store to a different building. In ad- dition to various other costs, X pays $5,000 to move the cash registers and $1,000 to reinstall them in the other store. X is not required to capitalize under this paragraph (d)(1) the $5,000 amount paid for moving the cash registers; however, X must capitalize under this paragraph (d)(1) the $1,000 amount paid to rein- stall the cash registers in its other store because, under paragraph (b)(4) of this section, installation costs are production costs. Example 5.Acquisition of land. X purchases a parcel of undeveloped real estate. X must capitalize under this paragraph (d)(1) the amount paid to acquire the real estate. See §1.263(a)–2(d)(3) for the treat- ment of amounts paid to facilitate the acquisition of real property. Example 6.Acquisition of building. X purchases a building. X must capitalize under this paragraph (d)(1) the amount paid to acquire the building. See §1.263(a)–2(d)(3) for the treatment of amounts paid to facilitate the acquisition of real property. Example 7.Acquisition of property for resale.X purchases goods for resale. X must capitalize under this paragraph (d)(1) the amounts paid to acquire the goods. See section 263A for the treatment of amounts paid to acquire property for resale. Example 8.Production of property for sale.X produces goods for sale. X must capitalize under this paragraph (d)(1) the amount paid to produce the goods. See section 263A for the treatment of amounts paid to produce property. Example 9.Production of building. X constructs a building. X must capitalize under this paragraph (d)(1) the amount paid to construct the building. See section 263A for the treatment of amounts paid to produce real property. Example 10.Acquisition of assets constituting a trade or business. Y owns tangible and intangible as- sets that constitute a trade or business. X purchases all the assets of Y in a taxable transaction. X must September 25, 20065522006–39 I.R.B. capitalize under this paragraph (d)(1) the amount paid for the tangible assets of Y. See §1.263(a)–4 for the treatment of amounts paid to acquire intangibles and §1.263(a)–5 for the treatment of amounts paid to fa- cilitate the acquisition of assets that constitute a trade or business. See section 1060 for special allocation rules for certain asset acquisitions. (2)Defense or perfection of title to property—(i)In general. Amounts paid to defend or perfect title to real or per- sonal property constitute amounts paid to acquire or produce property within the meaning of this section and must be capi- talized. See section 263A for the scope of costs required to be capitalized to property produced by the taxpayer or to property acquired for resale. (ii)Examples. The following examples illustrate the rule of this paragraph (d)(2): Example 1.Amounts paid to contest condemna- tion. X owns real property located in County. County filed an eminent domain complaint condemning a portion of X’s property to use as a roadway. X hired an attorney to contest the condemnation. Amounts paid by X to the attorney must be capitalized because they were to defend X’s title to the property. Example 2.Amounts paid to invalidate or- dinance. X is in the business of quarrying and supplying sand and stone in a certain municipality. Several years after X established its business, the municipality in which it was located passed an ordi- nance that prohibited the operation of X’s business. X incurred attorney’s feesin a successful prosecution of a suit to invalidate the municipal ordinance. X prosecuted the suit to preserve its business activities and not to defend X’s title in the property. Therefore, attorney’s fees paid by X are not required to be capi- talized under this paragraph (d)(2). However, under section 263A, all indirect costs, including otherwise deductible costs, that directly benefit or are incurred by reason of the taxpayer’s production activities must be capitalized to the property produced for sale. Therefore, because the amounts paid to invalidate the ordinance are incurred by reason of X’s production activities, the amounts paid must be capitalized under section 263A to the property produced for sale by X. Example 3.Amounts paid to challenge building line. The board of public works of a municipality established a building line across X’s business prop- erty, adversely affecting the value of the property. X incurred legal fees in unsuccessfully litigating the es- tablishment of the building line. Amounts paid by X to the attorney must be capitalized because they were to defend X’s title to the property. (3)Transaction costs—(i)In general. A taxpayer must capitalize amounts paid to facilitate the acquisition of real or personal property, including shipping costs, bidding costs, sales and transfer taxes, legal and ac- counting fees, title fees, engineering fees, survey costs, inspection costs, appraisal fees, recording fees, application fees, com- missions, and compensation for the ser- vices of a qualified intermediary or other facilitator of an exchange under section 1031. See §1.263(a)–5 for the treatment of amounts paid to facilitate the acquisi- tion of assets that constitute a trade or busi- ness. See section 263A for the scope of costs required to be capitalized to property produced by the taxpayer or to property ac- quired for resale. (ii)Examples. The following examples illustrate the rule of this paragraph (d)(3): Example 1.Legal fees, taxes, and commissions to facilitate an acquisition. X purchases a building and pays legal fees, sales taxes, and sales commis- sions to facilitate the acquisition. X must capitalize the amounts paid for legal fees, sales taxes, and sales commissions. Example 2.Moving costs to facilitate an acqui- sition. X purchases all the assets of Y and, in con- nection with the purchase, hires a transportation com- pany to move storage tanks from Y’s plant to X’s plant. X must capitalize the amount paid to move the tanks from Y’s plant to X’s plant because the amount paid facilitates the acquisition of the storage tanks. (4)12-month rule—(i)In general. Except as otherwise provided in this para- graph (d)(4), an amount paid for the acquisition or production (including any amount paid to facilitate the acquisition or production) of a unit of property (as determined under §1.263(a)–3(d)(2)) with an economic useful life (as defined in §1.263(a)–3(f)(2)) of 12 months or less is not a capital expenditure under paragraph (d)ofthissection. (ii)Coordination with section 461.In the case of a taxpayer using an accrual method of accounting, the rules of this paragraph (d)(4) do not affect the deter- mination of whether a liability is incurred during the taxable year, including the de- termination of whether economic perfor- mance has occurred with respect to the li- ability. See §1.461–4 for rules relating to economic performance. (iii)Exceptions to 12-month rule.The 12-month rule in paragraph (d)(4)(i) of this section does not apply to the following: (A) Amounts paid for property that is or will be included in property produced for sale or property acquired for resale; (B) Amounts paid to improve property under §1.263(a)–3; (C) Amounts paid for land; and (D) Amounts paid for any component of a unit of property. (iv)Character of property subject to 12-month rule. Property to which a tax- payer applies the 12-month rule contained in paragraph (d)(4)(i) of this section is not treated upon sale or disposition as a capi- tal asset under section 1221 or as property used in the trade or business under section 1231. (v)Election to capitalize. A taxpayer may elect not to apply the 12-month rule contained in paragraph (d)(4)(i) of this section with regard to a unit of property. An election made under this paragraph (d)(4)(v) applies to any unit of property during the taxable year to which para- graph (d)(4)(i) of this section would apply (but for the election under this paragraph (d)(4)(v)). A taxpayer makes the election by treating the amount paid as a capital expenditure in its timely filed original Federal income tax return (including ex- tensions) for the taxable year in which the amount is paid. In the case of a pass-through entity, the election is made by the pass-through entity, and not by the shareholders, partners, etc. An election may not be made through the filing of an application forchange in accounting method or by an amended Federal income tax return and an election may not be re- voked. (vi)Examples. The rules of this para- graph (d)(4) are illustrated by the follow- ing examples, in which it is assumed (un- less otherwise stated) that the taxpayer is a calendar year, accrual method taxpayer that has not elected out of the 12-month rule under paragraph (d)(4)(v) of this sec- tion with regard to the unit of property, and that none of the property is materials and supplies under §1.162–3: Example 1.Production cost. X corporation manufactures and sells aluminum storm windows and doors. To conduct its business, X purchases strips of aluminum called extrusions and applies paint electrostatically to the extrusions through a complex process. In 2008, X installs a leaching pit to provide a draining area for liquid waste produced in the process of painting the extrusions. X previ- ously had dumped this waste into a creek bed, but the local water department ordered it to cease this practice. The economic useful life of the leaching pit is 12 months, after which time the factory will be connected to the local sewer system. Assume that the leaching pit is the unit of property, as determined un- der §1.263(a)–3(d)(2). X is not required to capitalize under paragraph (d) of this section the amount paid to produce the leaching pitbecause the useful life of the leaching pit is 12 months or less. However, under section 263A, all indirect costs, including otherwise deductible costs, that directly benefit or are incurred by reason of the taxpayer’s manufacturing activities must be capitalized to the property produced for sale. Therefore, because the amounts paid for the leaching pit are incurred by reason of X’s manufacturing op- erations, the amounts paid must be capitalized under section 263A to the property produced for sale by X. 2006–39 I.R.B.553September 25, 2006 Example 2.Acquisition or production cost.X purchases or produces jigs, dies, molds, and patterns for use in the manufacture of motor vehicles and mo- tor vehicle parts. The economic useful life of the jigs, dies, molds, and patterns is 12 months. Assume each jig, die, mold, and pattern is a separate unit of property, as determined under §1.263(a)–3(d)(2). X is not required to capitalize under paragraph (d) of this section the amounts paid to produce or purchase the jigs, dies, molds, and patterns because the eco- nomic useful life is 12 months or less. However, un- der section 263A, all indirect costs, including other- wise deductible costs, that directly benefit or are in- curred by reason of the taxpayer’s manufacturing ac- tivities must be capitalized to the property produced for sale. Therefore, because the amounts paid for the jigs, dies, molds, and patterns are incurred by reason of X’s manufacturing operations, the amounts paid must be capitalized under section 263A to the prop- erty produced for sale by X. Example 3.Acquisition or production cost.As- sume the same facts as inExample 2, but the eco- nomic useful life of the jigs, dies, molds, and patterns is 3 years. X is required to capitalize under paragraph (d) of this section the amounts paid to produce or pur- chase the jigs, dies, molds, and patterns because the economic useful life is more than 12 months. Example 4.Acquisition cost. X corporation is an interstate motor carrier. On December 1, 2008, X purchases, pays for, and takes delivery of truck tires with an economic useful life of 12 months. Assume X does not use the original tire capitalization method described in Rev. Proc. 2002–27, 2002–1 C.B. 802 (see §601.601(d)(2) of this chapter). Also assume that each tire is a separate unit of property, as de- termined under §1.263(a)–3(d)(2). X is not required under paragraph (d) of this section to capitalize the amount paid for the tires because the economic use- ful life of the tires is 12 months or less. Example 5.Transaction costs. Assume the same factsasinExample 4, but in addition to the amount paid for the tires, X also pays sales tax and delivery charges for the tires. X is not required to capitalize under paragraph (d) of this section the sales tax and delivery charges because they were paid to facilitate the acquisition of property with an economic useful life of 12 months or less. Example 6.Coordination with section 461 fixed liability rule. Assume the same facts as inExample 4, except that instead of purchasing the tires on Decem- ber 1, 2008, X enters into a contract with the tire man- ufacturer on that date to purchase tires from the man- ufacturer in 2009. X purchases, pays for, and takes delivery of the tires on March 31, 2009. X does not incur a liability under section 461 for the tires in 2008 because X does not have a fixed liability with respect to the tires until 2009. When X incurs the amount in 2009, X is not required under paragraph (d) of this section to capitalize that amount. Example 7.Coordination with section 461 eco- nomic performance rule. Assume the same facts as inExample 4, except that the tires are not delivered to X until March 31, 2009. X does not incur a liability under section 461 for the tires in 2008 because eco- nomic performance does not occur with respect to the liability until the property is provided to X in 2009. See §1.461–4(d)(2). When X incurs the amount in 2009, X is not required under paragraph (d) of this section to capitalize that amount. Example 8.Election not to capitalize. Assume thesamefactsasinExample 4, except that X elects under paragraph (d)(4)(v) of this section not to apply the 12-month rule contained in paragraph (d)(4)(i) of this section to the tires purchased on December 1, 2008. X must capitalize under paragraph (d) of this section the amount paid for the tires. Example 9.Exception to 12-month rule — prop- erty acquired for resale. Assume the same facts as in Example 4, except that X purchases the tires for re- sale. The 12-month rule in paragraph (d)(4)(i) of this section does not apply because the tires are property acquired for resale. Thus, X is required under para- graph (d) of this section to capitalize the amount paid for the tires. Example 10.Exception to 12-month rule — com- ponentofproperty. Assume the same facts as in Example 4, except that the tires are the first set of tires to be installed on a truck tractor acquired by X and X uses the original tire capitalization method de- scribed in Rev. Proc. 2002–27 (see §601.601(d)(2) of this chapter) so that the truck tractor (including the tires) is the unit of property, as determined under §1.263(a)–3(d)(2). Also assume that the truck tractor has an economic useful life of more than 12 months and that the invoice for the acquisition of the truck tractor separately states the cost of tires and various other components of the truck tractor. X is required under paragraph (d) of this section to capitalize the amount paid for the trucktractor because the eco- nomic useful life of the truck tractor is more than 12 months. Further, X may not use the 12-month rule to currently deduct the amount paid for the tires or any other component of the truck tractor, regardless that some components may have an economic useful life of 12 months or less and regardless that the cost of individual components is separately stated in the in- voice. (e)Treatment of capital expenditures. Amounts required to be capitalized un- der this section are capital expenditures and must be taken into account through a charge to capital account or basis, or in the case of property that is inventory in the hands of a taxpayer, through inclusion in inventory costs. See section 263A for the treatment of amounts referred to in this section as well as other amounts paid in connection with the production of real property and personal property, includ- ing films, sound recordings, video tapes, books, or similar properties. (f)Recovery of capitalized amounts—(1)In general.Amounts that are capitalized under this section are recovered through depreciation, cost of goods sold, or by an adjustment to basis at the time the property is placed in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable Internal Revenue Code and regulation provisions relating to the use, sale, or disposition of property. For example, §§1.162–4 and 1.263(a)–3 determine whether amounts capitalized under this section §1.263(a)–2 for property that is used to replace a component of a unit of property are repair or maintenance expenses or capitalized as an improvement to the unit of property. (2)Examples. The following examples illustrate the rule of this paragraph (f)(1) and assume that the taxpayer does not treat the acquired property as materials and sup- plies under §1.162–3: Example 1.Recovery when property placed in service. X owns a 10-unit apartment building. The refrigerator in one of the apartments stops function- ing and X purchases a new refrigerator to replace the old one. X pays for the acquisition, delivery, and installation of the new refrigerator. Assume the re- frigerator is the unit of property, as determined under §1.263(a)–3(d)(2). Section 1.263(a)–2(d) requires capitalization of amounts paid for the acquisition, de- livery, and installation of the refrigerator. Under this paragraph (f), the capitalized amounts are recovered through depreciation when the refrigerator is placed in service by X. Example 2.Recoverywhenpropertyusedinare- pair. Assume the same facts as inExample 1, except that a window in one of the apartments needs to be replaced. X pays for the acquisition, delivery, and installation of a new window. Assume the window is a structural component of the apartment building and that the apartment building is the unit of prop- erty, as determined under §1.263(a)–3(d)(2). Section 1.263(a)–2(d) requires capitalization of amounts paid for the acquisition and delivery of the window be- cause the window is property with a useful life sub- stantially beyond the end of the taxable year. As- sume the replacement of the old window with the new one does not improve the apartment building under §1.263(a)–3. Under this paragraph (f), the capital- ized amounts paid to acquire the window are recov- ered as ordinary and necessary repair expenses under §1.162–4 when the window is used in the repair by its installation in the apartment building. Example 3.Recovery when property used in a repair; coordination with section 263A. Assume the same facts as inExample 2, except that the window that is replaced is in an office in a plant where X man- ufactures widgets for sale. Section 1.263(a)–2(d) re- quires capitalization of amounts paid to produce in- ventory. Under section 263A, all indirect costs, in- cluding otherwise deductible repair costs that directly benefit or are incurred by reason of the production of inventory must be capitalized to the inventory pro- duced. Although the repair cost otherwise would be deductible as an expense under §1.162–4, X must de- termine whether the cost of the repair, or an allocable portion thereof, is required to be capitalized to the in- ventory produced as an indirect expense that directly benefits or is incurred by reason of the production ac- tivities. Any portion of the repair capitalized to in- ventory is recovered through cost of goods at the time the property is sold or otherwise disposed of in accor- dance with the taxpayer’s method of accounting for inventories. (g)Effective date.Therulesinthissec- tion apply to taxable years beginning on or September 25, 20065542006–39 I.R.B. after the date of publication of the Treasury decision adopting these rules as final reg- ulations in theFederal Register. (h)Accounting method changes.[Re- served] §1.263(a)–3 Amounts paid to improve tangible property. (a)Overview. This section provides rules for applying section 263(a) to amounts paid to improve tangible prop- erty. Paragraph (b) of this section contains definitions. Paragraph (c) of this section contains rules for coordinating this section with other provisions of the Internal Rev- enue Code. Paragraph (d) of this section provides rules for determining the treat- ment of amounts paid to improve tangible property, including rules for determining the appropriate unit of property. Paragraph (e) of this section contains rules for deter- mining whether amounts paid materially increase the value of the unit of property. Paragraph (f) of this section contains rules for determining whether amounts paid restore the unit of property. Paragraph (g) of this section describes an optional repair allowance method. (b)Definitions. For purposes this sec- tion, the following definitions apply: (1)Amount paid. In the case of a tax- payer using an accrual method of account- ing, the termsamounts paidandpayment mean a liability incurred (within the mean- ing of §1.446–1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred. (2)Personal property.Personal prop- ertymeans tangible personal property as defined in §1.48–1(c). (3)Real property.Real propertymeans land and improvements thereto, such as buildings or other inherently permanent structures (including items that are struc- tural components of such buildings or structures) that are not personal prop- erty as defined in paragraph (b)(2) of this section. Local law is not controlling in determining whether property is real prop- erty for purposes of this section. (c)Coordination with other provisions of the Internal Revenue Code—(1)In gen- eral. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the In- ternal Revenue Code or regulations (other than section 162(a) or section 212 and the regulations under those sections). (2)Example. The following example illustratestherulesofthisparagraph(c): Example.Railroad rolling stock. X is a railroad that properly treats amounts paid for the rehabilitation of railroad rolling stock as deductible expenses un- der section 263(d). X is not required to capitalize the amounts paid because nothing in this section changes the treatment of amounts specifically provided for un- der section 263(d). (d)Improved property—(1)Capitaliza- tion rule. Except as provided in the re- pair allowance method in paragraph (g) of this section, a taxpayer must capital- ize the aggregate of related amounts paid to improve a unit of property (including a unit of property for which the acquisition or production costs were deducted under the 12-month rule in §1.263(a)–2(d)(4)), whether the improvements are made by the taxpayer or by a third party. See sec- tion 263A for the scope of costs required to be capitalized to property produced by the taxpayer or to property acquired for re- sale; section 1016 for adding capitalized amounts to the basis of the unit of prop- erty; and section 168(i)(6) for the treat- ment of additions or improvements to a unit of property. For purposes of this para- graph (d), a unit of property is improved if the amounts paid— (i) Materially increase the value of the unit of property (see paragraph (e) of this section); or (ii) Restore the unit of property (see paragraph (f) of this section). (2)Determining the appropriate unit of property—(i)In general. The unit of prop- erty rules in this paragraph (d)(2) apply only for purposes of section 263(a) and §§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3, and not any other Internal Revenue Code or regulation section. Under this para- graph (d)(2), the appropriate unit of prop- erty is initially determined by applying the rules in paragraph (d)(2)(ii) of this section, except as provided in paragraph (d)(2)(iv) of this section (relating to buildings and structural components). The initial unit of property determination is further ana- lyzed in accordance with the appropriate hierarchical category described in one of paragraphs (d)(2)(iii) through (d)(2)(vi) of this section and by applying the additional rule in paragraph (d)(2)(vii) of this section. The specific rules contained in paragraphs (d)(2)(iii) through (d)(2)(vii) of this sec- tion dictate whether one or more compo- nents of the initial unit of property deter- mination must be treated as separate units of property. This paragraph (d)(2) applies to all real and personal property, other than network assets. For purposes of this paragraph (d)(2), network assets means railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpay- ers in each of those respective industries. The term includes, for example, trunk and feeder lines, pole lines, and buried conduit. It does not include property that would be included as a structural component of a building under paragraph (d)(2)(iv), nor does it include separate property that is adjacent to, but not part of a network asset, such as bridges, culverts, or tunnels. (ii)Initial unit of property determina- tion. Except for property described in paragraph (d)(2)(iv) of this section (re- garding buildings and structural compo- nents), the unit of property determination under this paragraph (d)(2) begins by identifying property that consists entirely of components that are functionally inter- dependent. Components of property are functionally interdependent if the plac- ing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer. For purposes of this section, property that is aggregated and subject to a general asset account election may not be treated as a single unit of property. (iii)Category I: Taxpayers in regulated industries. In the case of a taxpayer en- gagedinatradeorbusinessinaregulated industry, the unit of property is the USOA (uniform system of accounts) unit of prop- erty. For purposes of this section, a reg- ulated industry is an industry for which a Federal regulator (including any Federal department, agency, commission, board, or similar entity) has a USOA identifying a particular unit of property (USOA unit of property). This rule applies to any tax- payer engaged in a trade or business in the regulated industry, regardless of whether the taxpayer is subject to the regulatory accounting rules of the Federal regulator. The unit of property determination made under this paragraph (d)(2)(iii) is subject to paragraph (d)(2)(vii) of this section, which may require one or more components to be treated as separate units of property. 2006–39 I.R.B.555September 25, 2006 (iv)Category II: Buildings and struc- tural components. In the case of a building (as defined in §1.48–1(e)(1)) other than that described in paragraph (d)(2)(iii) of this section, the building and its structural components (as defined in §1.48–1(e)(2)) are a single unit of property. The unit of property determination made under this paragraph (d)(2)(iv) is subject to para- graph (d)(2)(vii) of this section, which may require one or more components to be treated as separate units of property. (v)Category III: Other personal prop- erty. In the case of personal property other than that described in paragraph (d)(2)(iii) of this section, the unit of property deter- mination must be made on the basis of the four factors listed in this paragraph (d)(2)(v). These four factors are the exclu- sive factors under this paragraph (d)(2)(v). No one factor is determinative and it is not intended that a determination be made on the basis of the number of factors indicat- ing that a component is, or is not, a sepa- rate unit of property. The unit of property determination made under this paragraph (d)(2)(v) is subject to paragraph (d)(2)(vii) of this section, which may require one or more components to be treated as separate units of property. The following factors must be taken into account: (A) Whether the component is— (1) Marketed separately to the taxpayer by a party other than the seller/lessor of the property of which the component is a part at the time the property is initially acquired or leased; (2) Acquired or leased separately by the taxpayer from a party other than the seller/lessor of the property of which the component is a part at the time the prop- erty is initially acquired or leased; (3) Subject to a separate warranty contract (from a party other than the seller/lessor of the property of which the component is a part); (4) Subject to a separate maintenance manual or written maintenance policy; (5) Appraised separately; or (6) Sold or leased separately by the tax- payer to another party; (B) Whether the component is treated as a separate unit of property in industry practice or by the taxpayer in its books and records; (C) Whether the taxpayer treats the component as a rotable part (a part that is removable from property, repaired or improved, and eitherimmediately rein- stalled on other property or stored for later installation); and (D) Whether the property of which the component is a part generally functions for its intended use without the component property. (vi)Category IV: Other real property. In the case of real property other than that described in paragraphs (d)(2)(iii) and (d)(2)(iv) of this section, the unit of prop- erty determination must be made on the basis of all the facts and circumstances. The unit of property determination made under this paragraph (d)(2)(vi) is subject to paragraph (d)(2)(vii) of this section, which may require one or more components to be treated as separate units of property. (vii)Additional rule. If the taxpayer properly treats a component as a sepa- rate unit of property for any Federal in- come tax purpose, the taxpayer must treat the component as a separate unit of prop- erty for purposes of this paragraph (d)(2). For purposes of paragraph (d)(2), the term any Federal income tax purposeincludes, but is not limited to, the use of different placed-in-service dates (other than the use of a new placed-in-service date for an im- provement (as determined under this sec- tion) to the unit of property or a different placed-in-service date for a particular floor of a building) or different classes of prop- erty as set forth in section 168(e) (MACRS classes), for the component and the prop- erty of which the component is a part. If the taxpayer properly recognizes a loss un- der section 165, or under another applica- ble provision, from a retirement of a com- ponent of property or from the worthless- ness or abandonment of a component of property, the taxpayer must treat the com- ponent as a separate unit of property for purposes of this paragraph (d)(2). There- fore, any property that replaces the compo- nent also will be treated as a separate unit of property. See §1.263(a)–2(d)(1). For purposes of this paragraph (d)(2), merely claiming a tax credit related to tangible property does not constitute treatment of that property as a separate unit of property for a Federal income tax purpose. (viii)Examples. The rules of this para- graph (d)(2) are illustrated by the follow- ing examples, in which it is assumed (un- less otherwise stated) that the taxpayer has not made a general asset account election with regard to the property and that para- graph (d)(2)(vii) of this section does not re- quire the use of a different unit of property: Example 1.Category I. X is an electric utility company that operates a power plant to generate elec- tricity. X’s operation previously was regulated by the Federal Energy Regulatory Commission (FERC) but, for various reasons, is no longer subject to regulation by FERC. Under FERC’s USOA, each turbine, econ- omizer, generator, and pulverizer is treated as a sepa- rate unit of property for regulatory accounting pur- poses. The initial unit of property determined un- der paragraph (d)(2)(ii) of this section is the entire power plant, which consists entirely of components that are functionally interdependent. The power plant must next be analyzed under paragraph (d)(2)(iii) of this section because X is engaged in a trade or busi- ness in an industry for which a Federal regulator has a USOA. Under the rules in that paragraph, X must treat each turbine, economizer, generator, and pul- verizer as a separate unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 2.Category I. X is a Class I railroad. All Class I railroads are regulated by the Surface Trans- portation Board (STB). Under STB’s USOA, each locomotive and each freight car is treated as a sep- arate unit of property for regulatory accounting pur- poses. Although each locomotive consists of various components, such as an engine, generators, batteries, trucks, etc., those components are functionally inter- dependent. Thus, the locomotive is an initial unit of property as determined under paragraph (d)(2)(ii) of this section. Similarly, each freight car consists en- tirely of functionally interdependent components and, thus, each freight car is an initial unit of property un- der paragraph (d)(2)(ii) of this section. Each loco- motive and freight car must next be analyzed under paragraph (d)(2)(iii) of this section because X is en- gaged in a trade or business in an industry for which a Federal regulator has a USOA. Under the rules in that paragraph, X must treateach locomotive and each freight car as a separate unit of property for deter- mining whether an amount paid improves the unit of property for Federal income tax purposes. Example 3.Category I. Assume the same facts as inExample 2, except that X is a Class II railroad. The STB does not regulate Class II railroads. However, because X is engaged in a trade or business in an in- dustry (the railroad industry) for which a Federal reg- ulator has a USOA, the rules in paragraph (d)(2)(iii) of this section apply, regardless of whether X is sub- ject to those rules. Based on these facts, X must treat each locomotive and each freight car as a separate unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 4.Category I. X is a telecommunica- tions company regulatedby the Federal Communi- cations Commission (FCC) and subject to a USOA for telephone companies. The assets of X include a telephone central office switching center, which con- tains numerous switches and various other switching equipment that all work together to provide telephone service to customers. The initial unit of property de- termined under paragraph (d)(2)(ii) of this section is the central office switching center, which consists en- tirely of components that are functionally interdepen- dent. The telecommunications system must next be analyzed under paragraph (d)(2)(iii) of this section September 25, 20065562006–39 I.R.B. because X is engaged in a trade or business in an industry for which a Federal regulator has a USOA. Under the rules in that paragraph, X must treat each switch and/or piece of equipment as defined in the USOA of the FCC and used in the central office op- eration as a separate unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 5.Category II. X owns a manufactur- ing building containing various types of manufactur- ing equipment that are not structural components of the manufacturing building. Because the property is a building, as defined in §1.48–1(e)(1), paragraph (d)(2)(ii) of this section does not apply and the prop- erty must be analyzed under paragraph (d)(2)(iv) of this section. Under the rules in that paragraph, X must treat the manufacturing building and its struc- tural components as a single unit of property for de- termining whether an amount paid improves the unit of property for Federal income tax purposes. The ap- propriate unit of property determination for the man- ufacturing equipment must be made separately under paragraph (d)(2)(v) of this section. Example 6.Category III; additional rule.As- sume the same facts as inExample 5, except that X does a cost segregation study of the manufactur- ing building and properly determines that refriger- ation equipment used to create a walk-in freezer in the manufacturing building is section 1245 property as defined in section 1245(a)(3). The refrigeration equipment is not part of the HVAC system that re- lates to the general operation or maintenance of the building. For Federal income tax purposes, X prop- erly treats the refrigeration equipment as a separate unit of property for depreciation purposes. The rules of paragraph (d)(2)(v) of this section apply to deter- mine whether the refrigeration equipment, or some smaller component, is the appropriate unit of prop- erty. In this example, assume that no components of the refrigeration equipment meet any of the facts and circumstances listed in paragraph (d)(2)(v) of this section. Based on these facts, X must treat the refrig- eration equipment as the unit of property for deter- mining whether an amount paid improves the unit of property for Federal income tax purposes. Example 7.Category III; additional rule.As- sume the same facts as inExample 6, except that the refrigeration equipment for the walk-in freezer ceases to function. X decides not to repair the re- frigeration equipment, but to replace it altogether. X abandons the refrigeration equipment for the walk-in freezer and properly recognizes a loss under section 165 from the abandonment of the refrigeration equip- ment. Therefore, X must treat the refrigeration equip- ment for the walk-in freezer as a separate unit of prop- erty for determining whether amounts paid to replace the equipment must be capitalized for Federal income tax purposes. See §1.263(a)–2(d)(1). Example 8.Category III. (i) X is a commercial airline engaged in the business of transporting pas- sengers and freight throughout the United States and abroad. To conduct its business, X owns or leases var- ious types of aircraft. X purchases the aircraft engine separately at the time the aircraft is acquired. The engine is subject to a separate warranty and written maintenance policy provided by the engine manufac- turer. For financial accounting purposes, X accounts for each type of aircraft by maintaining separate ac- counts on its books for each type of airframe and en- gine in its fleet. To perform maintenance on an en- gine, X removes the engine from the aircraft and re- places it with another used engine that has returned from a maintenance visit. (ii) The initial unit of property determined under paragraph (d)(2)(ii) of this section is the aircraft (and not the entire fleet of aircraft), which consists entirely of components that are functionally interdependent. The aircraft must next be analyzed under one of para- graphs (d)(2)(iii) through (d)(2)(vi) of this section. AlthoughXisengagedinatradeorbusinessinanin- dustry regulated by the Federal Aviation Administra- tion (FAA), the FAA does not have a USOA. There- fore, the rules of paragraph (d)(2)(iii) of this section do not apply to X; instead, the rules of paragraph (d)(2)(v) of this section apply to determine whether the entire aircraft, or the engine, is the appropriate unit of property. In thisExample 8, the aircraft engine is acquired separately, is subject to a separate war- ranty and maintenance policy, is treated separately for financial accounting purposes, and is rotable. Based on these facts, X must treat the engine as the unit of property for determining whether an amount paid im- proves the engine for Federal income tax purposes. X must treat the aircraft without the engine as a unit of property for determining whether an amount paid im- proves the aircraft for Federal income tax purposes. Example 9.Category III. X is a corporation that owns a small aircraft for use in its trade or business. X performs required maintenance on its aircraft en- gines. The aircraft engine is not marketed, purchased, leased, appraised, or sold separately, but it is subject to a separate warranty and written maintenance policy provided by the engine manufacturer. For financial accounting purposes, X doesnot maintain separate accounts on its books for individual engines. X does not treat the engine as a rotable part. The initial unit of property determined under paragraph (d)(2)(ii) of this section is the aircraft, which consists entirely of com- ponents that are functionally interdependent. The air- craftmustnextbeanalyzedunder paragraph (d)(2)(v) of this section to determine whether the entire air- craft, or the engine, is the appropriate unit of prop- erty. Based on these facts, the engine is not a separate unit of property. Therefore,X must treat the aircraft, including the aircraft engine, as the unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 10.Category III. X is a towboat op- erator that owns and leases a fleet of towboats. X performs maintenance on its towboat engines every 3 to 4 years, in accordance with the engine manufac- turer’s maintenance manuals. Towboat engines are not marketed, purchased, leased, appraised, or sold separately; however, the engines are subject to a sep- arate warranty and written maintenance policy pro- vided by the engine manufacturer. For financial ac- counting purposes, X does not maintain separate ac- counts on its books for individual engines. X does not treat the engine as a rotable part. The initial unit of property determined under paragraph (d)(2)(ii) of this section is the towboat (and not the entire fleet of tow- boats), which consists entirely of components that are functionally interdependent. The towboat must next be analyzed under paragraph (d)(2)(v) of this section. Based on these facts, the engine is not a separate unit of property. Therefore, X must treat the towboat, in- cluding the towboat engine, as the unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 11.Category III. X purchases a car to use in X’s taxi service. The invoice received by X for the purchase of the car separately lists several op- tions, including air conditioning, automatic transmis- sion, antilock braking system, side impact air bags, power group, and special alloy wheels. Under para- graph (d)(2)(ii) of this section, the initial unit of prop- erty is the car because the options are functionally in- terdependent with the car. The options are not subject to separate warranties. X is an individual and does not keep books and records other than for tax purposes. For depreciation purposes, X properly treats the car and options as one unit of property. X does not treat any of the options as rotable parts. Based on these facts, the options are not separate units of property. X must treat the car, including the options, as the unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 12.Category III.Xisacommoncar- rier that owns a fleet of fuelhauling trucks and peri- odically performs maintenance on its truck engines. The entire fleet of trucks is subject to a general as- set account election, one for the truck trailers and one for the truck tractors. Under paragraph (d)(2)(ii) of this section, X may not treat the entire fleet as the unit of property. Instead, the initial units of property determined under paragraph (d)(2)(ii) of this section are each truck tractor and each truck trailer. Each tractor consists entirely of functionally interdepen- dent components and each trailer consists entirely of functionally interdependent components. To deter- mine whether the engine is a separate unit of property from the tractor, the factors in paragraph (d)(2)(v) of this section apply. The engines are marketed sepa- rately from the tractor and are subject to a separate warranty and written maintenance policy provided by the engine manufacturer. The engines are not treated as a separate unit of property in industry practice or by X in its books and records. The engine is removed from the tractor, repaired or improved, and stored for later installation on another tractor. Based on these facts, the engine is a separate unit of property. There- fore, X must treat the engine as the unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 13.Category III. Assume the same facts as inExample 12, except that the inquiry is whether the oil filter in the tractor engine is a separate unit of property. The oil filter is not marketed, acquired, leased, appraised, or sold separately, nor is it subject to a separate warranty or maintenance manual. The filter is not treated as a separate unit of property in industry practice or by X in its books and records, nor is it treated as a rotable part. Based on these facts, the oil filter is not a separate unit of property. Therefore, X must treat the engine, including the oil filter, as the unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 14.Category III. (i) X manufactures and sells computers and computer equipment. It also operates a separate computer maintenance business, for which X maintains pools of rotable spare parts that are primarily used to repair computer equipment purchasedorleasedbyitscustomers. Most of X’s computer maintenance business is conducted pur- 2006–39 I.R.B.557September 25, 2006 suant to standardized maintenance agreements that obligate X to provide all parts and labor, product upgrades, preventive maintenance, and telephone assistance necessary to keep a customer’s computer operational for the duration of the contract (usually one year) in exchange for a predetermined fee. In its computer maintenance business, X sends technicians to its customer’s location, who use the supply of rotable spare parts to diagnose problems in the cus- tomer’s equipment, and then exchange the working parts for any malfunctioning parts. A customer’s part that is identified as the cause of the malfunction is replaced with the identical functioning part from X’s rotable spare parts pool. The malfunctioning part removed from the customer’s equipment is then repaired and placed in X’s rotable spare parts pool for continued use in the computer maintenance business. (ii) Under paragraph (d)(2)(ii) of this section, X may not treat the entire pool of rotable spare parts as the unit of property. Instead, the initial unit of property determined under paragraph (d)(2)(ii) of this section is each rotable spare part because each part consists entirely of functionally interdependent com- ponents. Assume for purposes of thisExample 14 that paragraph (d)(2)(v) of this section does not re- quire any components of the rotable spare parts to be treated as separate units of property. Based on these facts, the entire pool of spare parts is not the unit of property. Therefore, X must treat each rotable spare part as a unit of property for determining whether an amount paid improves the unit of property for Federal income tax purposes. Example 15.Category III. (i) X is a dentist and operates a small dental clinic. On March 1, 2008, X purchases a new laptop computer, with a one-year warranty, for use in the dental business. On May 1, 2009, after the warranty has expired, the computer malfunctions and X contacts the manufacturer’s computer maintenance shop for assistance. The maintenance shop sends a technician to X’s dental clinic, who uses a supply of rotable spare parts to diagnose problems in X’s computer. The technician determines that the circuit board must be replaced and exchanges X’s malfunctioning circuit board with the identical functioning circuit board from the com- puter maintenance operation’s rotable spare parts pool. The malfunctioning circuit board removed from X’s computer is then repaired and placed in the manufacturer’s rotable spare parts pool for continued use in the computer maintenance business. (ii) The initial unit of property determined under paragraph (d)(2)(ii) of this section is the computer, which consists entirely of components (circuit board or motherboard, central processing unit or CPU, hard drive, RAM, keyboard, monitor, case, etc.) that are functionally interdependent. To determine whether the circuit board is a separate unit of property from the computer, the factors in paragraph (d)(2)(v) of this section apply. The circuit board was not marketed separately to X or acquired separately by X, nor is it subject to a separate warranty. The CPU, however, was marketed separately to the taxpayer, but not ac- quired separately. No component, including the cir- cuit board and CPU of the laptop computer, is treated as a separate unit of property by X in its books and records, nor does X treat any component as a rotable part. The computer does not function for its intended use without the circuit board and the CPU. Based on these facts, neither the circuit board nor the CPU is a separate unit of property. X must treat the entire lap- top computer, including the circuit board and CPU, as the unit of property for determining whether an amount paid improves the unit of property for Fed- eral income tax purposes. (3)Compliance with regulatory re- quirements. For purposes of this section, a Federal, state, or local regulator’s re- quirement that a taxpayer perform certain repairs or maintenance on a unit of prop- erty to continue operating the property is not relevant in determining whether the amount paid improves the unit of property. (4)Unavailability of replacement parts. For purposes of this section, if a taxpayer needs to replace part of a unit of property that cannot practicably be replaced with the same type of part (for example, because of technological advancements or prod- uct enhancements), the replacement of the part with an improved but comparable part does not, by itself, result in an improve- ment to the unit of property. (5)Repairs performed during an im- provement—(i)In general. Repairs that do not directly benefit or are not incurred by reason of an improvement are not required to be capitalized under section 263(a), re- gardless of whether they are made at the same time as an improvement. See section 263A for rules requiring capitalization of all direct costs of an improvement and all indirect costs that directly benefit or are in- curred by reason of the improvement. (ii)Exception for individuals.Atax- payer who is an individual may capital- ize amounts paid for repairs that are made at the same time as substantial capital im- provements to property not used in the tax- payer’s trade or business or for the produc- tion of income if the repairs are done as part of a remodeling or restoration of the taxpayer’s residence. (e)Value—(1)In general. A taxpayer must capitalize amounts paid that materi- ally increase the value of a unit of prop- erty. An amount paid materially increases the value of a unit of property only if it— (i) Ameliorates a condition or defect that either existed prior to the taxpayer’s acquisition of the unit of property or arose during the production of the unit of prop- erty, whether or not the taxpayer was aware of the condition or defect at the time of ac- quisition or production; (ii) Is for work performed prior to the date the property is placed in service by the taxpayer (without regard to any applicable convention under section 168(d)); (iii) Adapts the unit of property to a new or different use (including a permanent structural alteration to the unit of prop- erty); (iv) Results in a betterment (including a material increase in quality or strength) or a material addition (including an enlarge- ment, expansion, or extension) to the unit of property; or (v) Results in a material increase in capacity (including additional cubic or square space), productivity, efficiency, or quality of output of the unit of property. (2)Exception. Notwithstanding the rules in paragraph (e)(1)(i) through (e)(1)(v) of this section, an amount paid does not result in a material in- crease in value to a unit of property if the economic usefullife (as defined in §1.263(a)–3(f)(2)) of the unit of property is 12 months or less and the taxpayer did not elect to capitalize the amounts paid originally for the unit of property. (3)Appropriate comparison.For purposes of paragraphs (e)(1)(iv) and (e)(1)(v) of this section, in cases in which a particular event necessitates an ex- penditure, the determination of whether the amount paid materially increases the value of the unit of property is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the event necessitating the expen- diture. When the event necessitating the expenditure is normal wear and tear to the unit of property, the condition of the property immediately prior to the event necessitating the expenditure is the condi- tion of the property after the last time the taxpayer corrected the effects of normal wear and tear (whether the amounts paid were for maintenance or improvements) or, if the taxpayer has not previously cor- rected the effects of normal wear and tear, the condition of the property when placed in service by the taxpayer. (4)Examples. The following examples illustrate the rules of this paragraph (e) and assume that the amounts paid are not re- quired to be capitalized under any other provision of this section (paragraph (f), for example): Example 1.Pre-existing condition. In 2008, X purchased a store located on 10 acres of land that contained underground gasoline storage tanks left by September 25, 20065582006–39 I.R.B. prior occupants. The tanks had leaked, causing soil contamination. X was not aware of the contamination at the time of purchase. When X discovered the con- tamination, it incurred costs to remediate the soil. For purposes of thisExample 1, assume the 10 acres of land is the appropriate unit of property. The amounts paid for soil remediation must be capitalized as an improvement to the land because they ameliorated a condition or defect that existed prior to the taxpayer’s acquisition of the land. The comparison rule in para- graph (e)(3) of this section does not apply to these amounts paid. Example 2.Not a pre-existing condition; repair performed during an improvement.(i)Xowned land on which it constructed a building in 1969 for use as a bank. The building was constructed with asbestos-containing materials. The health dangers of asbestos were not widely known when the building was constructed. The presence of asbestos did not necessarily endanger the health of building occu- pants. The danger arises when asbestos-containing materials are damaged or disturbed, thereby releas- ing asbestos fibers into the air (where they can be inhaled). In 1971, Federal regulatory agencies des- ignated asbestos a hazardous substance. In 2008, X determined it needed additional space in its building to accommodate additional operations at its branch and decided to remodel the building. However, any remodeling work could not be undertaken without disturbing the asbestos-containing materials. The governmental regulations required that asbestos be removed if any remodeling was undertaking that would disturb asbestos-containing materials. There- fore, X decided to remove the asbestos-containing materials from the building in coordination with the overall remodeling project. (ii) For purposes of thisExample 2, assume that the building is the appropriate unit of property and that the amounts paid to remodel are required to be capitalized under §1.263(a)–3. The amounts paid to remove the asbestos are not required to be capitalized as a separate improvement under paragraph (e)(1)(i) of this section because the asbestos, although later de- termined to be unsafe under certain circumstances, was not an inherent defect to the property. The re- moval of the asbestos, by itself, also did not result in a material increase in value under paragraphs (e)(1)(ii) through (e)(1)(v) of this section. Under paragraph (d)(5)(i) of this section, repairs that do not directly benefit or are not incurred by reason of an improve- ment are not required to be capitalized under sec- tion 263(a). Under section 263A, all indirect costs, including otherwise deductible repair costs, that di- rectly benefit or are incurred by reason of the im- provement must be capitalized as part of the improve- ment. The amounts paid to remove the asbestos were incurred by reason of the remodeling project, which was an improvement. Therefore, X must capitalize under section 263A to the remodeling improvement amounts paid to remove the asbestos. Example 3.Work performed prior to placing the property in service. In 2008, X purchased a build- ing for use as a business office. The building was in a state of disrepair. In 2009, X incurred costs to repair cement steps; shore up parts of the first and second floors; replace electrical wiring; remove and replace old plumbing; and paint the outside and in- side of the building. Assume all the work was per- formed on the building or its structural components. In 2010, X placed the building in service and began using the building as its business office. For purposes of thisExample 3, assume the building and its struc- tural components are the appropriate unit of property. The amounts paid must be capitalized as an improve- ment to the building because they were for work per- formed prior to X’s placing the building in service. The comparison rule in paragraph (e)(3) of this sec- tion does not apply to these amounts paid. Example 4.Work performed prior to placing the property in service. In January 2008, X purchased new machinery for use in an existing production line of its manufacturing business. After the machinery was installed, X performed critical testing on the ma- chinery to ensure that it was operational. On Novem- ber 1, 2008, the new machinery became operational and, thus, the machinery was placed in service on November 1, 2008 (although X continued to perform testing for quality control). The amounts paid must be capitalized as an improvement to the machinery because they were for work performed prior to X’s placing the machinery in service. The comparison rule in paragraph (e)(3) of this section does not ap- ply to these amounts paid. Example 5.New or different use. X is an inte- rior decorating company and manufactures its own designs. In 2008, X decides to stop manufacturing and converts the manufacturing facility into a show- room for X’s business. To convert the facility, X removes certain load-bearing walls and builds new load-bearing walls to provide a better layout for the showroom and its offices. As part of building the new walls, X moves or replaces electrical, cable, and tele- phone wiring and paints the walls. X also repairs the floors, builds a fire escape, and performs small car- pentry jobs related to making the showroom acces- sible, including installing ramps and widening door- ways. For purposes of thisExample 5, assume the building and its structural components are the unit of property and that the work is performed on the struc- tural components. The amounts paid by X to con- vert the manufacturing facility into a showroom must be capitalized as an improvement to the building be- cause they adapted the building to a new or different use. The comparison rule in paragraph (e)(3) of this section does not apply to these amounts paid. Example 6.New or different use. X owned a building consisting of five separate retail stores, each of which it rented to different tenants. In 2008, two of the stores rented became vacant and remained va- cant for several months. One of the remaining ten- ants agreed to expand its occupancy to the two va- cant stores, which adjoined its own retail store. X in- curred costs to break down walls between the exist- ing stores and construct an additional rear entrance. For purposes of thisExample 6, assume the building and its structural components are the appropriate unit of property. The amounts paid by X to convert three retail stores into one larger store must be capitalized because they resulted in a permanent structural alter- ation, and thus a new or different use, to the building. The comparison rule in paragraph (e)(3) of this sec- tion does not apply to these amounts paid. Example 7.Not a new or different use. X owns a building for rental purposes and decides to sell it. In preparation of selling, X paints the interior walls, cleans the gutters, repairscracks in the porch, and re- finishes the hardwood floors. For purposes of thisEx- ample 7, assume the building and its structural com- ponents are the unit of property. Amounts paid for work done in anticipation of selling the building are not required to be capitalized unless the amounts paid materially increase the value as defined in paragraph (e)(3) of this section or prolong the economic useful life as defined in paragraph (f)(3). The amounts paid by X are not transaction costs paid to facilitate the sale of property under §1.263(a)–1(c), nor do they mate- rially increase the value of the building. Although the amounts were paid for the purpose of selling the building, the sale does not constitute a new or differ- ent use. Therefore, X is not required to capitalize as an improvement under paragraph (e) of this section the amounts paid for work performed on the build- ing. The comparison rule in paragraph (e)(3) of this section does not apply to these amounts paid. Example 8.Not a material increase in value.(i) X is a commercial airline engaged in the business of transporting passengers and freight throughout the United States and abroad. To conduct its business, X owns or leases various types of aircraft. As a con- dition of maintaining its airworthiness certification for these aircraft, X is required by the Federal Avia- tion Administration (FAA) to establish and adhere to a continuous maintenance program for each aircraft within its fleet. These programs, which are designed by X and the aircraft’s manufacturer and approved by the FAA are incorporated into each aircraft’s main- tenance manual. The maintenance manuals require a variety of periodic maintenance visits at various intervals during the operating lives of each aircraft. One type of maintenance visit is an engine shop visit (ESV), which is performed onX’s aircraft engines ap- proximately every 4 years. (ii) In 2004, X purchased a new aircraft and en- gine. In 2008, X performs its first ESV on the air- craft engine. The ESV includes some or all of the fol- lowing activities: disassembly, cleaning, inspection, repair, replacement, reassembly, and testing. Dur- ing the ESV, the engine is removed from the aircraft and shipped to an outside vendor who performs the ESV. When the engine arrives at the vendor, the en- gine is cleaned and externally inspected. Regard- less of condition, it is thoroughly inspected visually and, as appropriate, further inspected using a number of non-destructive testing procedures. The engine is then disassembled into major parts and, if necessary, into smaller parts. If inspection or testing discloses a discrepancy in a part’s conformity to the specifi- cations in X’s maintenance program, the part is re- paired, or if necessary, replaced with a new or used serviceable part conforming to the specifications. If a part can be repaired, but not in time to be returned to the engine with which the part had arrived, the ven- dor first attempts to replace the part with a similar part from customer stock (used parts from X’s aircraft that were replaced or exchanged and repaired during an earlierESVandthenstoredforfutureuseonX’sair- craft). If a part is not available from customer stock, the part is exchanged with a used, serviceable part in the vendor’s inventory. A part is replaced (generally with a used serviceable part) only if the part removed from X’s engine cannot be repaired timely. (iii) For purposes of thisExample 8,assume the aircraft engine is the appropriate unit of prop- erty. To determine whether the ESV results in a material increase in value under paragraph (e)(1)(iv) or (e)(1)(v) of this section, the comparison rule in paragraph (e)(3) of this section applies. Because the 2006–39 I.R.B.559September 25, 2006 event necessitating the ESV was normal wear and tear, and X had not previously performed an ESV on the engine, the relevant comparison is the condition of the property immediately after the ESV with the condition of the property when placed in service by X. Using this comparison, the ESV did not result in a material addition, betterment, or material increase in capacity, productivity, efficiency, or quality of output of the engine compared to the condition of the engine when placed in service, nor did it adapt the engine to a new or different use. Therefore, the amounts paid by X for the ESV did not result in a material increase in value to the engine. X is not required to capitalize as an improvement under paragraph (e) of this section amounts paid for the ESV. Example 9.Betterment; regulatory requirement. X owned a hotel in City that included five foot high unreinforced terra cotta and concrete parapets with overhanging cornices around the entire roof perime- ter. The parapets and cornices were in good condi- tion. In 2008, City passed an ordinance setting higher safety standards for parapets and cornices because of the hazardous conditions caused by earthquakes. To comply with the ordinance, X replaced the old parapets and cornices with new ones made of glass fiber reinforced concrete, which made them lighter and stronger than the original ones. They were at- tached to the hotel using welded connections instead of wire supports, making them more resistant to dam- age from lateral movement. For purposes of thisEx- ample 9, assume the hotel building and its structural components are the appropriate unit of property. The event necessitating the expenditure was the 2008 City ordinance. Prior to the ordinance, the old parapets and cornices were in good condition, but were deter- mined by City to create a potential hazard. After the expenditure, the new parapets and cornices signifi- cantly improved the structural soundness of the hotel. Therefore, the amounts paid by X to replace the para- pets and cornices must be capitalized because they re- sulted in a betterment to the hotel. City’s requirement that X correct the potential hazard to continue oper- ating the hotel is not relevant in determining whether the amount paid improved the hotel. See paragraph (d)(3) of this section. Example 10.Not a material increase in value; regulatory requirement. X owned a meat process- ing plant. In 2008, X discovered that oil was seep- ing through the concrete walls of the plant, creating a fire hazard. Federal meat inspectors advised X that it must correct the seepage problem or shut down its plant. To correct the problem, X incurred costs to add a concrete lining to the walls from the floor to a height of about four feet and also to add concrete to the floor of the plant. For purposes of thisExample 10, assume the plant building and its structural components are the appropriate unit of property. The event necessitat- ing the expenditure was the seepage of the oil. Prior to the seepage, the plant did not leak and was func- tioning for its intended use. The expenditure did not result in a material addition, betterment, or material increase in capacity, productivity, efficiency, or qual- ity of output of the plant compared to the condition of the plant prior to the seepage of the oil, nor did it adapt the plant to a new or different use. Therefore, the amounts paid by X to correct the seepage do not materially increase the value of the plant. X is not required to capitalize as an improvement under para- graph (e) of this section amounts paid to correct the seepage problem. The Federal meat inspectors’ re- quirement that X correct the seepage to continue oper- ating the plant is not relevant in determining whether the amount paid improved the plant. See paragraph (d)(3) of this section. Example 11.Not a material increase in value; re- placement with same part. X owns a small retail shop. In 2008, a storm damaged the roof of X’s shop by dis- placing numerous wooden shingles. X decides to re- place all the wooden shingles on the roof and hired a contractor to replace all the shingles on the roof with new wooden shingles. No part of the sheath- ing, rafters, or joists was replaced. For purposes of thisExample 11, assume the shop and its structural components are the appropriate unit of property. The event necessitating the expenditure was the storm. Prior to the storm, the retail shop was functioning for its intended use. The expenditure did not result in a material addition, betterment, or material increase in capacity, productivity, efficiency, or quality of out- put of the shop compared to the condition of the shop prior to the storm, nor did it adapt the shop to a new or different use. Therefore, the amounts paid by X to reshingle the roof with wooden shingles do not mate- rially increase the value of the shop. X is not required to capitalize as an improvement under paragraph (e) of this section amounts paid to replace the shingles. Example 12.Not a material increase in value; re- placement with comparable part.Assumethesame factsasinExample 11, except that wooden shingles are not available on the market. X decides to re- place all the wooden shingles with comparable as- phalt shingles. The amounts paid by X to reshingle the roof with asphalt shingles do not materially in- crease the value of the shop, even though the asphalt shingles may be an improvement over the wooden shingles. Because the wooden shingles could not practicably be replaced with new wooden shingles, the replacement of the old shingles with comparable asphalt shingles does not, by itself, result in an im- provement to the shop. X is not required to capitalize as an improvement under paragraph (e) of this section amounts paid to replace the shingles. Example 13.Betterment; replacement with im- proved parts. Assume the same facts as inExample 11, except that, instead of replacing the wooden shin- gles with asphalt shingles, X decides to replace all the wooden shingles with shingles made of lightweight composite materials that are maintenance-free and do not absorb moisture. The new shingles have a 50-year warranty and a Class A fire rating. X must capitalize as an improvement amounts paid to reshingle the roof because they result in a betterment to the shop. Example 14.Material increase in capacity.X owns a factory building with a storage area on the second floor. In 2008, Xreplaces the columns and girders supporting the second floor to permit storage of supplies with a gross weight 50 percent greater than the previous load-carrying capacity of the stor- age area. For purposes of thisExample 14, assume the factory building and its structural components are the appropriate unit of property. X must capitalize as an improvement amounts paid for the columns and girders because they resultin a material increase in the load-carrying capacity of the building. The com- parison rule in paragraph (e)(3) of this section does not apply to these amounts paid because the expendi- ture was not necessitated by a particular event. Example 15.Material increase in capacity.In 2008, X purchased harbor facilities consisting of a slip for the loading and unloading of barges and a channel leading from the slip to the river. At the time of purchase, the channel was 150 feet wide, 1,000 feet long, and 10 feet deep. To allow for ingress and egress and for the unloading of its barges, X needed to deepen the channel to a depth of 20 feet. X hired a contractor to dredge the channel to the required depth. For purposes of thisExample 15, assume the channel is the appropriate unit of property. X must capital- ize as an improvement amounts paid for the dredging because it resulted in a material increase in the capac- ity of the channel. The comparison rule in paragraph (e)(3) of this section does not apply to these amounts paid because the expenditure was not necessitated by a particular event. Example 16.Not a material increase in capac- ity. Assume the same facts as inExample 15, except that the channel was susceptible to siltation and, by 2009, the channel depth had been reduced to 18 feet. X hired a contractor to redredge the channel to a depth of 20 feet. The event necessitating the expenditure was the siltation of the channel. Both prior to the sil- tation and after the redredging, the depth of the chan- nel was 20 feet. Therefore, the amounts paid by X for redredging the channel did not materially increase the capacity of the unit of property. X is not required to capitalize as an improvement under paragraph (e) of this section amounts paid to redredge. Example 17.Not a material increase in capacity. X owns a building used in its trade or business. The first floor has a drop-ceiling. X decides to remove the drop-ceiling and repaint the original ceiling. For purposes of thisExample 17, assume the building and its structural components are the appropriate unit of property. The removal of the drop-ceiling does not create additional capacity in the building that was not there prior to the removal. Therefore, the amounts paid by X to remove the drop-ceiling and repaint the original ceiling did not materially increase the capac- ity of the unit of property. X is not required to capital- ize as an improvement under paragraph (e) of this sec- tion amounts paid related to removing the drop-ceil- ing. The comparison rule in paragraph (e)(3) of this section does not apply to these amounts paid because the expenditure was not necessitated by a particular event. (f)Restoration—(1)In general.Atax- payer must capitalize amounts paid that re- store a unit of property. Amounts paid re- store property if the amounts paid substan- tially (as defined in paragraph (f)(3) of this section) prolong the economic useful life of the unit of property. (2)Economic useful life—(i)Taxpayers with an applicable financial statement. For taxpayers with an applicable finan- cial statement (as defined in paragraph (f)(2)(iii) of this section), the economic useful life of a unit of property generally is presumed to be the same as the useful life used by the taxpayer for purposes of determining (at the time the property is originally acquired or produced by the September 25, 20065602006–39 I.R.B. taxpayer) depreciation in its applicable financial statement, regardless of any salvage value of the property. A tax- payer may rebut this presumption only if there is a clear and convincing basis that the economic useful life (as defined in paragraph (f)(2)(ii) of this section for taxpayers without an applicable financial statement) of the unit of property is signif- icantly different than the useful life used by the taxpayer for purposes of determin- ing depreciation in its applicable financial statement. If a taxpayer does not have an applicable financial statement at the time the property was originally acquired or produced, but does have an applicable financial statement at some later date, the economic useful life of the unit of prop- erty must be determined under paragraph (f)(2)(ii) of this section. Further, if a tax- payer treats amounts paid for a unit of property as an expense in its applicable financial statement on a basis other than the property having a useful life of one year or less, the economic useful life of the unit of property must be determined under paragraph (f)(2)(ii) of this section. For example, if a taxpayer has a policy of treating as an expense on its applica- ble financial statement amounts paid for property costing less than a certain dollar amount, notwithstanding that the property has a useful life of more than one year, the economic useful life of the property must be determined under paragraph (f)(2)(ii) of this section. (ii)Taxpayers without an applicable fi- nancial statement. For taxpayers that do not have an applicable financial statement (as defined in paragraph (f)(2)(iii) of this section), the economic useful life of a unit of property is not necessarily the useful life inherent in the property but is the pe- riod over which the property may reason- ably be expected to be useful to the tax- payer or, if the taxpayer is engaged in a trade or business or an activity for the pro- duction of income, the period over which the property may reasonably be expected to be useful to the taxpayer in its trade or business or for the production of income, as applicable. This period is determined by reference to the taxpayer’s experience with similar property, taking into account present conditions and probable future de- velopments. Factors to be considered in determining this period include, but are not limited to— (A) Wear and tear and decay or decline from natural causes; (B) The normal progress of the art, eco- nomic changes, inventions, and current de- velopments within the industry and the taxpayer’s trade or business; (C) The climatic and other local con- ditions peculiar to the taxpayer’s trade or business; and (D) The taxpayer’s policy as to repairs, renewals, and replacements. (iii)Definition of “applicable financial statement”. The taxpayer’s applicable financial statement is the taxpayer’s fi- nancial statement listed in paragraphs (f)(2)(ii)(A) through (C) of this section that has the highest priority (including within paragraph (f)(2)(ii)(B) of this sec- tion). The financial statements are, in descending priority — (A) A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10-K or the An- nual Statement to Shareholders); (B) A certified audited financial state- ment that is accompanied by the report of an independent CPA (or in the case of a foreign entity, by the report of a similarly qualified independent professional), that is used for— (1) Credit purposes, (2) Reporting to shareholders, partners, or similar persons; or (3) Any other substantial non-tax pur- pose; or (C) A financial statement (other than a tax return) required to be provided to the Federal or a state government or any Federal or state agencies (other than the SEC or the Internal Revenue Service). (3)Substantially prolonging economic useful life—(i)In general.Anamountpaid substantially prolongs the economic useful life of the unit of property if it extends the period over which the property may rea- sonably be expected to be useful to the tax- payer in its trade or business or for the pro- duction of income, as applicable (or, if the taxpayer is not engaged in a trade or busi- ness or an activity for the production of income, the period over which the prop- erty may reasonably be expected to be use- ful to the taxpayer) beyond the end of the taxable year immediately succeeding the taxable year in which the economic use- ful life of the unit of property was orig- inally expected to cease, or if the prop- erty’s economic useful life was previously prolonged (as determined under this para- graph (e)(3)(i)), the end of the taxable year immediately succeeding the taxable year in which the prolonged economic useful life was expected to cease. (ii)Replacements. Amounts paid will be deemed to substantially prolong the economic useful life of the unit of prop- erty if a major component or a substantial structural part of the unit of property is re- placed with either a new part or a part that has been restored to like-new condition as described in paragraph (f)(3)(iii) of this section. Thus, the replacement of a part with another part that is not new or is not in like-new condition (for example, a used or reconditioned part) does not constitute the replacement of a major component or substantial structural part of the unit of property under this paragraph (f)(3)(ii). Further, replacement of a relatively minor portion of the physical structure of the unit of property or a relatively minor portion of any of its major parts, even if those parts are new, does not constitute the replace- ment of a major component or substantial structural part of the unit of property. (iii)Restoration to like-new condition. Amounts paid will be deemed to substan- tially prolong the economic useful life of the unit of property if they result in the unit of property or a major component or sub- stantial structural part of the unit of prop- erty being restored to a like-new condi- tion (including bringing the unit of prop- erty or a major component or substantial structural part of the property to the status of new, rebuilt, remanufactured, or simi- lar status under the terms of any Federal regulatory guidelineor the manufacturer’s original specifications). (iv)Restoration after a casualty loss. Amounts paid will be deemed to substan- tially prolong the useful life of the unit of property if the taxpayer properly deducts a casualty loss under section 165 with respect to the unit of property and the amounts paid restore the unit of property to a condition that is the same or better than before the casualty. (4)Examples. The following examples illustrate the rules of this paragraph (f) and, except as otherwise provided, assume that the amounts paid would not be required to be capitalized under any other provision of this section (paragraph (e), for example): Example 1.Prolonged economic useful life.X is a Class I railroad that owns a fleet of locomotives. 2006–39 I.R.B.561September 25, 2006 In 1989, X purchased a newlocomotive with an eco- nomic useful life (as defined in paragraph (f)(2) of this section) of 22 years (from 1989 - 2011). X per- forms substantially the same cyclical maintenance on its locomotives approximately every 6 years. X per- formed cyclical maintenance on the locomotive in 1995, in 2001, and in 2007. Assume that the loco- motive (which includes the engine) is the appropriate unit of property and that none of the cyclical main- tenance projects resulted in a restoration under para- graph (f)(3)(ii) or (f)(3)(iii) of this section. Amounts paid for cyclical maintenance in 1995 and 2001 do not substantially prolong the economic useful life of the locomotive. However, the cyclical maintenance performed in 2007 will prolong the economic use- ful life of the locomotive to 2013, which is beyond the end of the next succeeding taxable year after the economic useful life of the locomotive ceases (2011). Therefore, under paragraphs (f)(1) and (f)(3)(i) of this section, X must capitalize as an improvement to the locomotive amounts paid for the cyclical main- tenance performed in 2007, regardless of whether X was required to capitalize the amounts paid in previ- ous years for cyclical maintenance. Example 2.Economic useful life not prolonged. Assume the same facts as inExample 1, except that in 2009, X replaces a filter in the locomotive engine. X generally replaces this type of filter every 4 years. Although the filter itself would last beyond the end of the locomotive’s economic useful life in 2011, the amount paid for the filter does not substantially pro- long the economic useful life of the locomotive be- cause the filter will not extend beyond 2009 the pe- riod over which the locomotive may reasonably be expected to be useful to X in its trade or business. Additionally, although the filter is a necessary com- ponent of the locomotive, the filter is not a substantial structural part or major component of the locomotive. Therefore, the amount paid to replace the filter does not substantially prolong the economic useful life of the locomotive. Example 3.Minor part replacement. X owns a small retail shop. In 2008, a storm damaged the roof of X’s shop by displacing numerous wooden shin- gles. X decides to replace all the wooden shingles on the roof and hires a contractor to replace all the shingles on the roof with new wooden shingles. No part of the sheathing, rafters, or joists was replaced. ForpurposesofthisExample 3, assume the shop and its structural components are the appropriate unit of property. The replacement of the shingles did not extend the useful life of the shop under paragraph (f)(3)(i) of this section. The portion of the roof re- placed is not a substantial structural part of the shop, nor does the replacement of the shingles restore to a like-new condition a major component or substantial structural part of the shop. Therefore, the amounts paid by X to reshingle the roof with wooden shingles do not substantially prolong the economic useful life of the shop. Example 4.Major component or substantial structural part. Assume the same facts as inExam- ple 3, except that when the contractor began work on the shingles, the contractor discovered that a major portion of the sheathing had rotted, and the rafters were weakened as well. The contractor replaced all the sheathing and a significant portion of the rafters. The roof (including the shingles, sheathing, rafters, and joists) is a substantial structural part of a build- ing. The replacement of theshingles, sheathing, and rafters restored to a like-new condition a substantial structural part of the shop. Therefore, under para- graphs (f)(1) and (f)(3)(iii) of this section, X must capitalize as an improvement to the shop amounts paid to replace the roof of the shop. Example 5.Not a major component or structural part. X uses a car in providing a taxi service. X pur- chased the car in 2008. Assume that the unit of prop- erty is the car. The car has an economic useful life of 5 years. In 2011, the battery dies and X takes the car to a repair shop, which replaces the battery. Al- though the battery itself may last beyond the end of the car’s economic useful life, the amount paid for the battery does not substantially prolong the economic useful life of the car because the battery will not ex- tend beyond 2013 the period over which the car may reasonably be expected to be useful to X in its trade or business. Although the battery is a necessary com- ponent of the car, the battery is not a substantial struc- tural part or major component of the car. Therefore, the amount paid to replace the battery does not sub- stantially prolong the economic useful life of the car. Example 6.Major component or structural part. AssumethesamefactsasExample 5, except rather than the battery dying, the car overheats and causes so much damage that the engine has to be rebuilt. The engine is a major component of the car. Therefore, X is required to capitalize asan improvement to the car under paragraphs (f)(1) and (f)(3)(iii) of this section the amounts paid to rebuild the engine. Example 7.Repair performed during an improve- ment; coordination with section 263A. Assume the same facts asExample 6, except that X has a bro- ken taillight fixed at the same time that the engine was rebuilt. The repair to the taillight was not in- curred because the engine was rebuilt, nor did it ben- efit the rebuild of the engine. The repair of the bro- ken taillight is a deductible expense under §1.162–4. Under section 263A, all indirect costs, including oth- erwise deductible repair and maintenance costs that directly benefit or are incurred by reason of the im- provement must be capitalized as part of the improve- ment. Therefore, all amounts paid that are incurred by reason of the engine being rebuilt must be capital- ized, including, for example, amounts paid for activi- ties that would usually be deductible maintenance ex- penses, such as refilling the engine with oil and radia- tor fluid. Amounts paid to repair the broken taillight, however, are not incurred byreason of the engine be- ing rebuilt, nor do the amounts paid directly benefit the engine rebuild, despite being repaired at the same time. Thus, X is not required to capitalize to the im- provement of the car (the rebuild of the engine) the amounts paid to repair the broken taillight. Example 8.Related amounts to replace major component or structural part. (i) X owns a retail gasoline station, consisting of a paved area used for automobile access to the pumps and parking areas, a building used to market gasoline, and a canopy cov- ering the gasoline pumps. The premises also consists of underground storage tanks (USTs) that are con- nected by piping to the pumps and are part of the machinery used in the immediate retail sale of gas. The pumps also are connected to a monitoring unit in the building that allows the sales clerk to monitor the gasoline sales. To comply with regulations issued by the Environmental Protection Agency, X is re- quired to remove and replace leaking USTs. In 2008, X hires a contractor to perform the removal and re- placement, which consists of removing the old tanks and installing new tanks with leak detection systems. The removal of the old tanks includes removing the paving material covering the tanks, excavating a hole large enough to gain access to the old tanks, discon- necting any strapping and pipe connections to the old tanks, and lifting the old tanks out of the hole. Instal- lation of the new tanks includes placement of a liner in the excavated hole, placement of the new tanks, installation of a leak detection system, installation of an overfill system, connection of the tank to the pipes leading to the pumps, backfilling of the hole, and re- placement of the paving. X is also required to pay a permit fee to the county to undertake the installation of the new tanks. (ii) X pays the permit fee to the county on October 15, 2008. The contractor performs all of the required work and, on November 1, 2008, bills X for the costs of removing the old USTs. On November 15, 2008, the contractor bills X for the remainder of the work. Assume the fuel distribution system is the appropriate unit of property. The USTs are major components of the fuel distribution system. Therefore, under para- graphs (f)(1) and (f)(3)(ii) of this section, X must cap- italize as an improvement to the fuel distribution sys- tem the aggregate of related amounts paid to replace the USTs, which related amounts include the amount paid to the county, the amount paid to remove the old USTs, and the amount paid to install the new USTs (regardless that the amounts were separately invoiced and paid to two different parties). Example 9.Major component or substantial structural part. X is a common carrier that owns a fleet of petroleum hauling trucks. In 2008, X replaces the existing engine, cab, and petroleum tank of a truck with a new engine, cab, and tank. Assume the tractor of the truck (which includes the cab and the engine) is a separateunit of property from the rest of the truck. Also assume that the trailer (which contains the petroleum tank) is a separate unit of property from the truck. The engine and the cab are major components of the truck tractor, and the petroleum tank is a major component of the trailer. Therefore, under paragraphs (f)(1) and (f)(3)(ii) of this section, X must capitalize as an improvement to the tractor amounts paid to replace the engine and cab, and must capitalize as an improvement to the trailer amounts paid to replace the petroleum tank. Example 10.Restoration of major component to like-new condition. (i) X is a towboat operator that owns and leases a fleet of towboats. In 2008, X re- places an existing towboat engine with a rebuilt en- gine. A towboat engine is rebuilt through a series of steps designed to put the engine in like-new operat- ing condition to the maximum extent possible. En- gines in a towboat nearing the end of its useful life or engines that have been removed from towboats due to a catastrophic malfunction are likely candidates for the rebuilding process. The goal of the rebuild- ing process is to bring each of an engine’s compo- nent parts to the manufacturer’s original dimensional specifications for new parts. (ii) Replacement of the existing towboat engine with a rebuilt engine involves dry-docking the tow- boat. The rebuilding and replacement process takes approximately 3 to 5 months. The process requires the removal of the engine from the towboat and the removal of all of the moving and nonmoving September 25, 20065622006–39 I.R.B. components from the engine as well. The engine’s crankcase and oil pan are separated, and every part of the engine is cleaned, inspected using intense illumi- nation, machined, and treated with special materials to restore the engine to like-new operating condition. The engine crankcase and oil pan are extensively ma- chined and welded, and numerous dimensional tests and checks are performed to ensure that the engine is returned to a like-new condition through the rebuild- ing process. In addition, a reconditioned crankshaft and camshaft normally are installed in the engine during the rebuilding process. The power packs are completely rebuilt with a large number of new parts during the rebuilding process. The oil pumps, water pumps, engine turbochargers, and governors are normally removed and exchanged for rebuilt parts during the rebuilding process. The accessory drive gears, all of the piping on the front and aft ends of the engine, the governor drive gear, and the turbocharger drive gears are removed and normally exchanged for rebuilt parts during the rebuilding process. The goal of the rebuilding process is to bring each of an en- gine’s component parts to the engine manufacturer’s original dimensional specifications for new parts. Assume the towboat (which includes the engine) is the appropriate unit of property. The work done on the towboat engine constitutes a remanufacture or rebuild of the engine, which is a major component of the towboat. Therefore, under paragraphs (f)(1) and (f)(3)(iii) of this section, X must capitalize as an improvement to the towboat amounts paid to rebuild the towboat engine. Example 11.Repairs performed during an im- provement; coordination with section 263A. Assume the same facts as inExample 10, except that while the towboat is in dry-dock to have the engine rebuilt, X also makes repairs to the hull and rudders that are not by themselves an improvement under this sec- tion. The amounts paid to repair the hull and rud- ders do not directly benefit nor are incurred by rea- son of the engine rebuild. Under section 263A, all indirect costs, including otherwise deductible repair costs that directly benefit or are incurred by reason of the improvement must be capitalized as part of the improvement. Therefore, all amounts paid that are incurred by reason of the engine being rebuilt must be capitalized to the improvement, including, for ex- ample, amounts paid for activities such as cleaning and inspecting the engine, which usually would be deductible maintenance costs. Amounts paid to re- pair the hull and rudders, however, are not incurred by reason of the engine being rebuilt, nor do the amounts paid directly benefit the engine rebuild, despite being incurred at the same time. Thus, in accordance with paragraph (d)(5)(i) of this section, X is not required to capitalize to the towboat amounts paid to repair the hull and rudders to the improvement. Example 12.Restoration to like-new condition; coordination with section 263A. Assume the same facts asExample 10, except that while the towboat is in dry-dock, X also makes substantial improve- ments to the propulsion systems and the mechani- cal systems, including rebuilding large sections of the hull, and rebuilding, replacing, or upgrading the steering systems, shafting systems, and electrical sys- tems, such that almost the entire towboat is restored to like-new condition. This process constitutes a re- manufacture or rebuild of the towboat. Under sec- tion 263A, all indirect costs, including otherwise de- ductible repair costs that directly benefit or are in- curred by reason of the improvement must be capi- talized as part of the improvement. Therefore, under paragraph (d)(5)(i) of this section, X must capital- ize to the improvement of the towboat (the rebuild) amounts paid that otherwise would be deductible re- pair costs that directly benefit or are incurred by rea- son of the improvement. Example 13.Restoration to like-new condition. X is a Class I railroad that owns a fleet of freight cars. Approximately every 10 years, X rebuilds its freight cars. The rebuild includes a complete dis- assembly, inspection, and reconditioning and/or re- placement of components of the suspension and draft systems, trailer hitches, and other special equipment. Modifications are made to the car to upgrade various components to the latest engineering standards. The freight car essentially is stripped to the frame, with all of its substantial components either reconditioned or replaced. The frame itself is the longest-lasting part of the car and is reconditioned. The walls of the freight-train car are replaced or are sandblasted and repainted. New wheels typically are installed on the car. All the remaining components of the car are restored before they are reassembled. At the end of the rebuild, the freight cars have been restored to like-new condition. Assume the freight car is the appropriate unit of property. The work done to the freight car constitutes a remanufacture or rebuild of the freight car. Therefore, under paragraphs (f)(1) and (f)(3)(iii) of this section, X must capitalize as an im- provement to the freight car amounts paid to rebuild the freight car. Example 14.Restoration of major component to like-new condition. X owned a factory that it ac- quired in 1997. In 2008, the factory roof began to leak. These leaks on occasion resulted in damage to X’s products and prevented the use of certain portions of the factory. X decided to reroof the entire factory and hired a contractor to perform the reroofing. The structure of the roof, including substantial portions of the rafters and joists, was restored to a like-new condition. Assume the factory building and its struc- tural components are the appropriate unit of property. The roofing process constitutes a remanufacture or rebuild of the roof, which is a substantial structural part of the factory. Therefore, under paragraphs (f)(1) and (f)(3)(iii) of this section, X must capitalize as an improvement to the factory amounts paid to reroof the factory. Example 15.Minor part replacement; coordina- tion with section 263A. X is in the business of smelt- ing aluminum. X’s aluminum smelting facility in- cludes a plant where molten aluminum is poured into molds and allowed to solidify. Because of the poten- tial of fire from a molten metal explosion, the plant’s roof must be made of fire-resistant material. The roof must also be without leaks because rain water hitting the molten aluminum could cause an explosion. The roof of the plant was made of roofing material and corrugated sheet metal decking, which supports the roofing material. During 2008, X removed and re- placed a minor portion of the plant’s roof decking and roofing material. At the time of the replacement, the pattern of the original metal support decking was not available. Therefore, X used comparable fire re- sistant wood decking to replace the corrugated metal decking. For purposes of thisExample 15, assume the plant building and its structural components are the appropriate unit of property and that the amount paid does not prolong the economic useful life of the plant under paragraph (f)(3)(i) of this section. The portion of the roof structure being replaced is not a substantial structural part of the plant, nor does the work performed return to like-new condition a major component or substantial structural part of the plant. Further, because X could not practicably replace the roof material with the same type of material, the re- placement of the original roof material with an im- proved, but comparable, material does not, by itself, result in an improvement. Therefore, the amount paid to remove and replace a minor part of the plant’s roof decking and roofing materially does not substantially prolong the economic useful life of the plant. How- ever, under section 263A, all indirect costs, includ- ing otherwise deductible costs, that directly benefit or are incurred by reason of the taxpayer’s manufactur- ing activities must be capitalized to the property pro- duced for sale. Therefore, because the amounts paid for the roof decking and materials are incurred by reason of X’s manufacturing operations, the amounts paid must be capitalized under section 263A to the property produced for sale by X. Example 16.Minor part replacement.(i)Xisa commercial airline engaged in the business of trans- porting passengers and freight throughout the United States and abroad. To conduct its business, X owns or leases various types of aircraft. As a condition of maintaining its airworthiness certification for these aircraft, X is required by the Federal Aviation Ad- ministration (FAA) to establish and adhere to a con- tinuous maintenance program for each aircraft within its fleet. These programs, which are designed by X and the aircraft’s manufacturer and approved by the FAA are incorporated into each aircraft’s main- tenance manual. The maintenance manuals require a variety of periodic maintenance visits at various intervals during the operating lives of each aircraft. One type of maintenance visit is an engine shop visit (ESV), which is performed onX’s aircraft engines ap- proximately every 4 years. (ii) In 2004, X purchased a new aircraft and en- gine. In 2008, X performs its first ESV on the air- craft engine. The ESV includes some or all of the fol- lowing activities: disassembly, cleaning, inspection, repair, replacement, reassembly, and testing. Dur- ing the ESV, the engine is removed from the aircraft and shipped to an outside vendor who performs the ESV. When the engine arrives at the vendor, the en- gine is cleaned and externally inspected. Regard- less of condition, it is thoroughly inspected visually and, as appropriate, further inspected using a number of non-destructive testing procedures. The engine is then disassembled into major parts and, if necessary, into smaller parts. If inspection or testing discloses a discrepancy in a part’s conformity to the specifi- cations in X’s maintenance program, the part is re- paired, or if necessary, replaced with a new or used serviceable part conforming to the specifications. If a part can be repaired, but not in time to be returned to the engine with which the part had arrived, the ven- dor first attempts to replace the part with a similar part from customer stock (used parts from X’s aircraft that were replaced or exchanged and repaired during an earlierESVandthenstoredforfutureuseonX’sair- craft). If a part is not available from customer stock, the part is exchanged with a used, serviceable part in the vendor’s inventory. A part is replaced (generally 2006–39 I.R.B.563September 25, 2006 with a used serviceable part) only if the part removed from X’s engine cannot be repaired timely. Although many minor parts may be replaced during the ESV, the ESV does not return the engine to a like-new con- dition. (iii) For purposes of thisExample 16, assume the aircraft engine is the appropriate unit of property. The ESV does not result in the replacement of the engine nor does it restore the engine to a like-new condition. Therefore, the amount paid for the ESV does not sub- stantially prolong the economic useful life of the en- gine. Example 17.Repairs performed during an improvement; coordination with section 263A.(i) Assume the same facts as inExample 16, except that X purchased the aircraft in 1986 and, in addition to the continuous maintenance program for engines, X adheres to a continuous maintenance program for its aircraft airframes. One type of maintenance visit is a heavy maintenance visit (HMV), which is performed on X’s aircraft airframes approximately every 8 years. In 2008, X decided to make substan- tial modifications to the airframe, which resulted in the restoration of the airframe to like-new condition. The modifications included removing all the belly skin panels on the aircraft’s fuselage and replacing them with new skin panels; replacing the metal supports under the lavatories and galleys; removing the wiring in the leading edges of both wings and replacing it with new wiring; removing the fuel tank bladders, harnesses, wiring systems, and connectors and replacing them with new components; opening every lap joint on the airframe and replacing the epoxyandrivetsusedtosealthelapjointswitha non-corrosive sealant and larger rivets; reconfiguring and upgrading the avionics and the equipment in the cockpit; replacing all the seats, overhead bins, side- wall panels, partitions, carpeting, windows, galleys, lavatories, and ceiling panels with new items; in- stalling a cabin smoke and fire detection system, and a ground proximity warning system; and painting the exterior of the aircraft. In addition, X performed much of the same work that would be performed duringanHMV. (ii) For purposes of thisExample 17, assume the aircraft airframe is the appropriate unit of property. The amounts paid to modify the airframe are required to be capitalized as an improvement to the airframe under paragraph (f) of this section because the mod- ifications restored the airframe to a like-new condi- tion. Assume the amounts paid for the HMV are not required to be capitalized as a separate improve- ment to the airframe. Under section 263A, all indi- rect costs, including otherwise deductible repair costs that directly benefit or are incurred by reason of the improvement must be capitalized as part of the im- provement. Therefore, X must capitalize to the im- provement of the airframe (the restoration) amounts paid that usually would be ordinary and necessary re- pair costs, including any amounts paid for the HMV that directly benefit or are incurred by reason of the improvement to the airframe. X is not required, how- ever, to capitalize to the improvement of the airframe any amounts paid for the HMV that do not directly benefit or are not incurred by reason of the improve- ment to the airframe. Example 18.Restoration of major component to like-new condition; coordination with section 263A. (i) X is a Class I railroad that owns a fleet of locomo- tives. In 1994, X purchased a new locomotive (Lo- comotive A) with an economic useful life (as defined in paragraph (f)(2) of this section) of 20 years (from 1994 - 2014). X performed cyclical maintenance on Locomotive A in 2000, and again in 2008. In 2000, X replaced the power cylinders on Locomotive A’s engine, and performed work on other components of Locomotive A. In 2008, X removed the engine and re- placed it with one it had previously remanufactured to the manufacturer’s original specifications, and again performed work on other components of Locomotive A. The engine that X removed from Locomotive A in 2008 was remanufactured to the manufacturer’s original specifications and installed on Locomotive B later in 2008. (ii) Assume the locomotive (which includes the engine) is the appropriate unit of property. The re- placement of the power cylinders and the other work performed on Locomotive A in 2000 did not prolong the economic useful life of Locomotive A under para- graph (f)(3) of this section. However, the amounts paid in 2008 to remove the engine and replace it with a previously manufactured engine must be capitalized under paragraph (f)(3)(ii) of this section. Assume the amounts paid in 2008 to perform work on other com- ponents of Locomotive A are not required to be cap- italized as a separate improvement to Locomotive A. Under section 263A, all indirect costs, including oth- erwise deductible repair costs that directly benefit or are incurred by reason of the improvement must be capitalized as part of the improvement. Therefore, X must capitalize to the improvement of Locomo- tive A (the installation of the remanufactured engine) amounts paid that usually would be ordinary and nec- essary repair costs, including any amounts paid for work on other components that directly benefit or are incurred by reason of the improvement to Locomo- tive A. X is not required, however, to capitalize to the improvement of Locomotive A any amounts paid for work performed on other components that do not di- rectly benefit or are not incurred by reason of the im- provement to Locomotive A. Further, X must capital- ize to the improvement of Locomotive B (the instal- lation of remanufactured engine) the amounts paid to remanufacture the engineremoved from Locomotive A and amounts paid to install the remanufactured en- gine on Locomotive B. (g)Repair allowance method—(1)In general. This paragraph (g) provides an optional simplified method (the repair al- lowance method) for determining whether amounts paid to repair, maintain, or im- prove certain tangible property are to be treated as deductible expenses or capital expenditures. A taxpayer that elects to use the repair allowance method described in paragraph (g)(3) of this section may use that method instead of determining whether amounts paid to repair, maintain, or improve property are capital expendi- tures or deductible expenses under the gen- eral principles of sections 162(a), 212, and 263(a). Thus, except for the rules in para- graph (d)(2) of this section for determining the appropriate unit of property, the cap- italization rules in §1.263(a)–3(d) do not applytopropertyforwhichthetaxpayer uses the repair allowance method under this paragraph (g). See section 263A for the scope of costs required to be capital- ized to property produced by the taxpayer or to property acquired for resale. (2)Election of repair allowance method. In the case of repair allowance property (as defined in paragraph (g)(6) of this section), a taxpayer may elect to use the repair allowance method described in paragraph (g)(3) of this section. See paragraph (g)(9) of this section for the manner of electing the repair allowance. A taxpayer that elects to use the repair allowance method must use that method for all of its repair allowance property in all MACRS classes (including prop- erty classified into a MACRS class for purposes of the repair allowance method under paragraph (g)(6)(ii) of this section). A taxpayer electing the repair allowance method must use that method consistently for all future years unless the taxpayer revokes the election in accordance with paragraph (g)(10) of this section. (3)Application of repair allowance method. Under the repair allowance method, a taxpayer must treat all amounts paid (other than amounts paid for ex- cluded additions, as defined in paragraph (g)(7) of this section) for materials and labor to repair, maintain, or improve all the repair allowance property in a particu- lar MACRS class as deductible expenses under section 162 for the taxable year, up to the repair allowance amount (as deter- mined in paragraph (g)(4) of this section) for that MACRS class, and treat the excess of all amounts paid to repair, maintain, or improve all the repair allowance prop- erty in that MACRS class (the capitalized amount) in accordance with paragraph (g)(5) of this section. (4)Repair allowance amount—(i)In general. Except as provided in paragraph (g)(4)(iv) of this section (with regard to buildings), under the repair allowance method for a particular taxable year, the repair allowance amount for a particular MACRS class consisting of repair al- lowance property is an amount equal to the average unadjusted basis (as defined in paragraph (g)(4)(ii) of this section) of repair allowance property in the MACRS class multiplied by the repair allowance September 25, 20065642006–39 I.R.B. percentage in effect for the MACRS class for the taxable year. (ii)Average unadjusted basis. For pur- poses of this section, average unadjusted basis is the average of the unadjusted basis (as defined in paragraph (g)(4)(iii) of this section) of all repair allowance property in the MACRS class at the beginning of the taxable year and the unadjusted basis of all repair allowance property in the MACRS class at the end of the taxable year. (iii)Unadjusted basis. For purposes of this section, unadjusted basis is the ba- sis as determined under section 1012, or other applicable sections of subchapter O, and subchapters C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (re- lating to capital gains and losses). Un- adjusted basis is determined without re- gard to any adjustments described in sec- tion 1016(a)(2) or (3) or to amounts for which the taxpayer has elected to treat as an expense (for example, under section 179, 179B, or 179C), but with regard to ba- sis reductions which are required because of credits taken on the property (for exam- ple, under section 44, 45G, 45H, or 50(c)). Unadjusted basis also must reflect the re- duction in basis for the percentage of the taxpayer’s use of property for the taxable year other than for use in the taxpayer’s trade or business (or for the production of income). (iv)Buildings. In the case of buildings and structural components that are repair allowance property, the repair allowance method is applied separately with respect to each unit of property. (5)Capitalized amount—(i)In general. Under the repair allowance method for a particular taxable year, the capitalized amount is the excess of all amounts paid to repair, maintain, or improve all the repair allowance property in a MACRS class over the repair allowance amount for that MACRS class. In addition, the capitalized amount includes all of the indirect costs of producing the repair allowance property in the MACRS class, which must be cap- italized in accordance with the taxpayer’s method of accounting for section 263A costs. Except as provided in paragraphs (g)(5)(iv), (g)(5)(v), and (g)(5)(vi) of this section, a taxpayer may choose to treat the capitalized amount as a single asset under paragraph (g)(5)(ii) of this section or, alternatively, may choose to allocate the capitalized amount to specific repair allowance property in the MACRS class in accordance with paragraph (g)(5)(iii) of this section. (ii)Single asset treatment of capital- ized amount. In general, the capitalized amount for a particular MACRS class may be treated by the taxpayer as a separate single asset and depreciated in accordance with that MACRS class. The single asset is treated as a section 168(i)(6) improve- ment and is treated as placed in service by the taxpayer on the last day of the first half of the taxable year in which the amount is paid, before application of the conven- tion under section 168(d). Except for a sale of assets constituting a trade or busi- ness, no gain or loss is recognized on cap- italized amounts treated as a single asset under this paragraph (g)(5)(ii) upon dispo- sition of any repair allowance property to which the capitalized amounts are related. A disposition includes the sale, exchange, retirement, physical abandonment, or de- struction of property. Taxpayers must con- tinue to depreciate the single asset over the remainder of the MACRS applicable re- covery period. (iii)Allocation treatment of capitalized amount. Instead of treating the capitalized amount as a single asset under paragraph (g)(5)(ii) of this section, a taxpayer may al- locate the capitalized amount for a partic- ular MACRS class to all repair allowance property in the particular MACRS class in proportion to the unadjusted basis of the property in that MACRS class as of the be- ginning of the taxable year. The capital- ized amount allocated to repair allowance property is treated as a section 168(i)(6) improvement to the underlying repair al- lowance property and is treated as placed in service by the taxpayer on the last day of the first half of the taxable year in which the amount is paid, before application of the convention under section 168(d). (iv)Section 168(g) repair allowance property. If any repair allowance property in a particular MACRS class as of the beginning of the taxable year is depre- ciated under section 168(g) pursuant to section 168(g)(1)(A) through (D) or other provisions of the Internal Revenue Code, the portion of the capitalized amount for that MACRS class that is attributable to all section 168(g) repair allowance prop- erty in that MACRS class (section 168(g) total capitalized amount) is determined by multiplying the capitalized amount for that MACRS class (as determined under paragraph (g)(5)(i) of this section) by a percentage that is equal to the unadjusted basis of all section 168(g) repair allowance property in that MACRS class as of the be- ginning of the taxable year divided by the unadjusted basis of all repair allowance property in that MACRS class as of the beginning of the taxable year. The section 168(g) total capitalized amount for a par- ticular MACRS class then is allocated to each section 168(g) repair allowance prop- erty in that MACRS class by multiplying the section 168(g) total capitalized amount for that MACRS class by a percentage that is equal to the unadjusted basis of the particular section 168(g) repair allowance property in that MACRS class as of the beginning of the taxable year divided by the unadjusted basis of all section 168(g) repair allowance property in that MACRS class as of the beginning of the taxable year. The capitalized amount allocated to each section 168(g) repair allowance property is depreciated in accordance with section 168(g), is treated as a section 168(i)(6) improvement to the underlying repair allowance property, and is treated as placed in service by the taxpayer on the lastdayofthefirsthalfofthetaxableyear in which the amount is paid, before ap- plication of the convention under section 168(d). (v)Section 168(g) election.Ifatax- payer makes an election under section 168(g)(7) for a particular MACRS class with respect to property placed in service in the current taxable year, the election applies to the capitalized amount for that MACRS class. If such an election is made, the taxpayer must allocate the capitalized amount for that MACRS class to all repair allowance property in the MACRS class in proportion to the unadjusted basis of the property in that MACRS class as of the beginning of the taxable year. The capitalized amount is treated as a section 168(i)(6) improvement to the underlying repair allowance property and is treated as placed in service by the taxpayer on the lastdayofthefirsthalfofthetaxableyear in which the amount is paid, before ap- plication of the convention under section 168(d). The depreciation of the capital- ized amount allocated to repair allowance property must be determined under section 168(g) whether or not the repair allowance 2006–39 I.R.B.565September 25, 2006 property in the MACRS class as of the be- ginning of the taxable year is depreciated under section 168(g). (vi)Public utility property.Ifanyre- pair allowance property in a particular MACRS class is public utility property (as defined in section 168(i)(10) or for- mer section 167(l)(3)(A)), the portion of the capitalized amount for that MACRS class that is attributable to all public util- ity property in that MACRS class (public utility property totalcapitalized amount) is determined by multiplying the capital- ized amount for that MACRS class (as determined under paragraph (g)(5)(i) of this section) by a percentage that is equal to the unadjusted basis of all public utility property in that MACRS class as of the be- ginning of the taxable year divided by the unadjusted basis of all repair allowance property in that MACRS class as of the beginning of the taxable year. The public utility property total capitalized amount for a particular MACRS class then is sub- tracted from the unadjusted basis of all repair allowance property in that MACRS class as of beginning of the taxable year to determine the non-public utility prop- erty total capitalized amount. A taxpayer may choose to treat the public utility property total capitalized amount for a particular MACRS class as a single asset in accordance with paragraph (g)(5)(ii) of this section, and the non-public utility property total capitalized amount for that MACRS class as another single asset in accordance with paragraph (g)(5)(ii) of this section. Alternatively, the taxpayer may choose to allocate the public utility property total capitalized amount for a particular MACRS class in proportion to the unadjusted basisof the public utility property in that MACRS class as of the beginning of the taxable year in accor- dance with paragraph (g)(5)(iii) of this section, and allocate the non-public util- ity property total capitalized amount for a particular MACRS class in proportion to the unadjusted basis of the non-public utility property in that MACRS class as of the beginning of the taxable year in accordance with paragraph (g)(5)(iii) of this section. In either case, the public utility property total capitalized amount for a particular MACRS class is subject to the normalization requirements of section 168(i)(9). (6)Repair allowance property—(i)In general. Except as provided in paragraph (g)(6)(iii) of this section, repair allowance property means real or personal property subject to section 168 of the Internal Rev- enue Code of 1986, or treated as subject to section 168 under paragraph (g)(6)(ii) of this section, that is used in the taxpayer’s trade or business or for the production of income. (ii)Certain property not subject to sec- tion 168. Repair allowance property in- cludes tangible depreciable property not otherwise in a MACRS class if the tax- payer classifies the property, only for pur- poses of the repair allowance method in paragraph (g)(4) of this section, to deter- mine the appropriate MACRS class and either the taxpayer placed the property in service before the effective date of section 168 of the Internal Revenue Code of 1986 or the taxpayer properly elected out of sec- tion 168 with regard to the property. (iii)Exclusions from repair allowance property. Repair allowance property does not include any property for which the taxpayer has elected to use the as- set guideline class repair allowance in §1.167(a)–11(d)(2); the method of ac- counting provided in section 263(d) (with regard to certain railroad rolling stock); the method of accounting provided in Rev. Proc. 2001–46, 2001–2 C.B. 263, or Rev. Proc. 2002–65, 2002–2 C.B. 700 (with re- gard to railroad track) (see §601.601(d)(2) of this chapter); or any other property or method of accounting that is designated in guidance published in theFederal Regis- teror the Internal Revenue Bulletin (see §601.601(d)(2) of this chapter). (7)Excluded additions—(i)In general. Excluded additionmeans any amount paid— (A) For the acquisition or production of a specific unit of property; (B) For work that ameliorates a condi- tion or defect that either existed prior to the taxpayer’s acquisition of the unit of prop- erty or arose during the production of the unit of property, whether or not the tax- payer was aware of the condition or defect at the time of acquisition or production; (C) For work performed prior to the date the unit of property is placed in ser- vice by the taxpayer (without regard to any applicable convention under section 168(d)); (D) That adapts the unit of property to a new or different use; or (E) That increases the cubic or square space of a building. (ii)Treatment of excluded additions. Any amount paid for an excluded addition is treated as a capital expenditure under sections 263(a) and 263A. (8)Repair allowance percentage.Ex- cept as provided in any future guidance published in theFederal Registeror the Internal Revenue Bulletin, the repair al- lowance percentage in effect for each MACRS class for a particular taxable year is as follows: MACRS ClassMACRS Recovery Period Repair Allowance Percentage 3-year property3 years16.5 5-year property5 years10 7-year property7 years7.14 10-year property10 years5 15-year property15 years3.33 20-year property20 years2.5 Water utility property25 years2 Residential rental property27.5 years1.82 Nonresidental rental property39 years1.28 Railroad grading or tunnel bore50 years1 September 25, 20065662006–39 I.R.B. (9)Manner of election.[Reserved] (10)Manner of revoking election.A taxpayer may revoke an election made un- der the repair allowance method only by obtaining the Commissioner’s consent to revoke the election. An election must be revoked prospectively and may not be re- voked through the filing of an amended Federal income tax return. A taxpayer that revokes an election may not re-elect the repair allowance method for a period of at least five taxable years, beginning with the year of the revocation unless, based on a showing of unusual and compelling cir- cumstances, consent is specifically granted by the Commissioner to re-elect the repair allowance at an earlier time. (11)Examples. The following exam- ples illustrate the rules of this paragraph (g) and assume that none of the rules in paragraph (g)(5)(iv) or (g)(5)(v) of this section applies: Example 1. X elects the repair allowance method described in this paragraph (g). X’s total unadjusted basis of all of its MACRS 10-year property as of Jan- uary 1, 2008 is $10 million. X’s total unadjusted ba- sis of all MACRS 10-year property as of December 31, 2008 is $15 million (computed without regard to amounts capitalized under this repair allowance pro- vision). During 2008, X pays $1,000,000 to repair, maintain, or improve MACRS 10-year property. As- sume that none of X’s property is an excluded ad- dition as defined in paragraph (g)(7) of this section. The repair allowance percentage for MACRS 10-year property is 5 percent. X’s repair allowance amount and capitalized amount are computed as follows: (i) X determines its average unadjusted ba- sis of MACRS 10-year property: ($10,000,000 + $15,000,000)/2 = $12,500,000. (ii) X multiplies its average unadjusted basis of MACRS 10-year property bythe prescribed repair allowance percentage for MACRS 10-year property to arrive at the repair allowance amount: $12,500,000 x 5% = $625,000. (iii) Because X’s amounts paid to repair, maintain, or improve MACRS 10-year property ($1,000,000) exceed the repair allowance amount for MACRS 10-year property ($625,000), X deducts under section 162(a) amounts paid to the extent of the repair allowance amount ($625,000) and capitalizes the amounts paid in excess of the repair allowance amount ($1,000,000 - $625,000 = $375,000). (iv) The capitalized amount ($375,000) is treated as an improvement under section 168(i)(6). The im- provement is depreciatedas 10-year property under section 168 and is considered placed in service on the last day of the first half of 2008. Example 2. X elects the repair allowance method described in this paragraph (g). X uses a car in providing a taxi service. X’s unadjusted basis in the car is $25,000. Assume that the unit of prop- erty (as determined under paragraph (d)(2) of this section) is the car. In 2008, X incurs various costs to maintain, repair, and improve the car, including: $4,500 for gasoline; $550 for car washes and de- tailing, $2,200 for scheduled maintenance such as oil changes, tire rotation, new brakes, minor parts, and fluid replacements, etc.; $80 for new headlights; $250 for new tires; and $4,800 to rebuild the engine after the car overheated. Assume that none of X’s expenditures are an excluded addition as defined in paragraph (g)(7) of this section. The car is classified as MACRS 5-year property. Assume that X has no other MACRS 5-year property. The repair allowance percentage for MACRS 5-year property is 10 per- cent. X’s repair allowance amount and capitalized amount are computed as follows: (i) X determines its average unadjusted basis of MACRS 5-year property is $25,000. (ii) X multiplies its average unadjusted basis of MACRS 5-year property by the prescribed repair al- lowance percentage for MACRS 5-year property to arrive at the repair allowance amount: $25,000 x 10% = $2,500. (iii) Because X’s amounts to repair, maintain, or improve MACRS 5-year property ($2,200 + $80 + $250 + $4,800 = $7,330) exceed the repair allowance amount for MACRS 5-year property ($2,500), X treats $2,500 as an otherwise deductible ordinary and necessary expenditure under section 162(a) and capitalizes $4,830 as the amounts paid in excess of the repair allowance amount. (iv) The capitalized amount ($4,830) is treated as an improvement under section 168(i)(6). The im- provement is depreciated as 5-year property under section 168 and is considered placed in service on the lastdayofthefirsthalfof2008. (h)Treatment of capital expenditures. Amounts required to be capitalized un- der this section are capital expenditures and must be taken into account through a charge to capital account or basis, or in the case of property that is inventory in the hands of a taxpayer, through inclusion in inventory costs. See section 263A for the treatment of amounts referred to in this section as well as other amounts paid in connection with the production of real property and personal property, includ- ing films, sound recordings, video tapes, books, or similar properties. (i)Recovery of capitalized amounts. Amounts that are capitalized under this section are recovered through deprecia- tion, cost of goods sold, or by an adjust- ment to basis at the time the property is placed in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable Internal Revenue Code and regulation provisions relating to the use, sale, or disposition of property. (j)Effective date. The rules in this sec- tion apply to taxable years beginning on or after the date of publication of the Treasury decision adopting these rules as final reg- ulations in theFederal Register. (k)Accounting method changes.[Re- served] Mark E. Matthews, Deputy Commissioner for Services and Enforcement. (Filed by the Office of the Federal Register on August 18, 2006, 8:45 a.m., and published in the issue of the Federal Register for August 21, 2006, 71 F.R. 48590) Notice of Proposed Rulemaking and Notice of Public Hearing User Fees Relating to Enrollment REG–145154–05 AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking and notice of public hearing. SUMMARY: This document contains pro- posed amendments to the regulations re- lating to user fees for the special enroll- ment examination to become an enrolled agent, the application for enrollment of en- rolled agents, and the renewal of this en- rollment. The charging of user fees is au- thorized by the Independent Offices Ap- propriations Act (IOAA) of 1952. This document also contains a notice of public hearing on these proposed regulations. DATES: Written or electronically-gen- erated comments must be received by September 28, 2006. Outlines of topics to be discussed at the public hearing sched- uled for September 29, 2006, must be received by September 28, 2006. ADDRESSES: Comments are encour- aged to be submitted to: CC:PA:LPD:PR (REG–145154–05), room 5203, Inter- nal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be sent elec- tronically via the IRS Internet site at www.irs.gov/regsor via the Federal eRule- making Portal atwww.regulations.gov (IRS–REG–145154–05). FOR FURTHER INFORMATION CONTACT: Concerning submissions of comments and/or to be placed 2006–39 I.R.B.567September 25, 2006 on the building access list to at- tend the hearing, Richard Hurst at Richard.A.Hurst@irscounsel.treas.gov or at (202) 622-7180; concerning cost methodology, Eva Williams at (202) 622–6400; concerning the proposed regulations, Matthew Cooper at (202) 622–4940 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Background Section 330 of Title 31 of the United States Code authorizes the Secretary of the Treasury to regulate practice before the Treasury Department. Pursuant to section 330 of Title 31, the Secretary has published regulations governing practice before the IRS in 31 CFR part 10 and reprinted them as Treasury Department Circular No. 230 (Circular 230). These regulations are ad- ministered by the IRS Office of Profes- sional Responsibility (OPR). Section 10.3 of Circular 230 generally authorizes attorneys, certified public ac- countants, enrolled agents and enrolled ac- tuaries to practice before the IRS. An en- rolled agent is defined as an individual en- rolled as an agent pursuant to the provi- sions of Circular 230. The provisions of Circular 230 provide that an individual de- siring to become an enrolled agent is eligi- ble for enrollment through either the suc- cessful passing of a written examination or through demonstration of sufficient ex- pertise in tax administration based on for- mer employment with the IRS. Specifi- cally, section 10.4(a) authorizes the Direc- tor of OPR to grant enrollment to an ap- plicant who demonstrates special compe- tence in tax matters by passing a written examination administered by, or adminis- tered under the oversight of, the Director of OPR and who has not engaged in any conduct that would justify the censure, sus- pension, or disbarment of any practitioner under the provisions of Circular 230. Ac- cordingly, every year OPR develops and administers a Special Enrollment Exami- nation (SEE) that is given to all applicants desiring to become enrolled agents so that they can practice before the IRS. The IRS charged applicants a user fee of $55 ($45 if taking the examination in part) in order to take the 2005 SEE. Section 10.4(b) authorizes the Director of OPR to grant enrollment for former IRS employees if the former employee meets certain requirements, including length of employment with the IRS and substantive tax expertise. Application for enrollment based on former employment with the IRS must be made within three years from the date of separation from such employment. Once eligible for enrollment, by either passing the examination or because of for- mer employment with the IRS, an appli- cant must file an application for enroll- ment on Form 23, “Application for Enroll- ment to Practice Before the Internal Rev- enue Service,” with the Director of OPR. As part of the application for enrollment process, the applicant must enclose a check or money order payable to the IRS in the amount set forth on Form 23, which consti- tutes a fee charged to each applicant for en- rollment. The fee is nonrefundable regard- less of whether the applicant is granted en- rollment. The current user fee for enroll- ment on the Form 23 (Rev. February 2005) is $80. The Director of OPR will act upon an application for enrollment and issue an enrollment card to each individual whose application for enrollment to practice be- fore the IRS is approved. Pursuant to section 10.6(d), each indi- vidual, once enrolled, is required to renew the enrollment every three years to main- tain an active enrollment to practice before the IRS. In order to qualify for renewal, an applicant must certify the completion of the continuing professional education re- quirements set forth in section 10.6(e) of Circular 230. A nonrefundable user fee of $80 is currently charged for each applica- tion for renewal of enrollment filed with the Director of OPR on Form 8554, “Appli- cation for Renewal of Enrollment to Prac- tice Before the Internal Revenue Service.” Contracting Out of Special Enrollment Examination OPR has recently contracted out certain functions pertaining to the SEE to a pri- vate contractor. The contractor will fur- nish the resources, facilities, and services necessary to administer the entire SEE pro- gram, which includesexamination devel- opment, administration of SEE, notifica- tion to IRS of candidates who took the ex- amination, and the results of the exami- nation. The contractor will receive pay- ment for its services by charging a fee to exam applicants. OPR will, nonetheless, still maintain an oversight role with respect to the SEE. The contractor will collect a user fee on behalf of the IRS based on the full costs incurred by the IRS. These pro- posed regulations only establish a user fee with respect to the government costs for overseeing the SEE anddonotincludeany fee that the contractor may charge for its services. Accordingly, while the user fee imposed pursuant to these regulations is less than the user fee that applicants were charged in 2005, the total fee that appli- cants will be charged is greater. The IRS estimates that by using a contractor, how- ever, the total fees incurred will be less than the total fees that would otherwise be charged by the IRS in order to recover the full cost of the IRS administering all as- pects of the SEE. User Fees for Special Enrollment Examination, Enrollment, and Renewal of Enrollment The user fee that the IRS currently charges applicants in order to take the SEE is being modified to reflect the change in IRS costs of administering the exam pro- gram as a result of the contracting out of the exam. The user fees that the IRS currently charge applicants for the enroll- ment and renewal of enrollment process are less than the actual cost of oversee- ing the enrollment process. The IRS is proposing new user fees to take the SEE to become an enrolled agent, the application for enrollment and the renewal of such enrollment. Proposed section 300.4 establishes an $11 per part user fee for the SEE. Proposed sections 300.5 and 300.6 establish separate $125 user fees for the enrollment and re- newal of enrollment process. Authority The IOAA of 1952 (31 U.S.C. 9701) authorizes agenciesto prescribe regula- tions that establish charges for services provided by the agency. The charges must be fair and be based on the costs to the Government, the value of the service to the recipient, the public policy or inter- est served, and other relevant facts. The IOAA of 1952 provides that regulations implementing user fees are subject to poli- cies prescribed by the President, which are currently set forth in OMB Circular A–25, September 25, 20065682006–39 I.R.B. 58 FR 38142 (July 15, 1993) (the OMB Circular). The OMB Circular encourages user fees for Government-provided services that confer benefits on identifiable re- cipients over and above those benefits received by the general public. Under the OMB Circular, an agency that seeks to impose a user fee for Government-pro- vided services must calculate its full cost of providing those services. In general, a user fee should be set at an amount in order for the agency to recover the cost of providing the special service, unless the Office of Management and Budget grants an exception. Pursuant to the guidelines in the OMB Circular, the IRS has calcu- lated its cost of providing services under the enrolled agents program. The IRS has determined that the full cost to the IRS of overseeing the SEE is $11 per part per applicant. The IRS has determined that the full cost of administering the enroll- ment and renenrollment process is $125 per enrolled agent. The proposed user fees will be imple- mented under the authority of the IOAA of 1952 and the OMB Circular. Proposed E ffective Date These regulations are proposed to apply thirty days after the date of publication in theFederal Registerof the final regula- tions. Special Analyses It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory as- sessment is not required. It is hereby cer- tified that these regulations will not have a significant economic impact on a substan- tial number of small entities. Accordingly, a regulatory flexibility analysis is not re- quired. This certification is based on the information that follows. The economic impact of these regulations on any small entity would result from a small entity, in- cluding a sole proprietor, being required to pay a fee prescribed by these regula- tions in order to obtain a particular service. The dollar amount of the fee is not, how- ever, substantial enough to have a signif- icant economic impactonanyentitysub- ject to the fee. Moreover, payment of the fee is voluntary. The only persons sub- ject to the fee are those who elect to take the special enrollment exam. Persons who elect to take the exam will have determined that it is in their economic interest to do so. Pursuant to section 7805(f) of the In- ternal Revenue Code, this notice of pro- posed rulemaking will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact. Comments and Public Hearing Before these proposed regulations are adopted as final regulations, consideration will be given to any written (a signed origi- nal and eight (8) copies) or electronic com- ments that are submitted timely to the IRS. The IRS and Treasury Department request comments on the substance of the pro- posed regulations, as well as on the clarity of the proposed rules and how they can be made easier to understand. All comments will be available for public inspection and copying. A public hearing has been scheduled for September 29, 2006, at 10 a.m. in the 11 th floor conference room at 1901 S. Bell Street, Arlington, VA 22202. Due to building security procedures, all visitors must present photo identification to enter the building. Because of access restric- tions, visitors will not be admitted beyond the immediate entrance area more than 30 minutes before the hearing starts. For in- formation about having your name placed on the building access list to attend the hearing, see the “FOR FURTHER INFOR- MATION CONTACT” section of this pre- amble. The rules of 26 CFR 601.601(a)(3) ap- ply to the hearing. Persons who wish to present oral comments at the hearing must submit electronic or written comments and an outline of the comments to be discussed and the time to be devoted to each topic (signed original and eight (8) copies) by September 28, 2006. A period of ten (10) minutes will be allotted to each person for making comments. An agenda showing the scheduling of the speakers will be pre- pared after the deadline for receiving out- lines has passed. Copies of the agenda will be available free of charge at the hearing. Drafting Information The principal author of these regula- tions is Matthew S. Cooper of the Office of the Associate Chief Counsel (Procedure & Administration), Administrative Provi- sions & Judicial Practice Division. ***** Proposed Amendments to the Regulations Accordingly, 26 CFR Part 300 is pro- posed to be amended as follows: PART 300—USERS FEES Paragraph 1. The authority citation for part 300 continues to read as follows: Authority: 31 U.S.C. 9701. Par. 2. Section 300.0 is amended as follows: 1. Paragraphs (b)(4), (5), and (6) are added. 2. Paragraph (c) is revised. The additions and revision read as fol- lows: §300.0 User fees, in general. ***** (b) * * * (4) Taking the special enrollment exam- ination to become anenrolled agent. (5) Enrolling an enrolled agent. (6) Renewing the enrollment of an en- rolled agent. (c)Effective Date. This part 300 is ap- plicable March 16, 1995, except that the user fee for processing offers in compro- mise is applicable November 1, 2003, and the user fee for the special enrollment ex- amination, enrollment, and renewal of en- rollment for enrolled agents is applicable thirty days after the date of publication in theFederal Registerof the final regula- tions. Par. 3. Section 300.4 is added to read as follows: §300.4 Special enrollment examination fee. (a)Applicability. This section applies to the special enrollment examination to become an enrolled agent pursuant to 31 CFR 10.4(a). (b)Fee. The fee for taking the special enrollment examination is $11.00 per part. 2006–39 I.R.B.569September 25, 2006 (c)Person liable for the fee. The person liable for the special enrollment examina- tion fee is the applicant taking the exami- nation. Par. 4. Section 300.5 is added to read as follows: §300.5 Enrollment of enrolled agent fee. (a)Applicability. This section applies to the initial enrollment of enrolled agents with the IRS Office of Professional Re- sponsibility pursuant to 31 CFR 10.5(b). (b)Fee. The fee for initially enrolling as an enrolled agent with the IRS Office of Professional Responsibility is $125.00. (c)Person liable for the fee. The per- son liable for the enrollment fee is the ap- plicant filing for enrollment as an enrolled agent with the IRS Office of Professional Responsibility. Par. 5. Section 300.6 is added to read as follows: §300.6 Renewal of enrollment of enrolled agent fee. (a)Applicability. This section applies to the renewal of enrollment of enrolled agents with the IRS Office of Profes- sional Responsibility pursuant to 31 CFR 10.6(d)(6). (b)Fee. The fee for renewal of enroll- ment as an enrolled agent with the IRS Office of Professional Responsibility is $125.00. (c)Person liable for the fee. The person liable for the renewal of enrollment fee is the person renewing their enrollment as an enrolled agent with the IRS Office of Professional Responsibility. Mark E. Matthews, Deputy Commissioner for Services and Enforcement. (Filed by the Office of the Federal Register on August 25, 2006, 12:09 p.m., and published in the issue of the Federal Register for August 29, 2006, 71 F.R. 51179) Notice of Proposed Rulemaking by Cross-Reference to Temporary Regulations Determination of Interest Expense Deduction of Foreign Corporations REG–120509–06 AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Notice of proposed rulemaking by cross-reference to temporary regula- tions. SUMMARY: In this issue of the Bulletin, the IRS is issuing temporary regulations (T.D. 9281) under sections 882 and 884 relating to the determination of the inter- est expense deduction of foreign corpora- tions engaged in a trade or business within the United States. These regulations up- date the 1996 final interest expense allo- cation rules for foreign corporations and take into account changes in the foreign banking industry. The rule changes are necessary to conform the final regulations more closely to current operating condi- tions in the foreign banking industry, and to harmonize the deemed earnings repa- triation from a foreign corporation’s trade or business within the United States, with the manner in which dividends are repatri- ated from U.S. resident companies to their foreign shareholders. These regulations are expected to simplify compliance bur- dens for many foreign corporations that al- locate interest expense to effectively con- nected income and provide greater latitude to taxpayers in determining when their ef- fectively connectedearnings are treated as remitted. The text of these regulations also serves as the text of these proposed regu- lations. DATES: Written or electronic comments and requests for a public hearing must be received by November 15, 2006. ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG–120509–06), In- ternal Revenue Service, PO Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be sent elec- tronically, via the IRS Internet site at www.irs.gov/regsor via the Federal eRule- making Portal atwww.regulations.gov (IRS REG–120509–06). FOR FURTHER INFORMATION CONTACT: Concerning the regula- tions, Gregory Spring or Paul Epstein, (202) 622–3870, concerning submis- sions of comments, Richard A. Hurst, Richard.A.Hurst@irscounsel.treas.gov,or (202) 622–7180 (not toll-free numbers). SUPPLEMENTARY INFORMATION: Paperwork Reduction Act The collection of information contained in this notice of proposed rulemaking has been submitted to the Office of Manage- ment and Budget for review in accordance with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the collection of information should be sent to theOffice of Management and Budget, Attn: Desk Officer for the Department of Treasury, Office of Information and Reg- ulatory Affairs, Washington, DC 20503, with copies to theInternal Revenue Ser- vice, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments on the collection of in- formation should be received by October 16, 2006. Comments are requested specif- ically concerning: Whether the proposed collection of in- formation is necessary for the proper per- formance of the functions of the Internal Revenue Service, including whether the information will have practical utility; The accuracy of the estimated burden associated with the proposed collection of information (see below); How the quality, utility, and clarity of the information to be collected may be en- hanced; How the burden of complying with the proposed collection of information may be minimized, including through the appli- cation or automated collection techniques or other forms of information technology; and Estimates of capital or start-up costs and costs of operation, maintenance, and purchase of service to provide information. The collections of information in these proposed regulations are in§§1.882–5T(d)(5)(ii)(B)and 1.884–1T(e)(3)(iv).This collection of information is required to facilitate September 25, 20065702006–39 I.R.B. administrability of reporting of allocable expense from without the United States. Section 1.882–5T(d)(5)(ii)(B) provides a simplified procedure for taxpayers to calculate an allocable amount of U.S. dol- lar denominated interest expense booked by foreign banks in foreign locations. The collection of information provides certainty of application and immediate verification in the advance review and resolution of such treatment on examina- tion. Section 1.884–1T(e)(3)(iv) provides the identical collection of information that was promulgated in final regulations in T.D. 8432, 1992–2 C.B. 157. The rule provides an election to reduce liabilities for purposes of treating effectively con- nected earnings and profits as reinvested. It also requires that U.S. connected liabilities be reduced for purposes of determining the allocation of interest expense to effectively connected income. The collection of information facilitates identification andverification of the coordinated treatment of the sections 882 and 884 provisions in accordance with the time, place and manner restrictions for making the election. The collections of information are mandatory. The likely respondents are foreign banks. Estimated total annual reporting bur- den: 37.5. Estimated average annual burden hours per respondent: 1 /2hour. Estimated number of respondents: 75. Estimated annual frequency of re- sponses: annually. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a valid control number assigned by the Of- fice of Management and Budget. Books and records relating to a collec- tion of information must be retained as long as their contents may become mate- rial in the administration of any internal revenue law. Generally, tax returns and tax return information are confidential, as re- quired by 26 U.S.C. 6103. Background In this issue of the Bulletin, the IRS is issuing temporary regulations under sec- tions 882 and 884 relating to the determi- nation of the interest expense deduction of foreign corporations engaged in a trade or business within the United States. The text of those regulations published in this issue of the Bulletin also serves as the text of these proposed regulations. The preamble to those temporary regulations explains the temporary regulations and these proposed regulations. Special Analyses It has been determined that this notice of proposed rulemaking is not a signifi- cant regulatory action as defined in Exec- utive Order 12866. Therefore, a regula- tory assessment is not required. It has also been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these reg- ulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Code, this regulation has been submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Comments and Requests for Public Hearing Before these proposed regulations are adopted as final regulations, considera- tion will be given to any written (a signed original and eight (8) copies) or electronic comments that are submitted timely to the IRS. The IRS and the Treasury Depart- ment specifically request comments on the clarity of the proposed regulations and how they can be made easier to under- stand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested by any person who timely submits comments. If a public hearing is scheduled, notice of the date, time and place for the hearing will be published in theFederal Register. Drafting Information The principal authors of these regulations are Paul S. Epstein and Gregory A. Spring of the Office of As- sociate Chief Counsel(International). ***** Proposed Amendments to the Regulations Accordingly, 26 CFR 1 is proposed to be amended as follows: PART 1—INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority:26U.S.C.7805*** Par. 2. Section 1.882–5 is amended to read as follows: 1.Paragraphs (a)(1), (a)(1)(i), (a)(1)(ii), (a)(1)(ii)(A), (a)(1)(ii)(B), (a)(2), (a)(7), (a)(7)(i), (a)(7)(ii), (b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4), (d)(2)(ii)(A)(2),(d)(2)(ii)(A)(3), (d)(2)(iii)(A), and (d)(5)(ii) are re- vised. 2. Paragraph (d)(6) Example 5 is added. The revisions and addition read as fol- lows: §1.882–5 Determination of interest deduction. (a) * * * (a)(1) through (a)(2) [The text of this proposed amendment is the same as the text of §1.882–5T(a)(1) through (a)(2) published elsewhere in this issue of the Bulletin]. ***** (a)(7) [The text of this proposed amendment is the same as the text of §1.882–5T(a)(7) published elsewhere in this issue of the Bulletin]. ***** (b) * * * (2) * * * (ii) * * * (b)(2)(ii)(A) [The text of this proposed amendment is the same as the text of §1.882–5T(b)(2)(ii)(A) published else- where in this issue of the Bulletin]. ***** (b)(2)(iv) [The text of this proposed amendment is the same as the text of §1.882–5T(b)(2)(iv)published elsewhere in this issue of the Bulletin]. ***** (b)(3) [The text of this proposed amendment is the same as the text of §1.882–5T(b)(3) published elsewhere in this issue of the Bulletin]. ***** 2006–39 I.R.B.571September 25, 2006 (c) * * * (2) * * * (c)(2)(iv) [The text of this proposed amendment is the same as the text of §1.882–5T(c)(2)(iv) published elsewhere in this issue of the Bulletin]. ***** (c)(4) [The text of this proposed amendment is the same as the text of §1.882–5T(c)(4) published elsewhere in this issue of the Bulletin]. ***** (d) * * * (2) * * * (ii) * * * (A) * * * (d)(2)(ii)(A)(2) through (3)[Thetextof these proposed amendments are the same as the text of §1.882–5T(d)(2)(ii)(A)(2) through (3) published elsewhere in this is- sue of the Bulletin]. ***** (d)(2)(iii)(A) [The text of this proposed amendment is the same as the text of §1.882–5T(d)(2)(iii)(A) published else- whereinthisissueoftheBulletin]. ***** (5) * * * (i) * * * (d)(5)(ii) [The text of this proposed amendment is the same as the text of §1.882–5T(d)(5)(ii)published elsewhere in this issue of the Bulletin]. ***** (d)(6)Example 5[The text of this pro- posed amendment is the same as the text of §1.882–5T(d)(6)Example 5published elsewhere in this issue of the Bulletin]. ***** Par. 3. Section 1.884–1 is amended by revising the entries for paragraphs §1.884–1(e)(3)(ii), (e)(3)(iv) and (e)(5) Example 2to read as follows: §1.884–1 Determination of interest deduction ***** (e) * * * (3) * * * (e)(3)(ii) [The text of this proposed amendment is the same as the text of §1.884–1T(e)(3)(ii) published elsewhere in this issue of the Bulletin]. ***** (e)(3)(iv) [The text of this proposed amendment is the same as the text of §1.884–1T(e)(3)(iv) published elsewhere in this issue of the Bulletin]. ***** (5) * * * (e)(5)Example 2[The text of this pro- posed amendment is the same as the text of §1.884–1T(e)(5)Example 2published elsewhere in this issue of the Bulletin]. ***** Mark E. Matthews, Deputy Commissioner for Services and Enforcement. (Filed by the Office of the Federal Register on August 15, 2006, 8:45 a.m., and published in the issue of the Federal Register for August 17, 2006, 71 F.R. 47459) 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- lations, Part 10, attorneys, certified public accountants, enrolled agents, and enrolled actuaries may not accept assistance from, or assist, any person who is under disbar- ment or suspension from practice before the Internal Revenue Service if the assis- tance relates to a matter constituting prac- tice before the Internal Revenue Service and may not knowingly aid or abet another person to practice before the Internal Rev- enue Service during a period of suspen- sion, disbarment, or ineligibility of such other person. To enable attorneys, certified public accountants, enrolled agents, and enrolled actuaries to identify persons to whom these restrictions apply, the Director, Of- fice of Professional Responsibility, will announce in the Internal Revenue Bulletin their names, their city and state, their pro- fessional designation, the effective date of disciplinary action, and the period of suspension. This announcement will ap- pear in the weekly Bulletin at the earliest practicable date after such action and will continue to appear in the weekly Bulletins for five successive weeks. September 25, 20065722006–39 I.R.B. Consent Suspensions From Practice Before the Internal Revenue Service Under Title 31, Code of Federal Regu- lations, Part 10, an attorney, certified pub- lic accountant, enrolled agent, or enrolled actuary, in order to avoid the institution or conclusion of a proceeding for his or her disbarment or suspension from prac- tice before the Internal Revenue Service, may offer his or her consent to suspension from such practice. The Director, Office of Professional Responsibility, in his dis- cretion, may suspend an attorney, certified public accountant, enrolled agent, or en- rolled actuary in accordance with the con- sent offered. The following individuals have been placed under consent suspension from practice before the Internal Revenue Ser- vice: NameAddressDesignationDate of Suspension Crane, StephenPalm Springs, CAEnrolled AgentMay 4, 2006 to August 3, 2007 Cohen, Ronald J.Newburgh, NYAttorneyIndefinite from June 21, 2006 Layson, David A.Corydon, INAttorneyApril 7, 2006 to October 6, 2007 Brough, Donald L.Salem, INCPAJuly 1, 2006 to June 30, 2010 Gulian, YervantGreat Neck, NYCPAApril 17, 2006 to December 16, 2007 Rivera-Smith, DawnBrick, NJCPAMay 30, 2006 to November 29, 2008 Eckstein, MatthewWoodbury, NYCPAJune 15, 2006 to March 14, 2007 Hecht, Jodee L.Clifton, VACPAIndefinite from June 19, 2006 Finch, Phillip W.Yorktown, VACPAIndefinite from June 22, 2006 Troese Jr., Henry A.Clarion, PAEnrolled AgentIndefinite from June 22, 2006 Robbins, Ronald E.Pittsford, VTCPAJune 24, 2006 to June 23, 2008 Shapiro, Sidney C.West Palm Beach, FLCPAIndefinite from July 1, 2006 2006–39 I.R.B.573September 25, 2006 NameAddressDesignationDate of Suspension Martini, AnthonyStamford, CTCPAJune 18, 2006 to December, 17, 2007 Cunningham, WilliamPhiladelphia, PACPAJuly 1, 2006 to March 31, 2007 Simontacchi, Joseph F.Morris Plains, NJCPAIndefinite from July 1, 2006 Carroccio, Ronald P.Staten Island, NYCPAIndefinite from July 1, 2006 Miller, Walter P.Roanoke, VACPAIndefinite from July 1, 2006 Aneji, PatrickHouston, TXCPAIndefinite from June 22, 2006 Rosenbloom, Mark L.Chicago, ILAttorneyAugust 15, 2006 to August 14, 2007 Viener, Ira S.Fort Lee, NJCPAIndefinite from August 1, 2006 Ganz, Sheldon M.Great Neck, NJCPAIndefinite from August 1, 2006 Tomasulo, MariaWantagh, NYCPAIndefinite from August 7, 2006 Galpern, Joel G.North Miami, FLCPAIndefinite from September 1, 2006 September 25, 20065742006–39 I.R.B. Expedited Suspensions From Practice Before the Internal Revenue Service Under Title 31, Code of Federal Regu- lations, Part 10, the Director, Office of Pro- fessional Responsibility, is authorized to immediately suspend from practice before the Internal RevenueService any practi- tioner who, within five years from the date the expedited proceeding is instituted (1) has had a license to practice as an attor- ney, certified public accountant, or actuary suspended or revoked for cause or (2) has been convicted of certain crimes. The following individuals have been placed under suspension from practice be- fore the Internal Revenue Service by virtue of the expedited proceeding provisions: NameAddressDesignationDate of Suspension Dolan Jr., John L.Memphis, TNAttorneyIndefinite from April 3, 2006 St. Mary, Randall L.Snohomish, WAAttorneyIndefinite from April 3, 2006 Theriault, Michael J.Bel Air, MDAttorneyIndefinite from April 3, 2006 Smith, Bernard P.Marblehead, MAAttorneyIndefinite from April 3, 2006 Bradley, Phillip M.West Point, VAAttorneyIndefinite from April 3, 2006 Haefele, Richard J.Wayzata, MNAttorneyIndefinite from April 3, 2006 Decker, William E.Mandeville, LAAttorneyIndefinite from April 3, 2006 Arbour, John J.Monroe, LAAttorneyIndefinite from April 3, 2006 Keller, John S.Martin Kenner, LAAttorneyIndefinite from April 3, 2006 Fallon, Charles D.Neptune, NJAttorneyIndefinite from April 3, 2006 Agresti, Thomas J.Centennial, COAttorneyIndefinite from April 3, 2006 Kirsch, Craig F.Pittsburgh, PACPAIndefinite from April 3, 2006 2006–39 I.R.B.575September 25, 2006 NameAddressDesignationDate of Suspension Hall, Lenny G.McDowell, KYCPAIndefinite from April 11, 2006 Hultgren, Jerry R.Fresno, CAAttorneyIndefinite from April 11, 2006 Loutos, Peter A.Chicago,ILAttorneyIndefinite from April 11, 2006 Smith III, Frank L.Bushnell, FLAttorneyIndefinite from April 11, 2006 Morley, Michael J.Springfield, PACPAIndefinite from April 11, 2006 Waters, Richard W.Smithfield, UTCPAIndefinite from April 11, 2006 Hartgraves, Travis M.Abilene, TXAttorneyIndefinite from April 14, 2006 Dunn, George T.Lockhart, TXAttorneyIndefinite from April 14, 2006 Adkins, Thomas R.Houston, TXAttorneyIndefinite from April 14, 2006 Hairston, John W.Sugar Land, TXAttorneyIndefinite from April 26, 2006 Marcone, Frank J.Upper Providence, PAAttorneyIndefinite from May 1, 2006 Fraley, Donald J.Minneapolis, MNAttorneyIndefinite from May 3, 2006 Tooke, S. JuddShreveport, LAAttorneyIndefinite from May 3, 2006 Reilly, Michael G.Council Bluffs, IAAttorneyIndefinite from May 3, 2006 Faneuil, Robert A.Newton, MAAttorneyIndefinite from May 3, 2006 September 25, 20065762006–39 I.R.B. NameAddressDesignationDate of Suspension Maignan, Peter R.Upper Marlboro, MDAttorneyIndefinite from May 3, 2006 Son, DavidPhoenix, AZAttorneyIndefinite from May 5, 2006 Susman, Warren I.New York, NYAttorneyIndefinite from May 8, 2006 Wurst, JeromeArlington, TXAttorneyIndefinite from May 8, 2006 O’Shea, Joseph G.Jackson Heights, NYAttorneyIndefinite from May 8, 2006 Biegelson, AlanBrooklyn, NYAttorneyIndefinite from May 8, 2006 Leonard, Robert K.Winston-Salem, NCAttorneyIndefinite from May 8, 2006 Cassidy, Michael M.Madison, WIAttorneyIndefinite from May 8, 2006 Dobkin, Daniel B.New Hyde Park, NYAttorneyIndefinite from May 8, 2006 Nealy, Joseph L.Sugarland, TXAttorneyIndefinite from May 16, 2006 Conmey, Edwin W.Oconomowoc, WIAttorneyIndefinite from May 16, 2006 Knott Jr., Robert T.Los Angeles, CAAttorneyIndefinite from May 16, 2006 Diamond, Howard S.Mendham, NJAttorneyIndefinite from May 16, 2006 Fitzgerald, Bill L.Lubbock, TXAttorneyIndefinite from May 16, 2006 Brubaker, Gregory A.San Francisco, CAAttorneyIndefinite from May 18, 2006 Dodenbier, Robert F.Lehi, UTAttorneyIndefinite from May 18, 2006 2006–39 I.R.B.577September 25, 2006 NameAddressDesignationDate of Suspension Young, Paul J.Taft, CAAttorneyIndefinite from June 8, 2006 Dahodwala, FatemaAndover, MAAttorneyIndefinite from June 8, 2006 Mendola, Joseph E.Monessen, PACPAIndefinite from June 8, 2006 Rooney, Edward F.Minneapolis, MNAttorneyIndefinite from June 8, 2006 Long, Rebecca L.Wichita,KSAttorneyIndefinite from June 8, 2006 West, Clifton C.Fayetteville, NCAttorneyIndefinite from June 8, 2006 Silva, Zoilo I.City Island, NYAttorneyIndefinite from June 8, 2006 Tyler Jr., Earle S.Bangor, MEAttorneyIndefinite from June 12, 2006 Horneber, Alice S.Sioux City, IAAttorneyIndefinite from June 12, 2006 Donnelly, Christine M.Blue Springs, MOAttorneyIndefinite from June 12, 2006 Driscoll Jr., PeterColumbia, MDAttorneyIndefinite from June 12, 2006 Souza, John C.Pocatello, IDAttorneyIndefinite from June 12, 2006 Crockett, Kevin J.Midvale, UTAttorneyIndefinite from June 12, 2006 White, Debra M. WyattNavasota, TXCPAIndefinite from June 12, 2006 Wilkins, Daniel J.Chelmsford, MAAttorneyIndefinite from June 12, 2006 Merica, Chad L.Murray, UTCPAIndefinite from June 12, 2006 September 25, 20065782006–39 I.R.B. NameAddressDesignationDate of Suspension Wintroub, David S.Omaha,NEAttorneyIndefinite from June 12, 2006 Smith, Roderick E.Kansas City, MOAttorneyIndefinite from June 12, 2006 Guida, Joseph M.Aberdeen, MDAttorneyIndefinite from June 12, 2006 Sonibare, NashSt. Paul, MNCPAIndefinite from June 12, 2006 Braun, Marc W.St. Louis, MOAttorneyIndefinite from June 12, 2006 Coffey, John J.Rye, NHAttorneyIndefinite from June 12, 2006 Whitehead, H. AllenNew York, NYAttorneyIndefinite from June 12, 2006 Lansky, SidneyMattapoisett, MAAttorneyIndefinite from June 12, 2006 Pazniokas, Paul M.Norwood, MAAttorneyIndefinite from June 12, 2006 Bajgrowicz, James J.Santa Rosa, CAAttorneyIndefinite from June 12, 2006 Davis, Bret J.Los Angeles, CAAttorneyIndefinite from June 12, 2006 McAvoy, TimothyChicago, ILAttorneyIndefinite from June 12, 2006 Loffadelli, Thomas C.Studio City, CAAttorneyIndefinite from June 12, 2006 Emeziem, Kelechi C.Antioch, CAAttorneyIndefinite from June 12, 2006 Pugh, William C.Wayzata,MNAttorneyIndefinite from June 12, 2006 Lamanna, Eugene C.Reading, PAAttorneyIndefinite from June 12, 2006 2006–39 I.R.B.579September 25, 2006 NameAddressDesignationDate of Suspension Bartels, John R.St. Paul, MNAttorneyIndefinite from June 12, 2006 Shapiro, Kenneth S.Bala Cynwyd, PACPAIndefinite from June 14, 2006 Stone, Jerry W.Austin, TXAttorneyIndefinite from June 21, 2006 Vanriper, Philip E.Binghamton, NYAttorneyIndefinite from June 21, 2006 Simuro, Valerie T.Gardiner, NYAttorneyIndefinite from June 21, 2006 Simms, William K.Brooklyn, NYAttorneyIndefinite from June 21, 2006 Weaver, Terring M.Clarksburg, WVCPAIndefinite from July 1, 2006 Norman, ClarenceBrooklyn, NYAttorneyIndefinite from August 3, 2006 Knight, John G.Winston-Salem, NCAttorneyIndefinite from August 3, 2006 Kronegold, Sheldon H.Englewood, NJAttorneyIndefinite from August 3, 2006 Foushee, Wayne H.Winston-Salem, NCAttorneyIndefinite 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- ulations, Part 10, after notice and an op- portunity for a proceeding before an ad- ministrative law judge, the following indi- viduals have been placed under suspension from practice before the Internal Revenue Service: NameAddressDesignationEffective Date Kahn, HaroldHollis, NYCPAJune 26, 2006 to June 25, 2010 September 25, 20065802006–39 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- lations, Part 10, after notice and an oppor- tunity for a proceeding before an adminis- trative law judge, the following individu- als have been disbarred from practice be- fore the Internal Revenue Service: NameAddressDesignationEffective Date Gailey, James N.Huntersville, NCCPAJune 5, 2006 Censure Issued by Consent Under Title 31, Code of Federal Reg- ulations, Part 10, in lieu of a proceeding being instituted or continued, an attorney, certified public accountant, enrolled agent, or enrolled actuary, may offer his or her consent to the issuance of a censure. Cen- sure is a public reprimand. The following individuals have con- sented to the issuance of a Censure: NameAddressDesignationDate of Censure Williams, Daniel S.Carlsbad, CAAttorneyMarch 29, 2006 Azan, Reinaldo L.Miami Beach, FLCPAJuly 24, 2006 Golub, Stephen B.Norwalk, CTCPAAugust 3, 2006 2006–39 I.R.B.581September 25, 2006 Definition of Terms Revenue rulings and revenue procedures (hereinafter referred to as “rulings”) that have an effect on previous rulings use the following defined terms to describe the ef- fect: Amplifieddescribes a situation where no change is being made in a prior pub- lished position, but the prior position is be- ingextendedtoapplytoavariationofthe fact situation set forth therein. Thus, if an earlier ruling held that a principle ap- plied to A, and the new ruling holds that the same principle also applies to B, the earlier ruling is amplified. (Compare withmodi- fied,below). Clarifiedis used in those instances where the language in a prior ruling is be- ing made clear because the language has caused, or may cause, some confusion. It is not used where a position in a prior ruling is being changed. Distinguisheddescribes a situation where a ruling mentions a previously pub- lished ruling and points out an essential difference between them. Modifiedis used where the substance of a previously published position is being changed. Thus, if a prior ruling held that a principle applied to A but not to B, and the new ruling holds that it applies to both A and B, the prior ruling is modified because it corrects a published position. (Compare withamplifiedandclarified, above). Obsoleteddescribes a previously pub- lished ruling that is not considered deter- minative with respect to future transac- tions. This term is most commonly used in a ruling that lists previously published rul- ings that are obsoleted because of changes in laws or regulations. A ruling may also be obsoleted because the substance has been included in regulations subsequently adopted. Revokeddescribes situations where the position in the previously published ruling is not correct and the correct position is beingstatedinanewruling. Supersededdescribes a situation where the new ruling does nothing more than re- state the substance and situation of a previ- ously published ruling (or rulings). Thus, the term is used to republish under the 1986 Code and regulations the same po- sition published under the 1939 Code and regulations. The term is also used when it is desired to republish in a single rul- ing a series of situations, names, etc., that were previously published over a period of time in separate rulings. If the new rul- ing does more than restate the substance of a prior ruling, a combination of terms is used. For example,modifiedandsu- persededdescribes a situation where the substance of a previously published ruling is being changed in part and is continued without change in part and it is desired to restate the valid portion of the previously published ruling in a new ruling that is self contained. In this case, the previously pub- lished ruling is first modified and then, as modified, is superseded. Supplementedis used in situations in which a list, such as a list of the names of countries, is published in a ruling and that list is expanded by adding further names in subsequent rulings. After the original rul- ing has been supplemented several times, a new ruling may be published that includes the list in the original ruling and the ad- ditions, and supersedes all prior rulings in the series. Suspendedis used in rare situations to show that the previous published rul- ings will not be applied pending some future action such as the issuance of new or amended regulations, the outcome of cases in litigation, or the outcome of a Service study. Abbreviations The fol lowing abbreviations in current use and for merly used will appear in material publis hedintheBulletin. A—Individual. Acq.—A cquiescence. B—Individual. BE—Beneficiary. BK—Bank . B.T.A.—Board of Tax Appeals. C—Individual. C.B.—Cu mulative Bulletin. CFR—Code of Federal Regulations. CI—City. COOP—Coo perative. Ct.D.—Court Decision. CY—County. D—Decede nt. DC—Dummy Corporation. DE—Donee. Del. Order —Delegation Order. DISC—Domestic International Sales Corporation. DR—Donor. E—Estate. EE—Employee. E.O.—Executive Order. ER—Emp loyer. ERISA—Employee Retirement Income Security Act. EX—Executor. F—Fiduc iary. FC—Foreign Country. FICA—Federal Insurance Contributions Act. FISC—Fo reign International Sales Company. FPH—Foreign Personal Holding Company. F.R.—Federal Register. FUTA—Fed eral Unemployment Tax Act. FX—Foreign corporation. G.C.M.—Chief Counsel’s Memorandum. GE—Grante e. GP—General Partner. GR—Grantor. IC—Insura nce Company. I.R.B.—Internal Revenue Bulletin. LE—Lessee. LP—Limited Partner. LR—Lessor. M—Minor. Nonacq.—No nacquiescence. O—Organization. P—Parent Corporation. PHC—Persona l Holding Company. PO—Possession of the U.S. PR—Partner. PRS—Pa rtnership. PTE—Prohibited Transaction Exemption. Pub. L.—Public Law. REIT—Re al Estate Investment Trust. Rev. Proc.—Revenue Procedure. Rev. Rul.—Revenue Ruling. S—Subsi diary. S.P.R.—Statement of Procedural Rules. Stat.—Statutes at Large. T—Target Corporation. T.C.—Tax Court. T.D.—Treasury Decision. TFE—Trans feree. TFR—Transferor. T.I.R.—Technical Information Release. TP—Taxpay er. TR—Trust. TT—Trustee. U.S.C.—Uni ted States Code. X—Corporation. Y—Corporation. Z—Corporat ion. September 25, 2006i2006–39 I.R.B. Numerical Finding List 1 Bulletins 2006–27 through 2006–39 Announcements: 2006-42, 2006-27 I.R.B.48 2006-43, 2006-27 I.R.B.48 2006-44, 2006-27 I.R.B.49 2006-45, 2006-31 I.R.B.121 2006-46, 2006-28 I.R.B.76 2006-47, 2006-28 I.R.B.78 2006-48, 2006-31 I.R.B.135 2006-49, 2006-29 I.R.B.89 2006-50, 2006-34 I.R.B.321 2006-51, 2006-32 I.R.B.222 2006-52, 2006-33 I.R.B.254 2006-53, 2006-33 I.R.B.254 2006-54, 2006-33 I.R.B.254 2006-55, 2006-35 I.R.B.342 2006-56, 2006-35 I.R.B.342 2006-57, 2006-35 I.R.B.343 2006-58, 2006-36 I.R.B.388 2006-59, 2006-36 I.R.B.388 2006-60, 2006-36 I.R.B.389 2006-61, 2006-36 I.R.B.390 2006-62, 2006-37 I.R.B.444 2006-63, 2006-37 I.R.B.445 2006-64, 2006-37 I.R.B.447 2006-65, 2006-37 I.R.B.447 2006-66, 2006-37 I.R.B.448 2006-67, 2006-38 I.R.B.509 2006-68, 2006-38 I.R.B.510 2006-69, 2006-37 I.R.B.449 Notices: 2006-56, 2006-28 I.R.B.58 2006-57, 2006-27 I.R.B.13 2006-58, 2006-28 I.R.B.59 2006-59, 2006-28 I.R.B.60 2006-60, 2006-29 I.R.B.82 2006-61, 2006-29 I.R.B.85 2006-62, 2006-29 I.R.B.86 2006-63, 2006-29 I.R.B.87 2006-64, 2006-29 I.R.B.88 2006-65, 2006-31 I.R.B.102 2006-66, 2006-30 I.R.B.99 2006-67, 2006-33 I.R.B.248 2006-68, 2006-31 I.R.B.105 2006-69, 2006-31 I.R.B.107 2006-70, 2006-33 I.R.B.252 2006-71, 2006-34 I.R.B.316 2006-72, 2006-36 I.R.B.363 2006-73, 2006-35 I.R.B.339 2006-74, 2006-35 I.R.B.339 2006-75, 2006-36 I.R.B.366 2006-76, 2006-38 I.R.B.459 Notices— Continued: 2006-82, 2006-39 I.R.B.529 Proposed Regulations: REG-135866-02, 2006-27 I.R.B.34 REG-146893-02, 2006-34 I.R.B.317 REG-159929-02, 2006-35 I.R.B.341 REG-148864-03, 2006-34 I.R.B.320 REG-168745-03, 2006-39 I.R.B.532 REG-109512-05, 2006-30 I.R.B.100 REG-145154-05, 2006-39 I.R.B.567 REG-112994-06, 2006-27 I.R.B.47 REG-118775-06, 2006-28 I.R.B.73 REG-118897-06, 2006-31 I.R.B.120 REG-120509-06, 2006-39 I.R.B.570 REG-124152-06, 2006-36 I.R.B.368 REG-125071-06, 2006-36 I.R.B.375 Revenue Procedures: 2006-29, 2006-27 I.R.B.13 2006-30, 2006-31 I.R.B.110 2006-31, 2006-27 I.R.B.32 2006-32, 2006-28 I.R.B.61 2006-33, 2006-32 I.R.B.140 2006-34, 2006-38 I.R.B.460 2006-35, 2006-37 I.R.B.434 2006-36, 2006-38 I.R.B.498 2006-37, 2006-38 I.R.B.499 2006-38, 2006-39 I.R.B.530 Revenue Rulings: 2006-35, 2006-28 I.R.B.50 2006-36, 2006-36 I.R.B.353 2006-37, 2006-30 I.R.B.91 2006-38, 2006-29 I.R.B.80 2006-39, 2006-32 I.R.B.137 2006-40, 2006-32 I.R.B.136 2006-41, 2006-35 I.R.B.331 2006-42, 2006-35 I.R.B.337 2006-43, 2006-35 I.R.B.329 2006-44, 2006-36 I.R.B.361 2006-45, 2006-37 I.R.B.423 2006-46, 2006-39 I.R.B.511 2006-47, 2006-39 I.R.B.511 2006-48, 2006-39 I.R.B.516 Treasury Decisions: 9265, 2006-27 I.R.B.1 9266, 2006-28 I.R.B.52 9267, 2006-34 I.R.B.313 9268, 2006-30 I.R.B.94 9269, 2006-30 I.R.B.92 9270, 2006-33 I.R.B.237 9271, 2006-33 I.R.B.224 9272, 2006-35 I.R.B.332 9273, 2006-37 I.R.B.394 Treasury Decisions— Continued: 9274, 2006-33 I.R.B.244 9275, 2006-35 I.R.B.327 9276, 2006-37 I.R.B.424 9277, 2006-33 I.R.B.226 9278, 2006-34 I.R.B.256 9279, 2006-36 I.R.B.355 9280, 2006-38 I.R.B.450 9281, 2006-39 I.R.B.517 9282, 2006-39 I.R.B.512 1 A cumulative list of all revenue rulings, revenueprocedures, Treasury decisions, etc., publishedin Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin 2006–26, dated June 26, 2006. 2006–39 I.R.B.iiSeptember 25, 2006 Finding List of Current Actions on Previously Published Items 1 Bulletins 2006–27 through 2006–39 Announcements: 2005-59 Updated and superseded by Ann. 2006-45, 2006-31 I.R.B.121 Notices: 2002-45 Amplified by Rev. Rul. 2006-36, 2006-36 I.R.B.353 2006-20 Supplemented and modified by Notice 2006-56, 2006-28 I.R.B.58 2006-53 Modified by Notice 2006-71, 2006-34 I.R.B.316 Proposed Regulations: REG-135866-02 Corrected by Ann. 2006-65, 2006-37 I.R.B.447 Ann. 2006-64, 2006-37 I.R.B.447 REG-134317-05 Corrected by Ann. 2006-47, 2006-28 I.R.B.78 Revenue Procedures: 2002-9 Modified and amplified by Notice 2006-67, 2006-33 I.R.B.248 2004-63 Superseded by 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 Revenue Rulings— Continued: 87-10 Amplified and modified by Rev. Rul. 2006-43, 2006-35 I.R.B.329 2002-41 Amplified by Rev. Rul. 2006-36, 2006-36 I.R.B.353 2003-43 Amplified by Notice 2006-69, 2006-31 I.R.B.107 2005-24 Amplified by Rev. Rul. 2006-36, 2006-36 I.R.B.353 Treasury Decisions: 9254 Corrected by Ann. 2006-44, 2006-27 I.R.B.49 Ann. 2006-66, 2006-37 I.R.B.448 9258 Corrected by Ann. 2006-46, 2006-28 I.R.B.76 9260 Corrected by Ann. 2006-67, 2006-38 I.R.B.509 9262 Corrected by Ann. 2006-56, 2006-35 I.R.B.342 9264 Corrected by Ann. 2006-46, 2006-28 I.R.B.76 9272 Corrected by Ann. 2006-68, 2006-38 I.R.B.510 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, 2006iii2006–39 I.R.B. INDEX Internal Revenue Bulletins 2006–27 through 2006–39 The abbreviation and number in parenthesis following the index entry refer to the specific item; numbers in roman and italic type following the parenthesis refers to the Internal Revenue Bulletin in which the item may be found and the page number on which it appears. Key to Abbreviations: AnnAnnouncement CDCourt Decision DODelegation Order EOExecutive Order PLPublic Law PTEProhibited Transaction Exemption RPRevenue Procedure RRRevenue Ruling SPRStatement of Procedural Rules TCTax Convention TDTreasury Decision TDOTreasury Department Order EMPLOYEE PLANS Anti-cutback rules, section 411(d)(6) protected benefits (TD 9280) 38,450 Disaster relief, additional postponement under section 7508A for filing certain 2004 and 2005 individual tax returns by certain taxpayers affected by Hurricane Katrina (Notice 56) 28,58 Employee stock ownership plan (ESOP), disallowance of deduc- tion for reacquisition payments (TD 9282) 39,512 Exempt organization employees, minimum coverage require- mentsofsection410(b)(TD9275)35,327 Full funding limitations, weighted average interest rate: For July 2006 (Notice 66) 30,99 For August 2006 (Notice 74) 35,339 Pension Protection Act of 2006 modifications (Notice 75) 36, 366 Nonbank trustee and nonbank custodian, approval list (Ann 45) 31,122 Qualified retirement plans: Government pick-up plans, employer contributions (RR 43) 35,329 Prohibited transaction excise tax, amount involved in elective deferral (RR 38) 29,80 Regulations: 26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ- ees of 501(c)(3) organizations in 401(k) and 401(m) plans (TD 9275) 35,327 26 CFR 1.411(a)–8, amended; 1.411(d)–3, amended; section 411(d)(6) protected benefits (TD 9280) 38,450 26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividends paid deduction for stock held in employee stock ownership plan (TD 9282) 39,512 Roth IRAs, distributions of designated Roth contributions, public hearing on REG–146459–05 (Ann 42) 27,48 EMPLOYMENT TAX Controlled services transactions under section 482, treatment, al- location of income and deductions from intangibles, and stew- ardship expense (TD 9278) 34,256; (REG–146893–02) 34, 317 Disaster relief: Additional postponement under section 7508A for filing cer- tain 2004 and 2005 individual tax returns by certain taxpay- ers affected by Hurricane Katrina (Notice 56) 28,58 Leave-sharing plans (Notice 59) 28,60 Disclosure of return information, Bureau of Economic Analysis (TD 9267) 34,313; (REG–148864–03) 34,320 Federal Insurance Contributions Act (FICA), application to pay- ments made for certain services (TD 9266) 28,52 Offers in compromise, nonrefundable down payments required (Notice 68) 31,105 Proposed Regulations: 26 CFR 31.3121(s)–1, amended; treatment of services under section 482, allocation of income and deductions from in- tangibles, stewardship expense (REG–146893–02) 34,317 26 CFR 301.6103(j)(1)–1, amended; disclosure of re- turn information to the Bureau of Economic Analysis (REG–148864–03) 34,320 Regulations: 26 CFR 31.3102–1, amended; 31.3121(a)–2, (a)(7)–1, (a)(8)–1, (i)–1, amended; 31.3121(a)(10)–1, revised; ap- plication of the Federal Insurance Contributions Act to payments made for certain services (TD 9266) 28,52 26 CFR 31.3121(s)–1, amended; 31.3121(s)–1T, added; treat- ment of services under section 482, allocation of income and deductions from intangibles, stewardship expense (TD 9278) 34,256 26 CFR 31.3401(a)–1, –4, amended; 31.3402(g)–1, amended; 31.3402(j)–1, amended; 31.3402(n)–1, revised; flat rate supplemental wage withholding (TD 9276) 37,423 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 Supplemental wages, withholding (TD 9276) 37,423 Tip reporting, Attributed Tip Income Program (ATIP) (RP 30) 31,110 ESTATE TAX Disaster relief, additional postponement under section 7508A for filing certain 2004 and 2005 individual tax returns by certain 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 Offers in compromise, nonrefundable down payments required (Notice 68) 31,105 Proposed Regulations: 26 CFR 301.6103(j)(1)–1, amended; disclosure of re- turn information to the Bureau of Economic Analysis (REG–148864–03) 34,320 2006–39 I.R.B.ivSeptember 25, 2006 ESTATE TAX—Cont. Regulations: 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 EXCISE TAX Disaster relief, additional postponement under section 7508A for filing certain 2004 and 2005 individual tax returns by certain 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 Disclosure requirements with respect to prohibited tax shelter transactions to which tax-exempt entities are parties (Notice 65) 31,102 Excise taxes with respect to prohibited tax shelter transactions to which tax-exempt entities are parties (Notice 65) 31,102 Health Savings Accounts (HSAs) under section 4980G, em- ployer comparable contributions (TD 9277) 33,226 Offers in compromise, nonrefundable down payments required (Notice 68) 31,105 Proposed Regulations: 26 CFR 301.6103(j)(1)–1, amended; disclosure of re- turn information to the Bureau of Economic Analysis (REG–148864–03) 34,320 Regulations: 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 EXEMPT ORGANIZATIONS Disaster relief, additional postponement under section 7508A for filing certain 2004 and 2005 individual tax returns by certain taxpayers affected by Hurricane Katrina (Notice 56) 28,58 Disclosure requirements with respect to prohibited tax shelter transactions to which tax-exempt entities are parties (Notice 65) 31,102 Excise taxes with respect to prohibited tax shelter transactions to which tax-exempt entities are parties (Notice 65) 31,102 List of organizations classifiedas private foundations (Ann 51) 32,222 Revocations (Ann 48) 31,136; (Ann 54) 33,254;(Ann55)35, 342; (Ann 60) 36,389; (Ann 69) 37,449 GIFT TAX Disaster relief, additional postponement under section 7508A for filing certain 2004 and 2005 individual tax returns by certain 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 GIFT TAX—Cont. Offers in compromise, nonrefundable down payments required (Notice 68) 31,105 Proposed Regulations: 26 CFR 301.6103(j)(1)–1, amended; disclosure of re- turn information to the Bureau of Economic Analysis (REG–148864–03) 34,320 Regulations: 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 INCOME TAX Accounting methods: Advance consent to change procedures (RP 37) 38,499 Revised instructions for Form 3115, Application for Change inAccountingMethod(Ann52)33,254 Capitalization of amounts paid to acquire, produce, or improve tangible property (REG–168745–03) 39,532 Collection, IRS’s use of private collection agencies (PCAs) in 2006 (Ann 63) 37,445 Computer software, domestic production activities deduction un- der section 199(c)(5)(B): Change in hearing location for REG–111578–06 (Ann 53) 33, 254 Correction to TD 9262 (Ann 56) 35,342 Conservation Security Program (CSP), cost-share payments (RR 46) 39,511 Consolidated returns, basis reallocation, loss suspension, and ex- piration of losses on certain stock dispositions, correction to TD 9254 (Ann 44) 27,49; correction (Ann 66) 37,448 Controlled services cost method under section 482 regulations, identification of specified eligible covered services (Ann 50) 34,321 Controlled services transactions under section 482, treatment, al- location of income and deductions from intangibles, and stew- ardship expense (TD 9278) 34,256; (REG–146893–02) 34, 317 Corporations: Attribution of earnings and profits to stock of controlled foreign corporations (REG–135866–02) 27,34; correction (Ann 64) 37,447; additional corrections (Ann 65) 37,447 Distributions of interests in a loss corporation from qualified trusts (TD 9269) 30,92 Foreign corporation interest expense allocations, branch prof- its tax election, branch profits tax liability reduction (TD 9281) 39,517; (REG–120509–06) 39,570 Information returns required with respect to certain foreign corporations and certain foreign-owned domestic corpora- tions (TD 9268) 30,94; (REG–109512–05) 30,100 Inversions, surrogate foreign corporations (Notice 70) 33,252 Look-through treatment of dividends from noncontrolled sec- tion 902 corporations, correction to TD 9260 (Ann 67) 38, 509 September 25, 2006v2006–39 I.R.B. INCOME TAX—Cont. Surrogate foreign corporation status for purposes of section 7874 (TD 9265) 27,1; (REG–112994–06) 27,47 Credits: Enhanced oil recovery credit, 2006 inflation adjustment (No- tice 62) 29,86 For income, war profits, excess profits taxes paid to foreign country or U.S. possession (REG–124152–06) 36,368 Low-income housing credit: Carryovers to qualified states, 2006 National Pool (RP 38) 39,530 Satisfactory bond, “bond factor” amounts for the period: January through September 2006 (RR 37) 30,91 New markets tax credit, low-income community business (Notice 60) 29,82 Nonbusiness energy property, siding not component specifi- cally and primarily designed to reduce heat loss or gain of dwelling (Notice 71) 34,316 Work opportunity and welfare-to-work tax credits (Ann 49) 29,89 Debit cards used to reimburse participants in self-insured medical reimbursement plans and dependent care assistance programs (Notice 69) 31,107 Disaster relief: Additional postponement under section 7508A for filing cer- tain 2004 and 2005 individual tax returns by certain taxpay- ers affected by Hurricane Katrina (Notice 56) 28,58 Casualty and theft loss deductions attributable to Hurricanes Katrina, Rita, and Wilma, safe harbor methods for individ- uals, personal-use residential real property and certain per- sonal belongings (RP 32) 28,61 Depreciation, Gulf Opportunity (GO) Zone additional first year depreciation deduction (Notice 67) 33,248 Leave-sharing plans (Notice 59) 28,60 Disciplinary actions involving attorneys, certified public accoun- tants, enrolled agents, and enrolled actuaries (Ann 57) 35,343 Disclosure of return information: Bureau of Economic Analysis (TD 9267) 34,313; (REG–148864–03) 34,320 By certain officers and employeesfor investigative purposes (TD 9274) 33,244 E-file, guidance necessary to facilitate business electronic filing and burden reduction, correction to TD 9264 (Ann 46) 28,76; correction to REG–134317–05 (Ann 47) 28,78 Effect of elections in certain multi-step transactions (TD 9271) 33,224 Employee stock ownership plan (ESOP), disallowance of deduc- tion for reacquisition payments (TD 9282) 39,512 Exempt organization employees, minimum coverage require- mentsofsection410(b)(TD9275)35,327 Fast Track Settlement (FTS) for SB/SE taxpayers to expedite case resolution (Ann 61) 36,390 Forms: 1042-S, Foreign Person’s U.S. Source Income Subject to Withholding, specificationsfor filing electronically or magnetically (RP 34) 38,460 INCOME TAX—Cont. 1098, 1099, 5498 and W-2G, requirements for filing electron- ically or magnetically (revised 8-2006) (RP 33) 32,140 3115, Application for Change in Accounting Method, instruc- tions revised May 2006 (Ann 52) 33,254 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips, specifications for filing electronically or magnetically (RP 29) 27,13 8802, Application for United States Residency Certification, user fees for processing (RP 35) 37,434 8830, Enhanced Oil Recovery Credit, credit phased out for 2006 (Ann 62) 37,444 8840, Closer Connection Exception Statement for Aliens, re- vision (Notice 73) 35,339 8898, Statement for Individuals Who Begin or End Bona Fide Residence in a U.S. Possession, postponement of filing date for tax years 2001 through 2005 (Notice 57) 27,13; revision (Notice 73) 35,339 Health reimbursement arrangements, taxable benefits of benefi- ciaries (RR 36) 36,353 Health Savings Accounts (HSAs) under section 4980G, em- ployer comparable contributions (TD 9277) 33,226 Indian tribal governments, limitation on issuance of tax-ex- empt bonds, advance notice of proposed rulemaking (REG–118788–06) (Ann 59) 36,388 Information reporting: For payments to attorneys, reporting of gross proceeds pay- ments (TD 9270) 33,237 Requirements for qualified tuition and related expenses (No- tice 72) 36,363 Insurance companies: Life-nonlife tacking rule, correction to TD 9258 (Ann 46) 28, 76 Recomputed differential earnings rate for 2004 (RR 45) 37, 423 Interest: Investment: Federal short-term, mid-term, and long-term rates for: July 2006 (RR 35) 28,50 August 2006 (RR 39) 32,137 September 2006 (RR 44) 36,361 Portfolio interest rules as appliedtopaymentsmadetopart- nerships and simple or grantor trusts (REG–118775–06) 28, 73; hearing rescheduled (Ann 58) 36,388 Inventory: LIFO, price indexes used by department stores for: May 2006 (RR 40) 32,136 June 2006 (RR 41) 35,331 July 2006 (RR 48) 39,516 Involuntary conversions, livestock sold on account of drought, extension of replacement period (Notice 82) 39,529 Levy, use of superpriority lien arguments as a defense to (RR 42) 35,337 Marginal production rates, 2006 (Notice 61) 29,85 Nonqualified deferred compensation, permitted accelerated pay- ment (Notice 64) 29,88 2006–39 I.R.B.viSeptember 25, 2006 INCOME TAX—Cont. Offers in compromise, nonrefundable down payments required (Notice 68) 31,105 Partnerships, portfolio interest rules as applied to payments made to partnerships and simple or grantor trusts (REG–118775–06) 28,73 Postponement of filing date for Form 8898, Statement for Indi- viduals Who Begin or End Bona Fide Residence in a U.S. Pos- session, for tax years 2001 through 2005 (Notice 57) 27,13 Private foundations, organizations now classified as (Ann 51) 32, 222 Procedures for requesting specialstatistical studies and compila- tions involving return information (RP 36) 38,498 Proposed Regulations: 26 CFR 1.162–4, revised; 1.263(a)–0, amended; 1.263(a)–1 thru –3, revised; guidance regarding deduction and cap- italization of expenditures related to tangible property (REG–168745–03) 39,532 26 CFR 1.367(b)–2, –4, revised; 1.1248–1, –2, –3, –7, re- vised; 1.1248–8, added; section 1248 attribution principles (REG–135866–02) 27,34; correction (Ann 64) 37,447;ad- ditional corrections (Ann 65) 37,447 26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–9, added; 1.861–8, amended; 1.6038A–3(a)(3), amended; 1.6662–6, amended; treatment of services under section 482, allocation of income and deductions from intangibles, stewardship expense (REG–146893–02) 34,317 26 CFR 1.671–5, amended; reporting rules for widely held fixed investment trusts (REG–125071–06) 36,375 26 CFR 1.706–1, amended; 1.901–2, revised; definition of taxpayer for purposes of section 901 and related matters (REG–124152–06) 36,368 26 CFR 1.860A–1, amended; 1.860G–3, amended; 1.863–1, amended; 1.1441–2, amended; REMIC residual interests- accounting for REMIC net income (including any excess inclusions (foreign holders) (REG–159929–02) 35,341 26 CFR 1.871–14, amended; 1.881–2, amended; revisions to regulations relating to repeal of tax on interest of nonres- ident alien individuals and foreign corporations received from certain portfolio debt investments (REG–118775–06) 28,73; hearing rescheduled (Ann 58) 36,388 26 CFR 1.882–5, amended; 1.884–1, amended; determina- tion of interest expense deduction of foreign corporations (REG–120509–06) 39,570 26 CFR 1.985–3, amended; United States dollar approximate separate transactions method (REG–118897–06) 31,121 26 CFR 1.6038–2, amended; 1.6038A–2, amended; informa- tion returns required with respect to certain foreign cor- porations and certain foreign-owned domestic corporations (REG–109512–05) 30,100 26 CFR 1.7874–2, added; guidance regarding expatriated en- tities and their foreign parents (REG–112994–06) 27,47 26 CFR 300.0, amended; 300.4, .5, .6, added; user fees relat- ing to enrollment (REG–145154–05) 39,567 26 CFR 301.6103(j)(1)–1, amended; disclosure of re- turn information to the Bureau of Economic Analysis (REG–148864–03) 34,320 INCOME TAX—Cont. Publications: 1187, Specifications for Filing Form 1042-S, Foreign Per- son’s U.S. Source Income Subject to Withholding, Elec- tronically or Magnetically, revised (RP 34) 38,460 1220, Specifications for Filing Forms 1098, 1099, 5498 and W-2G Electronically or Magnetically, 2006 revision (RP 33) 32,140 1239, Specifications for Filing Form 8027, Employer’s An- nual Information Return of TipIncome and Allocated Tips, Electronically or Magnetically, revised (RP 29) 27,13 Real Estate Investment Trust (REIT) income tests, rents from real property (Notice 58) 28,59 Real Estate Mortgage Investment Conduit (REMIC), allocation of income to foreign persons by certain entities (TD 9272) 35, 332; correction (Ann 68) 38,510; (REG–159929–02) 35,341 Record retention requirements for tax-exempt bonds (Notice 63) 29,87 Regulations: 26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividends paid deduction for stock held in employee stock ownership plan (TD 9282) 39,512 26 CFR 1.199–3T, –8T, amended; computer software under section199(c)(5)(B),correctiontoTD9262(Ann56)35, 342 26 CFR 1.338–3, amended; 1.338(h)(10)–1, amended; 1.338(h)(10)–1T, removed; effect of elections in certain multi-step transactions (TD 9271) 33,224 26 CFR 1.367(b)–0 thru –3, amended; 1.367(b)–6, revised; 1.367(b)–7, –8, –9, added; 1.381(a)–1, revised; stock trans- fer rules, carryover of earnings and taxes (TD 9273) 37,394 26 CFR 1.382–1, amended; 1.382–10, added; 1.382–10T, re- moved; distributions of interests in a loss corporation from qualified trusts (TD 9269) 30,92 26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ- ees of 501(c)(3) organizations in 401(k) and 401(m) plans (TD 9275) 35,327 26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–0T, –1T, –2T, –4T, –6T, –8T, –9T, added; 1.861–8, –8T, amended; 1.6038–3(a)(3), amended; 1.6038A–3T, added; 1.6662–6, amended; 1.6662–6T, added; treatment of services under section 482, allocation of income and deductions from in- tangibles, stewardship expense (TD 9278) 34,256 26 CFR 1.671–5, amended; 1.671–5T, added; reporting rules for widely held fixed investment trusts (TD 9279) 36,355 26 CFR 1.860A–0, –1, amended; 1.860A–1T, added; 1.860G–3, amended; 1.860G–3T, added; 1.863–0, –1, amended; 1.863–1T, added; 1.1441–0, –2, amended; 1.1441–2T, added; REMIC residual interests-accounting for REMIC net income (including any excess inclusions) (foreign holders) (TD 9272) 35,332; correction (Ann 68) 38,510 26 CFR 1.882–0, –5, amended; 1.882–5T, added; 1.884–1, amended; 1.884–1T, added; 602.101, amended; determina- tion of interest expense deduction of foreign corporations (TD 9281) 39,517 September 25, 2006vii2006–39 I.R.B. INCOME TAX—Cont. 26 CFR 1.904–4, amended; application of separate limitations to dividends from noncontrolled section 902 corporations, correctiontoTD9260(Ann67)38,509 26 CFR 1.1502–35, amended; suspension of losses on certain stock dispositions, correction to TD 9254 (Ann 44) 27,49; 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;(Ann54) 33,254;(Ann55)35,342; (Ann 60) 36,389;(Ann69)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 SELF-EMPLOYMENT TAX Disaster relief, additional postponement under section 7508A for filing certain 2004 and 2005 individual tax returns by certain taxpayers affected by Hurricane Katrina (Notice 56) 28,58 Offers in compromise, nonrefundable down payments required (Notice 68) 31,105 2006–39 I.R.B.viiiSeptember 25, 2006 September 25, 20062006–39 I.R.B. 2006–39 I.R.B.September 25, 2006 September 25, 20062006–39 I.R.B. 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