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Current Developments

American Bar Association

Section of Taxation

Tax Accounting Committee

6 May 2011

Moderator:

Jody Brewster

Skadden, Arps, Slate, Meagher & Flom LLP

Washington, D.C.

Panelists:

Andy Keyso

Deputy Associate Chief Counsel (Income Tax & Accounting)

Internal Revenue Service Washington, D.C.

Brandon Carlton Attorney Advisor

Office of Tax Policy Department of the Treasury

Washington, D.C.

George Blaine

Associate Chief Counsel (Income Tax & Accounting)

Internal Revenue Service Washington, D.C.

Eric Lucas

Attorney Advisor Office of Tax Policy

Department of the Treasury Washington, D.C.

Sam Weiler Manager

Ernst & Young National Tax

Washington, D.C.

The information contained herein is of general nature and based on authorities that are subject to change.

Applicability to specific situations is to be determined through consultation with your tax advisor. The

government panelists did not participate in the preparation of this handout.

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Tax Accounting Current Developments January 2011

Table of Contents

I. Acts

a. General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals

(Feb. 2011) – Tax accounting provisions

II. Temporary, Proposed and Final Treasury Regulations

a.

III. Revenue Rulings, Revenue Procedures, Notices and Announcements

a. Rev. Proc. 2011-21 (Mar. 21, 2011) – Guidance on section 280F limitations for 2011

b. Rev. Proc. 2011-26 (Mar. 29, 2011) - Guidance under § 2022(a) of the Small Business Jobs

Act of 2010, Pub. L. No. 111-240, 124 Stat. 2504 (September 27, 2010) (SBJA), and § 401(a)

and (b) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act

of 2010, Pub. L. No. 111-312, 124 Stat. 3296 (December 17, 2010) (TRUIRJCA)

c. Rev. Proc. 2011-22 (Apr. 4, 2011) – Guidance providing a safe harbor method for

determining the recovery period for depreciation of certain tangible assets used by wireless

telecommunications carriers

d. Rev. Proc. 2011-27 and Rev. Proc. 2011-28 (Apr. 4, 2011) – Guidance providing safe

harbor methods for taxpayers to use in determining whether expenditures to maintain,

replace or improve wireline network assets or wireless network assets must be capitalized

under section 263(a)

e. Rev. Proc. 2011-29 (Apr. 8, 2011) – Guidance providing safe harbor election for the

deduction of a percentage of success-based fees under Treas. Reg. § 1.263(a)-5(f) without

further documentation

f. Rev. Proc. 2011-30 (Apr. 14, 2011) – Safe harbor under section 118(a) for certain Clean

Coal Technology awards made by the National Energy Technology Laboratory of the United

States Department of Energy to corporate taxpayers

IV. Cases

a. Gibson & Associates, Inc. v. Commissioner, 136 T.C. No. 10 (Feb. 24, 2011) –

Construction activities that are not repairs qualify for section 199 deduction

b. Dominion Resources, Inc. v. U.S., 107 AFTR 2d 2011-1033 (Feb. 25, 2011) - Treas. Reg.

§ 1.263A-11(e)(1)(ii)(B) is not an arbitrary or capricious interpretation of section 263A(f)

c. Washington Mutual Inc. v. United States, 2011-1 U.S.T.C. ¶50,254 (Mar. 3, 2011) -

Financial institution has basis in rights received in acquisition of failing thrifts

d. Sprint Nextel Corporation and Subsidiaries v. United States, 2011-1 U.S.T.C. ¶50,269

(Mar. 4, 2011) – Universal Service Fund payments were not excludable from income under

section 118(a) as nonshareholder contributions to capital

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V. Rulings, Memoranda and Directives (PLRs, TAMs, CCAs, ILMs, LMSB guidance)

a. AOD 2011-01 (Feb. 8, 2011) – IRS Action on Decision to Robinson Knife Manufacturing

Company and Subsidiaries v. Commissioner, 600 F.3d 121 (2d Cir. 2010), rev’g T.C. Memo 2009-9

b. ILM 201107010 (Feb. 18, 2011) – Discounted amount of “markers” included in casino’s

income

c. ILM 201107011 (Feb. 18, 2011) – Loss discounts deductible by casino when gamblers settle

markers

d. LB&I-4-1010-029 (Feb. 23, 2011) – Status of the super completed contract method of

accounting changed from active to monitoring

e. LB&I-4-0211-002 (Mar. 1, 2011) - Field Guidance on the Planning & Examination of Sales-

Based Royalty Payments and Sales-Based Vendor Allowances

f. Appeals Settlement Guidelines, Exclusion of Income: Non-Corporate Entities and

Contributions to Capital (Mar. 2, 2011) – Non-corporate entities may not exclude from

income amounts received from non-owners under either section 118(a) or any common law

contribution to capital doctrine

g. Appeals Settlement Guidelines, State and Local Location Tax Incentives (Mar. 2,

2011) – SALT incentives do not qualify for exclusion as a contribution to capital by a non-

shareholder under section 118(a)

h. PLR 201111002 (Mar. 18, 2011) – Alternative Basis Recovery method approved for

installment sale transaction

i. TAM 201111004 (Mar. 18, 2011) – Involuntarily converted inventory in a presidentially

declared disaster area held for productive use under section 1033(h)(2)

j. CCA 201111006 (Mar. 18, 2011) – Guidance on pre-contract section 174 costs under the

percentage-of-completion method of section 460

k. FAA 20111101F (Mar. 18, 2011) – Section 197(f)(1) bars car dealership’s deduction for

worthless goodwill associated with a lost franchise agreement

l. Various PLRs granting 9100 relief and election revocations

VI. IRS 2010-2011 Priority Guidance Plan

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I. Acts

a. General Explanations of the Administration’s Fiscal Year 2012 Revenue Proposals (Feb.

2011) – Tax accounting provisions

President Obama released his budget proposals for fiscal year 2012 (the Budget) on Feb. 14, 2011. This

budget is the third proposal of his term. The Budget contains many of the President’s past tax policy

proposals that have yet to be passed by Congress. In total, the Budget includes $3.73 trillion in federal

spending and $2.6 trillion in federal revenues for a net of deficit of $1.1 trillion in 2012. Using the

Congressional Budget Office (CBO) baseline that the law will continue to apply as currently written, the

Budget is set to increase the deficit by $1.7 trillion (from $5.5 trillion to $7.2 trillion) over 10 years. In

comparison, using a modified PAYGO baseline, which reflects the Administration’s belief that several current

tax provisions scheduled to expire are likely to be extended without revenue offsets, the 10-year deficit would

rise to $9.4 trillion. In addition, the Budget assumes GDP growth of 2.7 percent in 2011, 3.6 percent in 2012,

and 4.4 percent in 2013 along with a decrease in unemployment from 9.1 percent in 2011 and to 8.2 percent

by the fourth quarter of 2012.

The below summaries highlight the more significant tax accounting proposals.

Permanently Extend the Increased Limits on Expensing Small Business Assets Under Internal Revenue Code Section 179(b)

as Provided for Under Section 202 of JGTRRA: Expense Up to $125,000 of Investment, Phased Out Dollar for Dollar

After Investment Reaches $500,000

• For years after 2012, the Administration proposes to permanently extend the section 179 expensing

limit of $125,000 and annual investment limit of $500,000 (in 2006 dollars, indexed for inflation

thereafter).

Enhance and Make Permanent the Research Tax Credit

• The research tax credit would be made permanent, effective Jan.1, 2012.The credit would also be

enhanced by increasing the alternative simplified credit rate from 14 percent to 17 percent.

Provide Additional Funds for Advanced Energy Property Manufacturing Credit

• The $2.3 billion cap on the credit resulted in credit funds going to less than one-third of the eligible

projects. The proposal would authorize an additional $5 billion of tax credits for investments in

eligible property used in a qualifying advanced energy project. Unlike the similar 2011 budget

proposal, taxpayers will only be able to apply for a credit on a portion of their qualifying

investment in the project. Also, unlike the original credit program that only provided a two-

month window for submitting applications, this second round of funding would provide a two-

year period to submit applications, beginning on the date the extension of the program is

enacted.

Provide Tax Credit for Energy Efficient Commercial Building Property Expenditures in Place of Existing Tax Deduction

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• The existing deduction would be replaced by a tax credit ranging from $0.60 per square foot for

energy cost reductions of at least 20 percent up to $1.80 per square foot for energy cost

reductions of 50 percent or more. The energy savings must come from the same three building

systems defined in the current law. The baseline for determining energy cost savings would be

prescriptive standards based on building types and climate zones as specified in

ASHRAE/IESNA Standard 90.1-2004. The proposal includes special rules allowing the credit

to benefit a REIT or its shareholders. The credit would be available for property placed in

service during 2012.

Increase Tax Benefits for Certain Low Income Housing Projects

• This proposal would allow state housing finance agencies to designate certain projects to receive, for

purposes of computing the low-income-housing tax credit, a 30-percent boost in eligible basis,

even if they are financed by tax-exempt bonds.

Designate Growth Zones

• The current programs would be replaced by a new Growth Zone program that would provide tax

incentives for 14 urban areas and six rural areas. The zones would be selected through a

competitive application process by the Secretary of Commerce in consultation with the Secretary

of Housing and Urban Development and the Secretary of Agriculture. There would be specific

requirements around maximum area size and population. Nominees would be required to submit

a competitiveness plan for attracting investment and jobs. Other factors to be considered would

include unemployment rates, poverty rates, household income, homeownership, labor force

participation and educational attainment.

• The new growth zones would be eligible for two tax incentives. An employment tax credit for

businesses that employ zone residents would apply to the first $15,000 of qualifying zone

employee wages. The proposed credit is 20 percent for zone residents employed inside the zone

and 10 percent for zone residents employed outside the zone. The second incentive is 100

percent bonus depreciation for qualified property placed in service inside the zone. Qualified

property would be new tangible property with a recovery period of 20 years or less, water utility

property, certain computer software and qualified leasehold improvements. The taxpayer must

purchase the property or begin manufacture or construction after the date of zone designation

and before Jan.1, 2017 and the property must be placed in service within the zone before Jan.1,

2017.

Allow Vehicle Sellers to Claim Qualified Plug-in Electric Drive Motor Vehicle Credit

• The credit would be claimed by the taxpayer that sells or finances the vehicle rather than the vehicle

owner and would only be allowed if the seller clearly discloses the amount of the credit to the

purchaser. This change would be effective for vehicles sold after 2011.

Continue Certain Expiring Tax Provisions through Calendar Year 2012

• The Administration proposes to extend most of these provisions (except for temporary incentives

for the production of fossil fuels) through Dec. 31, 2012.The provisions to be extended would

include the following popular tax breaks:

• Several energy incentives including:

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o Grants for specified energy property in lieu of tax credits;

o Credits for alcohol fuels, biodiesel, renewable diesel, alternative fuel and alternative

fuel mixtures;

o Credit for alternative fuel vehicle refueling property;

o Credit for non-business energy property.

• Business tax relief, including:

o 15-year straight line cost recovery for qualified leasehold, restaurant and retail

improvements;

o Various enhanced charitable contribution deductions;

o Expensing of brownfield environmental remediation costs;

o Work opportunity tax credit.

Repeal Last-In, First-Out (LIFO) Method of Accounting for Inventories

• The current proposal is to repeal LIFO effective for the first tax year beginning after Dec. 31, 2012.

If repealed, a taxpayer would be required to write up the value of its LIFO inventory to its FIFO

value, with the increase in gross income taken into account ratably over 10 years. The provision

is estimated to raise revenue of approximately $52.9 billion over 10 years.

Deny Deduction for Punitive Damages

• Under the Administration’s proposal, no deduction would be allowed for punitive damages paid or

incurred by a taxpayer, whether upon a judgment or in settlement of a claim. If the liability for

punitive damages is covered by insurance, the damages paid or incurred by the insurer would be

included in the gross income of the insured. The insurer would be required to report such

payments to the insured and to the IRS. The proposal would apply to damages paid or incurred

after Dec. 31, 2012, and would raise approximately $312 million over 10 years.

Repeal Lower-Of-Cost-Or-Market (LCM) Inventory Accounting Method

• The current proposal would prohibit taxpayers from writing down the value of FIFO inventories.

These changes would be effective for taxable years beginning after Dec. 31, 2012, and any one-

time increase in gross income would be included ratably over a four-year period beginning with

the year of change. The provision would raise revenue of approximately $8.2 billion over 10

years.

Eliminate Fossil Fuel Preferences

• The Administration proposal is to eliminate tax benefits for oil and gas producers and for coal and

hard-mineral companies after 2011. In addition, the amortization period for geological and

geophysical expenses for independent producers would increase from two to seven years.

II. Temporary, Proposed, and Final Treasury Regulations

III. Revenue Rulings, Revenue Procedures, Notices and Announcements

a. Rev. Proc. 2011-21 (Mar. 21, 2011) – Guidance on section 280F limitations for 2011

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In Rev. Proc. 2011-21, the IRS provides annual guidance on the limitations on depreciation deductions for owners of passenger automobiles first placed in service during calendar year 2011 and the amounts lessees should include in income for passenger automobiles leased during 2011. Rev. Proc. 2011-21 also includes separate tables setting forth limitations on depreciation deductions and inclusion amounts (for lessees) for trucks and vans. Additionally, the revenue procedure contains revised tables of depreciation limitations and lessee inclusion amounts for passenger automobiles that were first placed in service or leased during 2010 and to which the 50% additional first year depreciation deduction under section 168(k)(1)(A) or the 100% additional first year depreciation deduction under section 168(k)(5) applies.

For owners of passenger automobiles, section 280F(a) imposes dollar limitations on the depreciation deduction for the year that the passenger automobile is placed in service by the taxpayer and each succeeding year. Under section 280F(d)(7), the amounts allowable as depreciation deductions must be increased by a price inflation adjustment amount for passenger automobiles placed in service after 1988. The method of calculating the price inflation amount for trucks and vans placed in service in, or after, calendar year 2003, uses a different CPI automobile component than that used in the price inflation amount calculation for other passenger automobiles. The result is somewhat higher depreciation deductions for trucks and vans.

The Small Business Jobs Act of 2010 (Pub. L. No. 111-240) extended the 50% additional first year depreciation deduction under section 168(k) to qualified property acquired by the taxpayer after December 31, 2007, and before January 1, 2011. However, to qualify for the additional first year depreciation deduction, a written binding contract for the acquisition of property must not exist before January 1, 2008, and the taxpayer must place the property in service before January 1, 2011.

Section 401(a) of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (Pub. L. No. 111-312) (the “Act”) further extended the 50% additional first year depreciation deduction under section 168(k) to qualified property acquired after December 31, 2007, and before January 1, 2013, if no written binding contract exists before January 1, 2008, and the property is placed in service before January 1, 2013. The Act also added section 168(k)(5), which allows a 100% additional first year depreciation deduction for qualified property acquired by a taxpayer after September 8, 2010, and before January 1, 2012, if the taxpayer places the property in service before January 1, 2012.

Under section 168(k)(2)(D)(i), the 50% additional first year depreciation deduction does not apply to any property required to be depreciated under the alternative depreciation system of section 168(g), including property described in section 280F(b)(1). Further, under section 168(k)(2)(D)(iii) a taxpayer may elect not to claim the 50% additional first year depreciation deduction for any class of property. As amended by the Act, section 168(k)(4) allows a corporation to elect to increase the alternative minimum tax (“AMT”) credit limitation under section 53(c), instead of claiming the section 168(k) additional first year depreciation deduction for all eligible qualified property placed in service after December 31, 2010, that is round 2 extension property (as defined in section 168(k)(4)(l)(iv)). Accordingly, Rev. Proc. 2011-21 provides tables for passenger automobiles to which the additional depreciation deduction applies, and for passenger automobiles to which the deduction does not apply.

Additionally, for leased passenger automobiles, section 280F(c) requires a reduction in the deduction allowed to the lessee of the passenger automobile. The reduction must be substantially equivalent to the limitations on the depreciation deductions imposed on owners of passenger automobiles. Under Treas. Reg. § 1.280F-7(a), such reduction requires the lessees to include in gross income an inclusion amount determined by applying a formula to the amount obtained from a table in this revenue procedure.

There is a table for lessees of trucks and vans and a table for all other passenger automobiles. Each table shows inclusion amounts for a range of fair market values for each tax year after the passenger automobile is first leased.

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Rev. Proc. 2011-21 provides limitations on depreciation deductions for passenger automobiles that are first placed in service during calendar year 2011 and the amounts lessees should include in income for passenger automobiles leased during 2011. Rev. Proc. 2011-21 also includes separate tables setting forth limitations on depreciation deductions and inclusion amounts (for lessees), for trucks and vans. The limitations on depreciation deductions in § 4.01(2) of Rev. Proc. 2011-21 apply to passenger automobiles (other than leased passenger automobiles) that are placed in service by the taxpayer in calendar year 2011, and continue to apply for each tax year that the passenger automobile remains in service. Tables 1 and 2 should be used for passenger automobiles and trucks or vans for which the additional first year depreciation deduction applies. Tables 3 and 4 are for passenger automobiles and trucks or vans for which the deduction does not apply. The IRS intends to issue additional guidance on the interaction between the 100% additional first year depreciation deduction and section 280F(a) for the tax years subsequent to the first tax year.

The tables in § 4.02 of Rev. Proc. 2011-21 apply to leased passenger automobiles for which the lease term begins during calendar year 2011. Lessees of such passenger automobiles must use these tables (Tables 5 and 6) to determine the inclusion amount for each tax year during which the passenger automobile is leased.

Section 4.03 of Rev. Proc. 2011-21 contains the revised amounts for passenger automobiles placed in service in 2010. Tables 7 and 8 apply to passenger automobiles and trucks or vans placed in service in 2010 for which the additional first year depreciation deduction applies. If the additional first year depreciation deduction does not apply, the depreciation limitations for each tax year in Tables 1 and 2 of Rev. Proc. 2010-18 apply.

b. Rev. Proc. 2011-26 (Mar. 29, 2011) - guidance under § 2022(a) of the Small Business Jobs Act of

2010, Pub. L. No. 111-240, 124 Stat. 2504 (September 27, 2010) (SBJA), and § 401(a) and (b) of

the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, Pub. L.

No. 111-312, 124 Stat. 3296 (December 17, 2010) (TRUIRJCA)

The IRS on March 29 released Rev. Proc. 2011-26 covering the recently enacted provision allowing 100

percent expensing of bonus depreciation property placed in service through the end of 2011. The IRS offers

important guidance in the release, including the addition of rules that:

• Do not allow 100 percent bonus deprecation for self-constructed property when construction begins

before Sep. 9, 2010.

• Provide a special exception allowing 100 percent bonus for certain components of a larger self-

constructed project that is not eligible.

• Allow taxpayers to elect to take 50 percent bonus depreciation for all property placed in service in

the 2010 tax year.

General rules

Bonus depreciation under current law generally allows taxpayers an additional first-year depreciation

deduction of 50 percent of the cost of original use property acquired and placed in service in 2008 through

2012. However, the recently enacted TRUIRJCA provides a more generous 100 percent deduction for bonus

property both acquired and placed in service after Sep. 8, 2010 and before Jan. 1, 2012. (Aircraft and other

long-production period property qualify for 100 percent bonus if placed in service before Jan. 1, 2013 and 50

percent bonus if placed in service before Jan. 1, 2014). Property qualifying for bonus depreciation is defined

as:

• modified accelerated cost recovery system (MACRS) property with a useful life of 20 years or less;

• computer software;

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• water utility property; and

• qualified leasehold improvements.

Qualified restaurant and qualified retail property are specifically excluded from bonus depreciation, but the

new revenue procedure confirms that this property is eligible if it also qualifies as leasehold improvement

property.

Electing bonus depreciation

Taxpayers that do not want to use bonus depreciation must make an election to forgo the additional

depreciation by attaching a statement to a timely filed tax return. Taxpayers may make separate elections for

each class of property, but each election will apply to all the property placed in service in that class for the

year.

The revenue procedure confirms that taxpayers may not make separate elections for 50 percent bonus

depreciation property and 100 percent bonus depreciation property in the same tax year. (So a calendar year

taxpayer may not elect out of 50 percent bonus for property placed in service before Sep. 9, 2010 while using

100 percent bonus for property placed in service for the rest of 2010.) However, the revenue procedure does

provide relief that will allow taxpayers to elect 50 percent bonus depreciation for all property in each class for

the tax year that includes Sep. 9, 2010. (So calendar year taxpayers can use 50 percent bonus for all property

placed in service in 2010 if it is difficult to determine which property was placed in service after Sep. 8, 2010.)

Bonus depreciation is not available for property acquired pursuant to a binding written contract in place

before Jan. 1, 2008, but there is generally no additional binding contract rule applying specifically to 100

percent bonus depreciation. For example, qualified property acquired and placed in service in 2011 will

qualify for full expensing even if acquired pursuant to a binding contract entered into in July of 2010. The

revenue procedure provides that property is considered acquired when the taxpayer has incurred the expense.

Self-constructed property

Property that a taxpayer manufactures, constructs, or produces is considered acquired when the taxpayer

begins construction, manufacture, or production. So any self-constructed property in which construction

began before Sep. 9, 2010 will not qualify for full expensing regardless of whether it is placed in service in

2011.

However, the IRS provides a special exception for “components” of a larger self-constructed project.

Taxpayers may carve out components of a non-qualifying large self-constructed project and apply 100 percent

bonus depreciation if the components themselves meet the acquisition and placed-in-service requirements. It

appears the exception will function similar to the “shrink-back” rule that allows taxpayers to evaluate

subcomponents of a research project as stand-alone business components for purposes of the research credit.

The revenue procedure defines “component” broadly, saying it is intended to refer to any part used in the

manufacture, construction, or production of larger self-constructed property even if they are considered the

same asset or unit of property for depreciation purposes or other code sections.

The revenue procedure provides several examples on how the component rules operate. In Example 2, a

taxpayer enters into a binding written contract on Sep. 1, 2010 to acquire an uncompleted power plant for $5

million. The original owner began construction in August of 2008. The taxpayer incurs $10 million between

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Sep. 15, 2010 and November 2011 to complete the power plant. The example states that $5 million of the

$15 million unadjusted basis qualifies for 50 percent bonus depreciation because it was acquired before Sep.

9, 2010. The other $10 million qualifies for 100 percent bonus because the taxpayer acquired or began self-

constructing all of those components after Sep. 8, 2010.

Taxpayers wishing to use these rules must make an election on a timely filed tax return by attaching a

statement that indicates the taxpayer is making the election specified in Section 3.02(2)(b) of Rev. Proc. 2011-

26. The taxpayer must specify whether the election includes all or some of the eligible components.

Section 280F automobile limits

For passenger automobiles placed in service in 2010 and 2011, section 280F limits the amount of first year

depreciation that can be claimed to $11,060 (See Rev. Proc. 2011-21). Since 100 percent bonus depreciation

does not provide for a depreciation deduction after the year the property is placed in service, a strict

application of the section 280F rules would defer the recovery of basis in excess of the $11,060 limit until the

7th year after the automobile is placed in service. Rev. Proc. 2011-26 provides a special “safe harbor method

of accounting” that allows the excess to be recovered as if the first year calculation had been done using 50

percent bonus depreciation. This does not reduce the amount that can be claimed in the year the automobile

is placed in service, but does accelerate the recovery of the remainder of the cost of the automobile.

The safe harbor described in Rev. Proc. 2011-26 is adopted by its use on a return in the first taxable year

succeeding the year in which the automobile is placed in service. For automobiles placed in service in 2010,

the safe harbor will be elected by its use on the taxpayer’s 2011 Federal income tax return. It is not available

for property that is the subject of a section 179 election.

Mid-quarter convention

The IRS provides that the depreciable basis of property eligible for bonus depreciation is taken into account

in determining whether the mid-quarter convention applies.

Tax credit basis reduction

Property qualifying for tax credits that require a basis reduction (such as the Section 48 energy tax credit) will

be eligible for 100 percent bonus depreciation after the basis reduction is applied, with an exception for the

Section 47 rehabilitation credit.

Previously filed tax returns

The SBJA did not extend bonus depreciation to 2010 until its enactment on Sep. 27, 2010. Many fiscal year

taxpayers may have filed returns for months in 2010 before the enactment of the legislation. Taxpayers who

made no election but filed and did not deduct 50 percent bonus depreciation for 2010 qualified property may

claim the additional depreciation by:

• Filing an amended return for the applicable 2009 tax year or 2010 short tax year before filing a return

for the following taxable year; or

• Filing a Form 3115 for change in method of accounting with the tax year following the 2009 tax year

or 2010 short tax year

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Taxpayers who made an election not to deduct the 50 percent bonus depreciation may revoke this election

and claim the depreciation on an amended return before the taxpayer’s next tax return or June 17, 2011,

whichever is later.

c. Rev. Proc. 2011-22 (Apr. 4, 2011) – Guidance providing a safe harbor method for determining

the recovery period for depreciation of certain tangible assets used by wireless

telecommunications carriers

Rev. Proc. 2011-22 provides a safe harbor method of accounting for determining the recovery periods for

depreciation of certain tangible assets used by wireless telecommunications carriers. The safe harbor provides

recovery periods that will not be challenged by the Service for assets located at the taxpayer’s mobile

telephone switching office (MTSO) and cell sites. A taxpayer may elect to use one or all of the safe harbor

recovery periods for its wireless assets, provided the property for which it is electing the safe harbor method

meets the specific definitions of each type of property included in the revenue procedure. The revenue

procedure applies to taxpayers with a depreciable interest in telecommunication assets used primarily to

provide wireless communications or broadband services by mobile phones. The revenue procedure does not

apply to taxpayers that are primarily cable operators or primarily wireline telecommunications companies.

Rev. Proc. 2011-14 was updated to include a new automatic change in appendix section 6.26 for taxpayers

choosing to change to the safe harbor method provided in Rev. Proc. 2011-22. Rev. Proc. 2011-22 is

effective for tax years ending on or after December 31, 2010.

d. Rev. Proc. 2011-27 and Rev. Proc. 2011-28 (Apr. 4, 2011) – Guidance providing safe harbor

methods for taxpayers to use in determining whether expenditures to maintain, replace or

improve wireline network assets or wireless network assets must be capitalized under section

263(a)

Revenue Procedure 2011-27 and Rev. Proc. 2011-28 provide two alternative safe harbor methods for

taxpayers to use in determining whether expenditures to maintain, replace or improve wireline network assets

(Rev. Proc. 2011-27) or wireless network assets (Rev. Proc. 2011-28) must be capitalized under section 263(a).

The revenue procedures state that taxpayers and the IRS often disagree on which items within a network

constitute discrete units of property and whether certain repairs materially increase the value or prolong the

useful life of a unit of property. The revenue procedures are intended to reduce disputes in this area. Neither

of these revenue procedures applies to taxpayers that are cable operators primarily.

The network asset maintenance allowance method allows a taxpayer to take a certain percentage of the

adjusted basis of network assets, as defined in the revenue procedures, and treat that amount as deductible

maintenance expenses. The network asset maintenance expenses in excess of the allowance amount would

be treated as capital expenditures. For wireless network assets the safe harbor maintenance percentage is five

percent. For wireline network assets that percentage is twelve percent. The adjusted basis of the assets (upon

which the allowance is calculated) includes a reduction for the cost of property other than wireless or wireline

network assets (such as land); the cost of any network assets acquired in an applicable asset acquisition under

section 1060 or acquired in a transaction to which section 338(h)(10) applies; and any other basis adjustments

described in 1016 other than basis adjustments attributable to changes made after December 31, 2007 to the

taxpayer’s unit of property definitions or any adjustments described in sections 1016(a)(2) and 1016(a)(3).

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The units of property method provides that the IRS will not challenge any of the specifically described unit of

property determinations for purposes of the application of section 263(a) for both wireless and wireline

network assets.

Taxpayers wishing to change their method of accounting under either of these two revenue procedures may

do so under the automatic procedures of Rev. Proc. 2011-14 (as amended by Rev. Proc. 2011-27 and 2011-

28). These methods apply only to taxpayers that own a depreciable interest in wireless or wireline network

assets used primarily to provide telecommunication or broadband services; however, the revenue procedure

does not apply to a company that is primarily a cable operator, or is in some other industry.

e. Rev. Proc. 2011-29 (Apr. 8, 2011) – Guidance providing safe harbor election for the deduction of

a percentage of success-based fees under Treas. Reg. § 1.263(a)-5(f) without further

documentation

On April 8, 2011, the IRS issued Rev. Proc. 2011-29 providing a safe harbor election for the deduction of a percentage of success-based fees under Treas. Reg. § 1.263(a)-5(f) without further documentation. Treas. Reg. § 1.263(a)-5 requires a taxpayer to capitalize an amount paid to facilitate a business acquisition or reorganization transaction described in Treas. Reg. § 1.263(a)-5(a). An amount is paid to facilitate a transaction if it is paid in the process of investigating or otherwise pursuing the transaction. Under Treas. Reg. § 1.263(a)-5(f), an amount that is contingent on the successful closing of a transaction (i.e., success-based fee) is presumed to facilitate the transaction. That presumption may be rebutted by sufficient documentation to establish that a portion of the fee is allocable to activities that do not facilitate the transaction. Specifically, in Rev. Proc. 2011-29, the IRS acknowledged the controversy regarding the success-based fee documentation requirement and notes that in order to eliminate “much of this controversy”, it is providing a safe harbor for allocating success-based fees between facilitative and non-facilitative costs. In lieu of maintaining sufficient documentation as required by Treas. Reg. § 1.263(a)-5(f), a taxpayer may irrevocably elect to treat 70% of the success-based fees paid in a transaction as non-facilitative under Treas. Reg. § 1.263(a)-5. The remaining 30% must be capitalized as facilitative transaction costs. Such election is made by attaching a statement to the original federal income tax return for the taxable year in which the success-based fee is paid or incurred that:

(i) States the taxpayer is electing the safe harbor, (ii) Identifies the transaction, and (iii) States the success-baesd fee amounts that are deducted and capitalized.

The election applies to all success-based fees paid or incurred in connection with the transaction for which the election is made. The election is made on a transaction-by-transaction basis, and does not represent a change in the taxpayer’s method of accounting for such costs. Rev. Proc. 2011-29 is effective for success-based fees paid or incurred in taxable years ending on or after April 8, 2011 (i.e., transactions closing on or after April 8, 2011).

f. Rev. Proc. 2011-30 (Apr. 14, 2011) – Safe harbor under section 118(a) for certain Clean Coal

Technology awards made by the National Energy Technology Laboratory of the United States

Department of Energy to corporate taxpayers

In Rev. Proc. 2011-30, the IRS announced a safe harbor under section 118(a) for certain Clean Coal Technology awards made by the National Energy Technology Laboratory (NETL) of the United States Department of Energy (DOE) to corporate taxpayers. Section 118(a) allows a corporation to exclude

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contributions to its capital from gross income. Treas. Reg. § 1.118-1 further provides that section 118(a) applies to contributions to capital made by a person other than a shareholder (e.g., property contributed to a corporation by a governmental unit to enable the corporation to expand its operating facilities). When a corporation receives money from a nonshareholder as a contribution to capital, section 362(c)(2) requires the corporation to reduce the basis in its property.

The DOE has been directed to (1) provide assistance for projects that advance efficiency, environmental

performance, and cost competitiveness well beyond the level of technologies that are in commercial service

or have been demonstrated on a scale that the DOE determines is sufficient to demonstrate that commercial

service is viable as of August 8, 2005, and (2) carry out a program to demonstrate technologies for the large-

scale capture of carbon dioxide from industrial sources. To implement these programs, NETL issued two

Financial Assistance Funding Opportunity Announcements (hereinafter referred to as “CCPI-Round 3” and

“ICCS”). Additionally, on September 27, 2010, NETL awarded assistance for a commercial-scale, oxy-

combustion power plant and carbon dioxide sequestration facility (“FutureGen 2.0”). The DOE subsequently

allocated approximately $796 million to CCPI - Round 3, approximately $703 million to ICCS, and

approximately $995 million to FutureGen 2.0.

In Rev. Proc. 2011-30, the IRS stated that it will not challenge a corporate taxpayer’s treatment of any award

received from the DOE under either the CCPI-Round 3, ICCS, or FutureGen 2.0 programs as

nonshareholder capital contributions under section 118(a), provided that the taxpayer properly reduces the

basis of their property under section 362(c)(2) and the regulations thereunder. In addition the revenue

procedure further indicates that it applies to a corporate taxpayer that “has the right to retain ownership of its

inventions made under an award, either by statute or under waiver of patent rights from DOE.” However,

Rev. Proc. 2011-30 does not apply to the portion of an award paid or incurred for non-capital expenditures

(i.e., operating expenses) or for research and experimental expenditures under section 174. Further, Rev.

Proc. 2011-30 does not apply to noncorporate taxpayers. Rev. Proc. 2011-30 is effective April 14, 2011.

IV. Cases

a. Gibson & Associates, Inc. v. Commissioner, 136 T.C. No. 10 (Feb. 24, 2011) – Construction

activities that are not repairs qualify for section 199 deduction

In Gibson & Associates, Inc. v. Commissioner, 136 T.C. No. 10 (“Gibson”), the Tax Court recently held that the

activities of an engineering and heavy construction company were qualified activities for purposes of section

199. The issue in Gibson was whether certain of the taxpayer’s activities constituted “construction” for

purposes of section 199.

Section 199 allows taxpayers to claim a deduction equal to a percentage of the income earned from

production activities undertaken in the United States. The deduction, called the domestic production

activities deduction, is limited the smaller of the “qualified production activities income” or taxable income

multiplied by the applicable percentage. The deduction cannot be greater than fifty percent of the Form W-2

wages of the taxpayer for the tax year that relate to the qualifying production activity. Qualified production

activities income is the excess of gross receipts earned from qualified activities within the United States over

the allocable cost of goods sold and other expenses related to those activities.

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Section 199(c)(4)(iii) provides that income earned by a taxpayer engaged in the active conduct of a

construction trade or business is qualified production activities income. Qualifying construction activities

include the construction of real property performed in the United States by the taxpayer in the ordinary

course of such trade or business. Treasury Reg. § 1.199-3(m) clarifies that activities constituting construction

are those performed in connection with a project to erect or substantially renovate real property. Substantial

renovation is defined in the regulations as the renovation of a major component or substantial structural part

of real property where that renovation materially increases the value of the property, substantially prolongs

the useful life of the property, or adapts the property to a new or different use. Real property is defined as

buildings (including items that are structural components of such buildings), inherently permanent structures,

inherently permanent land improvements, oil and gas wells, and infrastructure.

In Gibson, the taxpayer was an engineering and heavy construction company that erected or rehabilitated

streets, bridges, airport runways, and other related real property. The rehabilitation services at issue in the

case related mainly to real property that was significantly damaged from a casualty or to real property which

had fallen into a state of disrepair – and was no longer fit for its intended use. The court looked at all 136

construction projects worked on by the taxpayer in the year at issue in order to determine whether the

contracts qualified as the erection or substantial renovation of real property. The Tax Court looked to

section 263 and the rules thereunder in order to determine whether the taxpayer’s activities constituted

“substantial renovations.” Specifically, the court looked at numerous cases and the proposed regulations

under section 263(a) in order to interpret the phrases “materially increases the value of the property”,

“substantially prolongs the useful life of the property”, and “adapts the property to a new or different use.”

Based on the testimony of two expert witnesses, the Tax Court concluded that the subject projects extended

the useful life of the real property and/or substantially increased the value of such property. Accordingly, the

Tax Court held that the taxpayer’s activities constituted construction for purposes of section 199 and that its

revenue from such activities constitutes domestic production gross receipts under section 199.

b. Dominion Resources, Inc. v. U.S., 107 AFTR 2d 2011-1033 (Feb. 25, 2011) - Treas. Reg. §

1.263A-11(e)(1)(ii)(B) is not an arbitrary or capricious interpretation of section 263A(f)

In a recent Court of Federal Claims case, Dominion Resources, Inc. v. U.S., 107 AFTR 2d 2011-1033 (2011), the

court held that Treas. Reg. § 1.263A-11(e)(1)(ii)(B) is not an arbitrary or capricious interpretation of section

263A(f). Dominion Resources (“Dominion”), whose primary business is providing electric power and natural

gas to individual and commercial customers, replaced “burners” in two of its electric generating units. The

generating units had to be taken out of service for several months while burners were replaced. Existing coal

burners were replaced with low-nitrous-oxide burners in order to comply with requirements of the Clean Air

Act. The court stated that “Dominion’s improved burners are subject to the overarching provisions of

section 263A . . . .” Therefore, the cost of the replacement had to be capitalized rather than deducted.

Section 263A requires that direct and indirect costs related to property produced by the taxpayer be

capitalized to such property. Section 263A(f)(2) provides that interest related to certain property with a long

useful life or a long production period must be capitalized. Capitalizable interest includes interest that is

directly attributable (traced) to production expenditures related to the covered property and also interest on

any other indebtedness to the extent that the taxpayer’s interest on the other debt (not directly related to the

project) could have been reduced or avoided had the production expenditures not been incurred. In other

words, section 263A(f) requires capitalization of interest on unrelated debt to the extent of the “production

expenditures” incurred on the project. Other than that general statement of the rule, the statute does not

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provide any specific rules as to the allocation of interest on debt that is not directly related to the project.

The definition of “production expenditures” in section 263A(f)(4)(C) states that “The term ‘production

expenditures’ means the cost (whether or not incurred during the production period) required to be

capitalized under [263A(a)].”

The definition of “production expenditures” is important because the amount of production expenditures

will drive – in part – the amount of interest capitalized to a project. Treasury Reg. § 1.263A-11(e)(1)(ii)(B)

provides that “accumulated production expenditures with respect to the improvement consist of . . . in the

case of any improvement to a unit of real property . . . the adjusted basis of any property that . . .must be

temporarily withdrawn from service to complete the improvement” as long as the property withdrawn from

service benefits from or the improvement was incurred by reason of the property removed from service. The

taxpayer did not include the basis of the property temporarily removed from service in its interest

capitalization calculation – arguing that to include the basis of the temporarily withdrawn property would be

inconsistent with the requirements of the statute itself. IRS exam argued that Dominion was not capitalizing

the required amount of interest under Section 263A(f), and the regulations thereunder, because it was not

including the basis of the temporarily closed plant in the interest allocation.

Dominion filed a claim for refund of taxes paid claiming that the regulation – requiring the inclusion of the

basis of temporarily withdrawn property in the interest capitalization calculation - is inconsistent with the

statutory text of section 263A(f). Dominion argued that the inclusion of the adjusted basis of the boilers and

associated generating units in “production expenditures” violates the allocation rule set forth in

263A(f)(2)(A)(ii), because the amount representing the basis of the boilers could not have been used to

reduce debt (and reduce interest expense) if Dominion had not replaced the burners. Dominion also argued

that the inclusion of the basis of temporarily removed property in the calculation is inconsistent with the

definition of “production expenditures” as defined in section 263A(f)(4)(C) – which included only the costs

that were required to be capitalized under section 263A(a).

In order to determine whether the regulations interpreting section 263A(f) were valid, the court applied the

deference standards set out in two Supreme Court cases, Chevron, U.S.A., Inc. v. Natural Res. Def. Council, Inc.,

467 U.S. 837 (1984) and Mayo Found. for Med. Educ. & Research v. United States, 131 S. Ct. 704 (2011). Under

the standard set out in Chevron, when a court reviews an agency’s construction of a statute which the agency

administers, it must ask two questions. The first question is whether Congress (i.e., the statute) speaks to the

precise question at issue. If the statute is clear, that is the end of the analysis. If the statute is silent or

ambiguous with respect to a specific issue, the next question for the court is whether the agency’s answer [to

the question at issue] is based on a permissible construction of the statute. In the more recent Mayo decision,

the Court held that these steps apply to all Treasury Regulations – whether interpretive or legislative. When

applying the second question from the Chevron analysis, a regulation is binding in the courts unless

procedurally defective, arbitrary or capricious in substance, or manifestly contrary to the statute. In this case,

the court determined that the section 263A(f) was ambiguous with respect to the specific issue presented.

Because the statute was not clear, the court looked at the second question in the Chevron analysis- whether

or not the Treasury Regulation is based on a permissible construction of the statute.

In the Dominion case, the court agreed that including the associated property basis in the interest computation

is at best an approximation of “economic costs” of closing the plant. However, the court could not say that

the regulations overstepped the latitude granted by the statute. Therefore, Treas. Reg. § 1.263A-11(e)(1)

survived Dominion’s challenge that the regulation is inconsistent with the statute itself. Thus, Dominion was

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required to include the basis of the burners and the temporarily closed plants in its interest allocation method

under Section 263A

c. Washington Mutual Inc. v. United States, 2011-1 U.S.T.C. ¶50,254 (Mar. 3, 2011) - Financial

institution has basis in rights received in acquisition of failing thrifts

During the late 1970s and early 1980s, in response to the savings and loan industry crisis, the Federal Savings

and Loan Insurance Corporation (FSLIC) offered incentives to strong financial institutions that were willing

to acquire failing savings and loan associations (“thrifts”). In 1981, Home Savings of America FSB (“Home

Savings”) acquired three failing thrifts. Among the incentives provided to Home Savings by FSLIC was the

right to maintain branches in other states (“branching rights”) and the right to use the “purchase method” of

accounting for regulatory capital reserve purposes (“RAP rights”). The purchase method of accounting

allowed an acquiring bank to create an “asset” for financial statement purposes (known as “supervisory

goodwill”) that was equal to the amount of the failing thrifts’ liabilities assumed by the acquiring bank over

the fair market value of the acquired thrifts’ assets. The supervisory goodwill benefitted the acquiring bank

by helping it meet its capital reserve obligations.

In Washington Mutual Inc. v. United States (No. 09-36109), the Ninth Circuit held Home Savings had cost basis

in “branching rights” and the RAP rights acquired as part of the above described transaction.

Washington Mutual Inc. acquired Home Savings and filed amended tax returns for the 1990, 1992, and 1993

tax years seeking refunds based on the amortization of RAP rights and a section 165 loss based on the

abandonment of some of the branching rights received when it acquired the failing thrifts. The IRS denied

the refund claims and a district court granted the government summary judgment, finding that Home Savings

had no basis the branching rights or the RAP rights.

The court stated that the case required a return to “the very basics of tax law” and explained that the

fundamental concept of basis is “a taxpayer’s capital stake in an asset for tax purposes.” The IRS argued that,

while the taxpayer did assume liabilities in excess of the fair market value of the assets received, the RAP

rights and branching rights were not received as part of that actual transaction, but were, instead, received

from FSLIC. The IRS argued that excess of liabilities over the fair market value of the assets received did not

relate to the rights received from FSLIC in – what amounted to – a separate transaction. The court examined

the documentary evidence, including merger and assistance agreements between Home Savings and the

FSLIC, as well as a resolution issued by the Federal Home Loan Bank Board, and found that acquisition of

the RAP and branching rights; and the acquisition of the failing thrifts were all part of one transaction. The

branching rights and the RAP rights were part of the consideration received by Home Savings and that by

acquiring the failing thrifts, it lowered the FSLIC’s own insurance liability regarding those thrifts. According

to the court, “the cost to Home Savings for acquiring these various incentives and benefits was the excess of

the three failing thrifts’ liabilities over the value of their assets.” The court found that “Home Savings,

therefore, received a cost basis in the branching rights and the RAP rights equal to some part of the total

amount of that excess liability.”

The Ninth Circuit rejected the government’s argument that allowing a cost basis in the rights was

incompatible with the merger being recognized as a tax-free G reorganization under section 368. The court

found that the government had taken certain statements made by Washington Mutual out of context in

reaching this conclusion and held that “recognizing that Home Savings had a cost basis in the branching

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rights and the RAP rights is not incompatible with the Home Savings-Southern merger being recognized as a

tax-free ‘G’ reorganization.”

d. Sprint Nextel Corporation and Subsidiaries v. United States, 2011-1 U.S.T.C. ¶50,269 (Mar.

4, 2011) – Universal Service Fund payments were not excludable from income under section

118(a) as nonshareholder contributions to capital

On March 4, 2011, the United States District Court for the District of Kansas issued a memorandum and

order in Sprint Nextel Corp. et. al. v. United States, sustaining the government’s motion for summary judgment

by holding that universal service fund high-cost support payments received from the Federal

Communications Commission did not constitute capital contributions under section 118(a).

In 1983, the Federal Communications Commission (“FCC”) created the universal service fund (“USF”),

which provided financial assistance to local telecommunications carriers that provided service to high-cost

areas of the country. Sprint Nextel and its predecessors have been receiving USF high-cost support payments

since 1983. The FCC did not require Sprint Nextel's applications for USF high-cost support payments to

include any proposal for future expansion or improvement of its telecommunications network infrastructure

nor did the FCC in any way order Sprint Nextel to expand its infrastructure as a condition of receiving the

payments or otherwise require it to spend the payments it received on particular products or services. During

1990 through 1994, the tax years at issue, Sprint Nextel deposited its USF high-cost support payments into its

general corporate bank accounts and did not segregate them from other funds in the accounts. During each

of these years, Sprint Nextel spent more money on capital investments in its telecommunications

infrastructure than it received in USF high-cost support payments and issued common-stock dividends worth

more than it received in USF high-cost support payments. Between 1990 and 1994, the taxpayer received

$176,143,385 in USF high-cost support payments and included these amounts in gross income. The taxpayer

subsequently amended its federal income tax returns for tax years 1990 through 1994 to treat the USF high-

cost support payments as contributions to capital under section 118(a) and reduced its claims for depreciation

deductions in its amended tax returns in accordance with section 362(c).

As a result of treating the USF high-cost support payments as capital contributions, the taxpayer’s amended

1990 tax return reflected a carryback of an additional $17,851,212 net operating loss from 1990 to the 1988

tax year. Although this carryback did not yield a tax refund, the taxpayer was able to claim additional

alternative minimum tax credit amounts that could be carried forward and used in future tax years.

Sprint Nextel never filed Form 3115 (Application for Change in Accounting Method) with the IRS regarding

its treatment of the USF high-cost support payments on its amended tax returns for 1990 through 1994. The

taxpayer also did not seek or receive the consent of the Secretary of Treasury, the IRS, or any of their

delegates, in its decision to treat the USF high-cost support payments as contributions to capital under

section 118(a). By letter dated June 20, 2007, the IRS formally denied Sprint Nextel's refund claims for the

1990 through 1994 tax years as well as the additional alternative minimum tax credit amount it claimed for the

1988 tax year.

Law

Gross income under section 61 is broadly defined and, as a corollary to this principle, courts must narrowly

construe exclusions from income. Under section 118(a), a corporation’s gross income does not include

contributions to capital. Although the Internal Revenue Code does not define the term “contribution to

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capital,” Treas. Reg. § 1.118-1 provides that section 118 “applies to contributions to capital made by persons

other than shareholders. For example, the exclusion applies to the value of land or other property

contributed to a corporation by a governmental unit or by a civic group for the purpose of inducing the

corporation to locate its business in a particular community, or for the purpose of enabling the corporation to

expand its operating facilities.” The court noted that neither the Treasury Regulation, which essentially

summarizes Supreme Court case law, nor the Supreme Court's decisions on the issue, provide a particularly

clear definition of "contribution to capital."

The court also stated that although several of the Supreme Court cases were decided prior to the enactment

of section 118(a), “a number of federal circuit courts of appeal have concluded that the legislative history of

section 118 makes it clear that Congress intended to incorporate existing (i.e., pre-1954) court decisions that

defined contributions to capital . . .” Therefore, according to the court, the pre-1954 Supreme Court

decisions in effect when Congress enacted section 118 are still applicable after the codification of section 118.

Specifically, the court examined Edwards v. Cuba Railroad Co, 268 U.S. 628 (1925), Texas & Pacific Railway Co. v.

United States, 286 U.S. 285 (1932), Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943), and Brown Shoe Co. v.

Commissioner, 339 U.S. 583 (1950) and the principles set forth therein by the Supreme Court. Additionally, the

court discussed United States v. Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973) (“CB&Q”), a case

that was decided by the Supreme Court in 1972, and stated that the Court emphasized that the intent of the

transferor is the controlling factor when determining whether to treat corporate receipts as taxable income or

as nontaxable contributions to capital. The court also noted the non-exclusive list of five characteristics of a

nonshareholder contribution to capital that the Supreme Court set forth in CB&Q: (1) the receipt must

become a permanent part of the transferee’s working capital structure; (2) the property may not be

compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the

transferee; (3) the property must be bargained for; (4) the contribution must result in a benefit to the

transferee in an amount commensurate with its value; and (5) the contribution of property ordinarily, if not

always, will be employed in or contribute to the production of additional income and its value assured in that

respect.

Analysis

The court examined the purpose of the USF high-cost support program and the intent of the FCC in creating

the program to determine whether the payments were contributions to capital. The parties' arguments

focused on four aspects of the USF high-cost support program: (1) its purpose and structure; (2) expenses

considered in calculating the payments; (3) the public benefit of the program; and (4) the five CB&Q factors.

Purpose & Structure

The court found that the purpose of the USF high-cost support program was to give everyone in the Unites

States access to nation-wide and world-wide telecommunications (including radio) services at reasonable rates.

In other words, the FCC wanted to incentivize telecommunication companies to provide services to areas in

the U.S. that would otherwise be cost prohibitive. The court found that this was similar to the FCC

subsidizing a telecommunication carrier’s income. The court was also persuaded by the fact that USF high-

cost support payments were not conditioned on any construction work (i.e. capital investment), but were

instead measured by a variety of expenses including general operating costs.

Calculation of the USF Payments

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The court next analyzed how the USF high-cost support payments were calculated. The formula included the

cost of capital, depreciation attributable to facilities, facility maintenance expenses, corporate operations,

other expenses, and taxes. The court concluded that by covering a portion of a carrier’s general operating

costs, the FCC intended the USF high-cost support program to subsidize a carrier's gross income rather than

contribute to its capital. In particular, the court gave substantial weight to the fact that the payments did not

require recipients to spend the funds on capital projects nor were the payments conditioned on the

construction of capital projects.

Public Benefit

The parties agreed that the USF high-cost support payments provided a public benefit (affordable

telecommunication services to the entire U.S.), but disagreed as to the significance of this factor. The

taxpayer argued that payments to provide a public benefit were per se contributions to capital. In contrast, the

government argued that an intent to provide a public benefit was insufficient to make the payments

contributions to capital. The court stated that although courts look to the end benefit of a payment, such a

determination does not necessarily control when determining whether a payment is gross income or a capital

contribution. Rather, the court concluded that the other characteristics of the USF high-cost support

program -- its structure and the formula for calculating payments – were evidence that the FCC did not

intend the payments to be contributions to capital.

CB&Q Factors

Before the court analyzed the five-factor CB&Q test, it noted that both parties agreed that the factors were of

questionable value in this context since CB&Q involved contributions of hard assets (e.g., signals, signs,

floodlights, railroad crossings, etc.) and this case involved cash payments.

1. Permanent Part of Working Capital Structure. The court concluded that the USF high-cost support payments

did not satisfy this factor since the FCC did not condition receipt of the funds on capital expenditures.

Rather, a carrier could have spent the money on dividends, taxes, or general operating expenses unrelated to

capital projects. What the taxpayer actually did with the payments was irrelevant to the analysis. It was

sufficient that the taxpayer had the option to use the funds for purposes other than capital expenditures.

2. Not Compensation for Services. The court rejected the government’s argument that the payments failed the

second factor because the taxpayer used the money to perform services. The court stated that the second

factor is specifically limited to payments for services provided "for the transferor by the transferee." Here,

since the FCC was not a customer, the second factor was satisfied.

3. Bargained For. The court noted that the taxpayer was a third-party beneficiary of a regulatory decision and

instead of trying to decide whether lobbying constituted “bargained for,” the court decided that it would “not

rely on this factor as it is inapt.”

4. Benefit to Transferee in Amount Commensurate with Value. The court, without much discussion, held that cash

payments are by its very definition commensurate with its value. As a result, the fourth factor was satisfied.

5. Contribute to Production of Additional Income. The court concluded that this factor was not satisfied since, as

discussed above, the taxpayer was free to use the payments in any manner desired, including using the

amounts to pay taxes or salaries. Although the taxpayer could have used the payments to produce additional

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income, nothing in the USF high-cost support program required or ensured that the payments would be used

for such a purpose.

Attempting to weigh the CB&Q factors, the court stated that the five-factor test sent mixed signals when

applied to the taxpayer and failed to dictate a particular outcome. Notably, in a footnote to the opinion, the

court declined to adopt the Fifth Circuit’s rule that a contribution to capital must strictly conform to the first

four CB&Q factors, and ordinarily the fifth as well. Rather, the court held that it was sufficient that the

taxpayers had not established that the USF high-cost support payments satisfied each of the CB&Q factors

and the other aspects of the program, mentioned above, which led the Court to conclude that the high-cost

support payments which plaintiffs received were not contributions to capital. Specifically, the court, relying

on the structure of the high-cost support program and the costs considered in calculating the payments,

determined that the FCC intended the payments to be taxable supplements to gross income and not

nontaxable nonshareholder contributions to capital. As a result, the court did not consider the government's

change of method of accounting argument.

V. Rulings, Memoranda, and Directives (PLRs, TAMs, CCAs, ILMs, LMSB guidance)

a. AOD 2011-01 (Feb. 8, 2011) – IRS Action on Decision to Robinson Knife Manufacturing Company

and Subsidiaries v. Commissioner, 600 F.3d 121 (2d Cir. 2010), rev’g T.C. Memo 2009-9

On Feb. 8, 2011, the IRS announced in AOD 2011-01 that it “will not follow the Second Circuit’s holding

that sales-based royalty payments are deductible expenses except in litigating cases appealable to the Second

Circuit.”

In Robinson Knife, the Tax Court agreed with the IRS in holding that the taxpayer’s royalty payments made

to a third party for the use of a patent, which gave the taxpayer the right to manufacture the third party’s

branded kitchen tools, were capitalizable to inventory because the patents directly benefited the taxpayer’s

production activities. Without the right to use the patents, the taxpayer would not have been allowed to

manufacture the goods. In reversing the Tax Court, the Second Circuit in Robinson Knife held that the

taxpayer could deduct “royalty payments that are (1) calculated as a percentage of sales revenue from certain

inventory, and (2) incurred only upon sale of such inventory.” It is important to note, however, that the

Second Circuit rejected the taxpayer’s argument that all royalty payments may be immediately deductible.

Rather, the Second Circuit noted that lump-sum minimum royalty payments (i.e., those of a specified amount

which do not vary with the number of trademarked items manufactured or sold) should be reasonably

allocated between ending inventory and cost of goods sold.

In disagreeing with the Second Circuit’s decision in Robinson Knife, the IRS states in AOD 2011-01 that it

believes “the court confused the timing with the purpose of the payments. Robinson incurred the royalty

expenses to first produce then sell the trade-marked items. Like all manufacturers, Robinson had to

manufacture the tools to sell them. We think that the Tax Court correctly held that Robinson incurred the

royalty expenses ‘by reason of’ its production activities, and the royalty payments were production costs

within the meaning of §1.263A-1(e)(3)(i).”

b. ILM 201107010 (Feb. 18, 2011) – Discounted amount of “markers” included in casino’s income

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In this legal memorandum, the IRS concluded that when a customer gambles and loses using a prenegotiated

discounted marker, the discounted amount is the actual price paid for the services (i.e., is the net sales price)

and is the amount required to be included in gross income. If the casino later collects an amount greater than

the discounted amount, it must include the difference in gross income.

In connection with its gambling operations, a casino routinely extends lines of credit to its premium players

to encourage their patronage and promote gambling at its facilities, with each premium player signing a

promissory note at the time the credit is extended (called a “marker”). After signing the marker, the player

may then exchange the marker for gambling chips to gamble at the casino.

To induce a player to play at a particular casino, a casino may provide a marker discount, which is a

prearranged arrangement whereby the casino agrees to accept less than the face amount of the marker if the

customer loses. The amount of the discount is a fixed percentage for the customer’s losses, with the player

knowing the amount of the discount they will receive before they begin gambling. If the player wins, they

must pay the full face amount of the marker.

In reaching its conclusion, the IRS looked at the purpose and intent of the parties. The IRS stated that the

discounts were established to provide an incentive for customers to gamble at the casino and to retain the

customer’s business. As the discounted markers were negotiated before the customers commenced play, the

IRS determined that the purpose and intent was to reach an agreed upon net sales price for the services. The

IRS concluded that as the discounted amount (i.e., the net sales price) is the actual agreed price for the

gambling services, the casino is required to include only the discounted amount in gross income. The IRS

also stated that if the casino later collected an amount greater than the prenegotiated discount amount, the

difference is required to be included in gross income.

c. ILM 201107011 (Feb. 18, 2011) – Loss discounts deductible by casino when gamblers settle

markers

In this legal memorandum, the IRS concluded that when a customer gambles and loses using a prenegotiated

discounted marker, the discounted amount is the actual price paid for the services (i.e., is the net sales price)

and is the amount required to be included in gross income. The IRS also concluded that for subsequent

discounts made after the prenegotiated discounts, the subsequent discount gives rise to a section 165

deduction for the amount of the discount that is forgiven at the time a customer settles its marker.

The marker discounts at issue were prearranged agreements between a casino and its customers, whereby the

casino agreed to accept less than the face amount of the marker if the customer loses. The amount of the

discount was a fixed percentage for the customer’s losses. Additionally, the customers were required to sign

the marker for the full amount of the credit despite the discount agreement. If the customer won, the

customer was required to pay the full face amount of the marker. These discounts were subject to re-

negotiation after gambling was completed until the customer settled its account with the casino. The casino

also had the right to enforce the full face amount of the marker until the customer settled the marker. For

financial accounting purposes, the casino included the undiscounted amount of its gambling winnings in

gross revenues.

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In reaching its conclusion, the IRS looked at the purpose and intent of the parties. The IRS stated that the

discounts were established to provide an incentive for customers to gamble at the casino and to retain the

customer’s business. As the discounted markers were negotiated before the customers commenced play, the

IRS determined that the purpose and intent was to reach an agreed upon net sales price for the services. The

IRS concluded that as the discounted amount (i.e., the net sales price) is the actual agreed price for the

gambling services, the casino is required to include only the discounted amount in gross income. The IRS

also stated that if the casino later collected an amount greater than the prenegotiated discount amount, the

difference is required to be included in gross income. In contrast to the prenegotiated discount markers, the

subsequent discounts were agreed to after the customer completed play. As such, the subsequent discount

was not made with the intent of reaching an agreed upon net sales price. Rather, the subsequent discounts

were used to preserve and retain the customer’s continued patronage at the casino. Therefore, the IRS

concluded that (1) the discounted marker (net sales price) was the actual price paid by the customer for the

casino’s services, and the casino realized only the discounted amount in income; and (2) the casino may take a

section 165 deduction for subsequent discounts made to preserve and retain the customer’s continued

patronage at the time the customer settled their marker.

d. LB&I-4-1010-029 (Feb. 23, 2011) – Status of the super completed contract method of

accounting changed from active to monitoring

In this Industry Director's Directive, the IRS has advised that it has moved the Tier II so-called "super completed contract method" (SCCM) issue from active to monitoring status. Under monitoring status, examiners may resolve SCCM issues by applying existing guidance without the extensive coordination required for issues in active status. Even though the IRS changed the status of the SCCM issue, the IRS states that the second Industry Director's Directive still applies.

e. LB&I-4-0211-002 (Mar. 1, 2011) - Field Guidance on the Planning & Examination of Sales-

Based Royalty Payments and Sales-Based Vendor Allowances

On March 1, 2011, the IRS issued LB&I 4-0211-002 (the “LB&I Directive”), providing guidance to agents

for the planning and examination of taxpayers paying sales-based royalties and receiving sales-based vendor

allowances. Consistent with the proposed regulations and AOD 2011-01, the IRS keeps to its position that

sales-based royalties are incurred by reason of, or to benefit production or resale activities and are, therefore,

capitalized under section 263A. The IRS also continues to view sales-based vendor allowances as a reduction

in cost, not an increase in gross receipts. The LB&I Directive acknowledges that there is controversy on

these issues, but insists on the propriety of the Tax Court’s ruling in Robinson Knife and the proposed

regulations. Pending finalization of the proposed regulations, the LB&I Directive instructs agents not to

expend resources challenging a taxpayer’s treatment of sales-based royalties under the proposed regulations or

under a method that yields a similar result. In addition, agents are instructed not to challenge the treatment of

sales-based vendor allowances if such treatment is consistent with the proposed regulations, or with the

current regulations which would allow an allocation of these amounts to ending inventory under the

simplified resale method.

f. Appeals Settlement Guidelines, Exclusion of Income: Non-Corporate Entities and

Contributions to Capital (Mar. 2, 2011) – Non-corporate entities may not exclude from

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income amounts received from non-owners under either section 118(a) or any common law

contribution to capital doctrine

The IRS recently published appeals settlement guidelines with respect to the application of Section 118 to

noncorporate entities. The industry/taxpayer position was that if the transfer of funds or property

constitutes a contribution to capital under the criteria established in case law, it does not matter whether the

form of the entity receiving the funds or property is a partnership or other non-corporate entity. However,

the guidelines advise that neither section 118(a) nor any common-law contribution to capital doctrine permits

the exclusion from gross income of amounts paid to noncorporate entities by a non-owner.

In establishing these guidelines, the IRS relied on judicial precedent as well as the plain language of Section

118(a) and other relevant code sections. For example, Section 61 provides a general definition that except as

otherwise provided, gross income means all income from whatever source derived. The guidelines also cite to

Commissioner v. Glenshaw Glass, 348 U.S. 426 (1955), where the Supreme Court ruled that payments which

constitute accessions to wealth, clearly realized, and over which the taxpayers have complete dominion fall

squarely within the definition of income and the intent of Congress was for this code section to have a

pervasive and broad scope. Courts have also specifically held that payments by the government to reimburse

a taxpayer for expenditures to construct or purchase property or to make repairs were income to the

recipient. Baboquivari Cattle Co. v. Commissioner, 135 F.2d 114 (9 Cir. 1943). The settlement guidelines

summarize this point by indicating that where the taxpayer has complete dominion and control over the

funds or property received, hazards strongly favor the determination that "contributions" received by non-

corporate entities which represent an accession to wealth will be considered gross income.

As a related matter, the IRS notes that the courts have emphasized that any exclusion from gross income

must be narrowly construed, and that, as Section 118 is an exclusionary provision, it must be construed

narrowly in determining which payments will be considered contributions to capital.

The guidelines also provide that a plain reading of the Section 118 and the absence of clear guidance

regarding its application make it unlikely that a court would apply Section 118 to noncorporate entities.

Specifically, the guidelines state that non-corporate entities cannot rely on Section 118 to exclude funds or

properties received from non-owners from gross income based on a plain reading of Section 118, which does

not address non-corporate entities. Case law preceding the enactment of Section 118 did not address the

form of the entity and, therefore, provide no guidance regarding non-corporate entities or support for

applying this exclusion to non-corporate entities. Prior case law indicates that the courts would not support a

common-law argument when a statute has been enacted specifically limiting the exclusion to corporate

entities. See, Commissioner v. Kowalski, 434 U.S. 77 (1977) and In Re Chrome Plate v. District Director, 614 F.2d 990

(5th Cir. 1980), aff'g 442 F.Supp. 1023 (W.D. Tex. 1977), cert. denied, 449 U.S. 842 (1980). The guidelines

further state that the type of entity is clearly a choice made by the taxpayer with the associated benefits and

burdens and cited Federal Bulk Carriers, Inc. v. Commissioner, 558 F2d 128, 130 (2d Cir. 1977), which noted that

when "knowledgeable parties cast their transaction voluntarily into a certain formal structure . . . they should

be and are, bound by the tax consequences of the particular type of transaction which they created."

As a result, the IRS concluded in these settlement guidelines that it is unlikely that a court would apply

Section 118, an exclusion created for corporations, to non-corporate entities.

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g. Appeals Settlement Guidelines, State and Local Location Tax Incentives (Mar. 2, 2011) –

SALT incentives do not qualify for exclusion as a contribution to capital by a non-shareholder

under section 118(a)

In redacted appeals settlement guidelines discussing the treatment of SALT incentives, the IRS addressed the inclusion of incentives in gross income under section 61 and their exclusion as capital contributions under section 118(a). In addressing whether SALT incentives are includible in gross income under section 61, the IRS concluded that SALT incentives are not income, in part, because the taxes subject to SALT incentives generally are never due or payable before the incentive is given to a taxpayer. Therefore, there is never a cancellation of an obligation and no clear accession to wealth that results in gross income. As a consequence of SALT incentives not being included in gross income, it is the IRS’s position that section 118(a) is not applicable.

However, the IRS nonetheless addressed the applicability of section 118(a) to SALT incentives. The IRS concluded that even if SALT incentives are included in gross income, SALT incentives do not qualify for exclusion as a section 118(a) capital contribution because they fail the US Supreme Court’s five factor test developed in U.S. v. Chicago, Burlington & Quincy R.R. Co., 412 U.S. 401 (1993) (“CB&Q”). The five factors the US Supreme Court considered were whether: (1) the contribution becomes a permanent part of the taxpayer’s working capital; (2) the contribution is not compensation, such as for specific and quantifiable services; (3) the contribution is bargained for; (4) the assets transferred result in a benefit to the transferee commensurate with its value; and (5) the asset transferred ordinarily, if not always, will be used to produce additional income.

In analyzing the CB&Q factors, several of the IRS’s conclusions were based on the determination that SALT incentives are an operating expense adjustment and not a capital asset. The IRS stated that although taxpayers usually are required to make a capital investment in order to receive a SALT incentive, the amount is usually calculated as a function of an expense. Therefore, it is the IRS’s position that SALT incentives are really just a reduction in an operating expense item and not a capital contribution.

Permanent Part of Working Capital: After examining the nature of SALT incentives (i.e., to induce a taxpayer to invest in a specific local area, to create jobs, and reduce operating expenses) the IRS concluded that SALT incentives do not become a permanent part of the taxpayer’s working capital. In reaching its conclusion, the IRS stated that SALT incentives are distinguishable from a contribution of land or cash used to purchase a capital asset, which do become part of a taxpayer’s working capital.

Contribution Must Not be Compensation for Specific Services: The IRS stated that SALT incentives generally are adopted to foster capital investment and job creation within a local jurisdiction, which leads to the enhancement of the economy as a whole. Although this is not compensation for services because it provides for a general public benefit, this benefit alone is not sufficient to establish that incentives are contributions to capital under section 118(a).

Contribution Must be Bargained For: The IRS stated that in order for a taxpayer to satisfy this factor, there must be meaningful negotiations between the local government and taxpayer. According to the IRS, while some SALT incentives entail some bargaining, the level of negotiating varies between local governments and the type of incentive. However, the IRS stated that SALT incentives in the form of rate reductions generally are established by statute and available to any company meeting the specific requirements who make the required investments and expenditures and file the appropriate forms. Therefore, the IRS concluded that in some instances there is no indication of a bargaining process. The IRS also pointed out that even in those instances where the bargained for factor is satisfied, it is not outcome determinative of whether SALT incentives constitute a capital contribution under section 118(a).

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Benefit Must be Commensurate with Value: The IRS stated that the key question under this factor of the CB&Q test is whether the taxpayer can demonstrate that it is more valuable as a result of the benefit. The IRS’s position, as discussed above, is that SALT incentives are an operating expense item. As a result, the IRS has taken the position that there is no asset transferred that can increase the value of the taxpayer. The IRS stated that even if the benefit (i.e., incentive) is classified as a capital asset instead of a reduction in an operating expense and the asset has a specific value, it also must make the taxpayer more valuable. Therefore, the IRS asserted that SALT incentives do not automatically constitute a benefit that enhances the value of the taxpayer by more than the amount of the deemed payment.

Must be Used to Produce Additional Income: The IRS stated that in examining this factor, the classification of the

SALT incentive as either an operating expense or a capital asset is essential in considering the factor. If the

incentive is merely an operating expense, no asset is transferred that is capable of producing income. In

contrast, if a capital asset is determined to be transferred, there is high potential to produce additional

income. As mentioned above, the IRS has taken the position that SALT incentives are an operating expense

item. Therefore, it is the IRS’s position that SALT incentives do not produce additional income. The IRS

also asserted that assuming SALT incentives are akin to a capital asset, they generally do not produce

additional income because the incentives could be used for paying dividends or operating expenses.

h. PLR 201111002 (Mar. 18, 2011) – Alternative Basis Recovery method approved for installment

sale transaction

The IRS recently issued PLR 201111002, allowing a taxpayer to use an alternative method of basis recovery

for the sale of assets in connection with a contingent payment installment sale. The IRS determined that the

proposed alternative represents a reasonable method of basis recovery and will result in basis recovery at a

rate at least twice as fast as the rate at which basis would be recovered using the normal rules.

Under section 453(b)(1) an installment sale is defined as the disposition of property where at least one

payment is to be received after the end of the taxable year in which the disposition occurs. The installment

method required by section 453(a) generally requires that income recognized for any taxable year is in the

proportion of the payments received in that year to the total contract price. However, if the maximum stated

selling price cannot be determined, due to the existence of contingent payments, but the maximum period

over which payments may be received is fixed, then – under the general rule - the taxpayer’s basis should be

allocated to the taxable years in which payments may be received in equal annual increments.

The regulations contemplate that the general basis recovery rule could substantially defer the recovery of the

taxpayer’s basis in the context of a contingent payment sale. Accordingly, Treas. Reg. § 15a.453-1(c)(7)(ii)

provides that a taxpayer may use an alternative basis recovery method if a private letter ruling is requested

prior to the due date of the tax return including extensions for the taxable year in which the first payment is

received. The taxpayer must, in the private letter ruling request, demonstrate that that the application of the

normal basis recovery rule will substantially and inappropriately defer the recovery of the taxpayer’s basis.

The taxpayer must show that the alternative method is a reasonable method of ratably recovering basis and

that under that method it is reasonable to conclude that over time the taxpayer will recover basis at a rate

twice as fast as the rate at which basis would have been recovered under the normal rule.

In demonstrating that the application of the normal basis recovery rule would substantially and

inappropriately defer recovery of basis, the taxpayer may rely on immediate past relevant sales, profit or other

factual data that are subject to verification. Normally, a taxpayer may not rely on projections of future

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productivity, receipts or profits, unless a reasonable projection may be made based on specific event that has

already occurred.

The taxpayer in the letter ruling sold its assets in an installment sale, which consisted of a fixed cash payment

and three contingent payments. The contingent payments are paid only if the buyer achieves certain

consolidated target EBITDA levels for years 1, 2 and 3, to be paid in years 2, 3 and 4. The business the buyer

purchased was in the oil and gas services industry. Subsequent to the sale there was an event which

decreased demand for the business’s products. Additionally, increased competition and declines in the price

of crude oil also contributed to the decrease in business. Prior to the filing of the return for year 2, the

taxpayer was aware that the EBITDA level required for the contingent payment to be received in year 2 was

not met. The taxpayer also does not expect to receive the contingent payments in years 3 and 4, based on the

same factors. Because the taxpayer could demonstrate that the normal basis rule would substantially defer

basis recovery they were allowed to use an alternative basis recovery method, as long as they did not actually

receive any contingent payments in years 3 or 4.

i. TAM 201111004 (Mar. 18, 2011) – Involuntarily converted inventory in a presidentially declared

disaster area held for productive use under section 1033(h)(2)

In technical advice memorandum, the IRS concluded that inventory involuntarily converted in a Presidentially

declared disaster is “property held for productive use in a trade or business” for purposes of section

1033(h)(2). As described, the operations of some of the Taxpayer’s business units were damaged by the 2006

Gulf Coast hurricanes, which were Presidentially declared disasters. The Taxpayer received insurance and

salvage proceeds relating to property involuntarily converted as a result of the hurricanes, more than half of

which was for lost or damaged inventory. The Taxpayer realized gain in excess of basis from these

recoveries. The Taxpayer reinvested most of the proceeds in new store construction property (i.e., section

1245 and section 1250 property) and reduced the basis of the new property by the amount of the deferred

gain. Since the 2006 hurricanes, the Taxpayer purchased and sold inventory but did not designate any

acquired inventory as replacement property for the involuntarily converted inventory.

Section 1033(a)(2) provides that if property (as a result of its destruction in whole or in part, theft, seizure, or

requisition or condemnation or threat or imminence thereof) is compulsorily or involuntarily converted into

money and if the taxpayer during the statutory replacement period, for the purpose of replacing the converted

property, purchases other property similar or related in service or use to the converted property, then, at the

election of the taxpayer, the gain shall be recognized only to the extent that the amount realized on the

conversion exceeds the cost of the replacement property.

Section 1033(h)(2) provides that if a taxpayer's property held for productive use in a trade or business or for

investment is located in a disaster area and is compulsorily or involuntarily converted as a result of a Federally

declared disaster, tangible property held for productive use in a trade or business is treated as property similar

or related in service or use to the converted property.

In TAM 201111004, the IRS acknowledged it is arguable that inventory is not property held for productive

use in a trade or business or for investment because inventory does not "produce" property or services within

the plain meaning of that term. However, the IRS, based largely on statutory construction, concluded that

the use of the term "productive" in section 1033(h)(2) does not necessarily exclude inventory. Specifically,

the IRS stated that section 1033(h)(2), unlike sections 1031(a)(2)(A) (providing that the deferral of gain under

section 1031(a) is not permitted for exchanges of "stock in trade or other property held primarily for sale")

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and 1033(g)(1) (applying to certain conversions of "real property (not including stock in trade or other

property held primarily for sale)"), does not contain any language excluding conversions of inventory from its

application. The IRS stated that had Congress intended to exclude inventory from the language "held for

productive use in a trade or business or for investment" in section 1033(h)(2), it would have expressly done

so as it did in sections 1031(a)(2)(A) and 1033(g).

The IRS also stated the following legislative history of section 1033(h)(2), in explaining the reason for adding

paragraph (h)(2) to section 1033, indicates no Congressional intent to deny inventory businesses the benefit

of the gain deferral:

The property damage in a Presidentially declared disaster may be so great that businesses

may be forced to suspend operations for a substantial time. During that hiatus, valuable

markets and customers may be lost. If this suspension causes the businesses to fail, and

the owners of the business wish to reinvest their capital in a new business venture, the

involuntary conversion rules will force them to recognize gain when they buy

replacement property that is needed for the new business but not similar to that used in

the failed business. This provision will offer relief to such businesses by allowing them to

reinvest their funds in any tangible business property without being forced to recognize

gain. No such deferral of gain is available now, if the taxpayer decides not to reinvest in

tangible business property. S. Rep. 104-281, at 14 (1996).

Further, the IRS stated that the position that section 1033(h)(2) applies to conversions of inventory is

consistent with Notice 2003-18, 2003-1 C.B. 699, which provides guidance on the treatment of grant

payments to businesses to aid in the recovery from the September 11, 2001, terrorist attacks. Notice 2003-18

provides that businesses may elect under section 1033 to defer gain on payments received to compensate for

losses due to damage to, or destruction of, real property or other tangible assets, including inventory used in a

trade or business. Notice 2003-18 also states that because the property for which businesses will receive

grant payments was destroyed in a Presidentially declared disaster, businesses may use grant payments to

purchase any tangible property of a type held for use in a trade or business and still defer recognition of the

gain.

Based on these authorities, the IRS ruled that inventory held by the taxpayer that was involuntarily converted

in a Presidentially declared disaster is "property held for productive use in a trade or business" for purposes

of section 1033(h)(2)

j. CCA 201111006 (Mar. 18, 2011) – Guidance on pre-contract section 174 costs under the

percentage-of-completion method of section 460

In CCA 201111006, the IRS concluded that a taxpayer’s design and development costs, which included

section 174 research and experimentation (R&E) costs, should be capitalized as “pre-contracting year costs”

under the percentage-of-completion method (PCM). These costs become deductible when the taxpayer

receives a purchase order obligating them to manufacture and deliver items.

Under section 460(c)(1), costs that directly benefit long-term contract activities are allocated under the section

451 principles, which generally require income be included in the taxable year in which it is received.

Accordingly, Treas. Reg. § 1.460-4(b)(5)(iv) directs that a taxpayer must capitalize costs incurred for long-term

contracts that it reasonably expects to enter into in a future tax year. Treas. Reg. § 1.460-1(d) similarly

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provides that the taxpayer must allocate gross receipts and costs that are incident to or necessary for the

manufacture, building, installation, or construction of the subject matter of the taxpayer's long-term contracts

to those long-term contracts. However, under sections 460(c)(4 ) and (c)(5), independent research and

development (IR&D) expenses are not allocated in this manner, which leaves open the question of whether

they should always be deducted in the year incurred. (IR&D costs expenses include any expense incurred in

the performance of research or development, except (1) any expenses which are directly attributable to a

long-term contract in existence when the expenses are incurred, or (2) any expenses under an agreement to

perform research or development.)

This question is further complicated by the PCM rules. (See Notice 89-15, 1989-1 CB 634.) Under these

rules, a taxpayer does not include any costs incurred before a contract is entered into in current year estimated

contract revenue. Essentially, under the PCM rules, the taxpayer does not consider these costs when

determining the completion percentage. When applying the pre-contracting year cost rule to uncompensated

costs, costs that are allocable to a long-term contract but are incurred before the contract is signed are not

deductible until signing. It is unclear whether this treatment was meant to apply to IR&D costs.

CCA 201111006 considered this question in light of a taxpayer that had entered into “terms agreements” with

its customers that required the taxpayer to design and develop certain items. The agreements set out terms

for sale of the components under purchase orders that were to be submitted by the customer. Before these

purchase orders were submitted, the taxpayer wasn't obligated to provide the customer with any

manufactured item. However, the taxpayer reasonably expected to enter into a long-term contract with the

customer when it incurred the design and development costs. The taxpayer, relying on Treas. Reg. §§ 1.460-

1(d) and 1.460-1(j), argued that the cost incurred for design and development could not be allocable contract

costs because they arose from non-long-term contract activities and did not benefit an existing long-term

contract. The CCA concluded that taxpayer’s design and development costs, including its section 174 R&E

costs, were allocable costs that had to be capitalized.

The CCA stated that it was inconsistent with the statutory definition of IR&D expenses to read Treas. Reg. §

1.460-1(d) as implying that non-long-term contract activity costs were allocable only if incurred to benefit an

existing long-term contract. The CCA noted that section 460(c) splits R&D expenses that are not IR&D

expenses into two categories, both of which are allocable contract costs. Section 460(c)(5)(A) includes costs

incurred to benefit existing long-term contracts. Section 460(c)(5)(B) includes costs performed under an

agreement that is not represented by evidence of a benefit to long-term contracts. The CCA stated that

requiring non-long-term contract activity costs, such as IR&D costs, to benefit existing long-term contracts in

order to be allocable would nullify section 460(c)(5)(B). The CCA also stated that the taxpayer’s argument

that non-long-term contract activity costs should not be capitalized as pre-contracting year costs was

inconsistent with the capitalization of bidding costs that was required under Treas. Reg. § 1.460-4(b)(5)(iv).

The position was also inconsistent with treatment of “labor costs incurred in anticipation that a contract will

be awarded” under the PCM rules in Notice 89-15. These rules suggested the pre-contract rule covered the

taxpayer’s R&E costs.

Further, the CCA noted that even if Treas. Reg. § 1.460-1(d) contains an implicit requirement that non-long-

term contract activity costs benefit an existing long-term contract in order to be allocable cost, it still requires

that both the revenue and costs associated with a non-long-term contract activity be allocated to a benefitting

long-term contract unless the two activities were compensated separately, although this might not defeat

allocation. In this case, the taxpayer wasn’t separately compensated for designing and developing the item,

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but was anticipating recovering these costs from future related long-term contracts. Also, in taxpayer’s case,

capitalizing the cost resulted in matching income and associated costs. Finally, the CCA stated that the

historical treatment of section 174 costs showed that in certain circumstances Congress directed

capitalization.

k. FAA 20111101F (Mar. 18, 2011) – Section 197(f)(1) bars car dealership’s deduction for worthless

goodwill associated with a lost franchise agreement

In FAA 20111101F, the IRS concluded that a car dealership (Dealer) whose franchise agreements (entitling it

to sell certain automobiles and parts) were terminated was not entitled to utilize section 165 to deduct the

goodwill associated with those franchise agreements. The Dealer had purchased certain assets from another

car dealership and the purchase price included an amount for goodwill related to the franchise rights to sell

(including parts) and service five types of automobiles. The Manufacturer subsequently terminated the

Dealer’s franchise rights to sell two of the five automobile products and paid the Dealer approximately 2

percent of the purchase price as consideration for termination of the franchise rights. The Dealer claimed

that the goodwill associated with its terminated franchise rights became worthless and that it was entitled to a

deduction for the purported worthlessness under section 165.

Section 165(a) allows a deduction for any loss sustained during the taxable year and not compensated for by

insurance or otherwise. The amount of any such deduction is subject to any provision of the Code that

prohibits it or limits the amount. Treas. Reg. § 1.165-1(a). Section 197(a) allows a taxpayer to amortize an

"amortizable section 197 intangible" ratably over a 15-year period. An "amortizable section 197 intangible"

means any "section 197 intangible" that is acquired by a taxpayer after August 11, 1993, and is held in

connection with the conduct of a trade or business or an activity described in section 212, sec. 197(c)(1),

including goodwill and any franchise, trademark, or trade name. Sec. 197(d)(1)(A), (F).

However, section 197(f)(1) provides that, if there is a disposition of any amortizable section 197 intangible

acquired in a transaction or series of related transactions (or any such intangible becomes worthless) and one

or more other amortizable section 197 intangibles acquired in such transaction or series of related

transactions are retained, then (i) no loss may be recognized, and (ii) appropriate basis adjustments must be

made to the retained intangibles. See also, Treas. Reg. § 1.197-2(g)(1). The abandonment of an amortizable

section 197 intangible, or any other event rendering an amortizable section 197 intangible worthless, is treated

as a disposition of the intangible for purposes of section 197(f)(1) and Treas. Reg. § 1.197-2(g)(1). Treas. Reg.

§ 1.197-2(g)(1)(i)(B).

In FAA 20111101F, the IRS concluded that the Dealer's facts fell within section 197(f)(1). Specifically, the

IRS stated that the goodwill the Dealer claimed was deductible as worthless under section 165 was an

amortizable section 197 intangible and that, because the Dealer retained other amortizable section 197

intangibles (i.e., the goodwill associated with the three remaining franchise agreements) acquired in the same

transaction or series of related transactions as the purportedly worthless goodwill, section 197(f)(1)(A)(i)

prohibits any deduction for worthlessness. See Treas. Reg. § 1.197-2(g)(1). Instead, the IRS stated, the

Dealer must under section 197(f)(1)(A)(ii) adjust the basis of its remaining goodwill for any loss not

recognized. See Treas. Reg. § 1.197-2(g)(1).

The Dealer made two principal arguments in support of deducting the goodwill associated with the franchise

rights that were terminated. First, the Dealer claimed that the asset purchase agreement separately stated a

goodwill value for one of the two franchise agreements terminated and that the remainder of the goodwill

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was allocable to the four remaining franchise agreements. The IRS stated that it reviewed the purchase

agreement and found no such allocation and that even if there were evidence showing that the goodwill was

separately stated for each franchise agreement, section 197(f)(1) still applied as all of the goodwill was

acquired in a single transaction or series of related transactions. Second, the Dealer claimed that section

197(f)(1) did not apply to its “special situation” and that the “spirit” of the statute did not contemplate

automobile franchises. The IRS stated that it found no support for this argument and that section 197 clearly

defines the intangibles to which it applies and allows limited exceptions. Further, the IRS stated that the

goodwill the Dealer claimed was deductible as worthless was included in the definition of “amortizable

section 197 intangible” and not excluded by any exception.

l. PLRs Granting 9100 Relief and Election Revocations

VI. IRS 2010-2011 Priority Guidance Plan

On December 7, 2010, the IRS and Treasury released the 2010-2011 Priority Guidance Plan. The following is

an excerpt of the items related to the Tax Accounting Committee:

TAX ACCOUNTING

1. Guidance under §168 regarding the asset class for wireless telecommunications network assets. 2. Guidance under §168(k) on electing out of the additional first-year depreciation deduction, as extended

by § 2022 of the Small Business Jobs Act of 2010. 3. Regulations under §174 regarding procedures for adopting and changing methods of accounting for

research and experimental expenditures. 4. Guidance under §179(f), as added by §2021 of the Small Business Jobs Act of 2010, regarding qualified

real property. 5. Final regulations under §181 regarding deductions for the costs of producing qualified film and television

productions. Temporary regulations were published on February 9, 2007. 6. Final regulations under §§195, 248, and 709 regarding the elections to amortize start-up and

organizational expenditures. Temporary regulations were published July 8, 2008. 7. Final regulations under §263(a) regarding the deduction and capitalization of expenditures for tangible

assets. Proposed regulations were published on March 10, 2008. 8. Regulations under §263(a) regarding the treatment of capitalized transaction costs. 9. Guidance under §263(a) regarding capitalization or deduction of electric utility transmission and

distribution costs. 10. Guidance under §263(a) regarding capitalization or deduction of telecommunication network asset costs. 11. Guidance regarding the supporting documentation required under §1.263(a)-5(f) to allocate success-based

fees between activities that facilitate a transaction and activities that do not facilitate a transaction.

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12. Regulations under §263A regarding the treatment of sales-based costs, such as sales-based royalties. 13. Regulations under §263A regarding including negative amounts in additional §263A costs. 14. Guidance regarding the application of §263A to motor vehicle dealerships.

• PUBLISHED 12/06/10 in IRB 2010-49 as REV. PROC. 2010-44 (RELEASED 11/09/10). 15. Regulations on the carryover of last-in first-out (LIFO) layers following a §351 or §721 transaction. 16. Final regulations under §381(c)(4) and (5) regarding changes in method of accounting. Proposed

regulations were published on November 16, 2007. 17. Guidance amplifying, clarifying and modifying Rev. Proc. 2008-52, which provides procedures for

obtaining automatic consent for certain changes in methods of accounting under §446. 18. Guidance regarding the nonaccrual experience method under §448. 19. Guidance under §§451 and 461 regarding the sale and use of gift cards. 20. Guidance under §453 addressing the exchange of property for an annuity. 21. Regulations under §460 addressing the application of the lookback interest rules to certain pass-through

entities with tax-exempt owners. 22. Guidance under §460 regarding home construction contracts. Proposed regulations were published on

August 4, 2008. 23. Guidance applying the all events test of §461 to services and other liabilities related to the services. 24. Regulations under §1.471-8 regarding the treatment of vendor allowances under the retail inventory

method. 25. Regulations under §1.472-8 regarding the inventory price index computation (IPIC) method. GENERAL TAX ISSUES 1. Guidance under §23 (redesignated as §36C by §10909 of the ACA) regarding the finality of foreign

adoptions.

• PUBLISHED 10/04/10 in IRB 2010-40 as REV. PROC. 2010-31 (RELEASED 09/29/10).

2. Regulations under §36B as added by §1401 of the ACA regarding the premium assistance tax credit. 3. Guidance under §36C of the Code and §10909 of the ACA regarding the refundable adoption credit.

• PUBLISHED 10/18/10 in IRB 2010-42 AS NOT. 2010-66 (RELEASED 09/29/10).

4. Proposed regulations under §41 on the exception from the definition of “qualified research” for internal use software under §41(d)(4)(E).

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5. Regulations under §41 on whether the gross receipts component of the research credit computation for a controlled group under §41(f) includes gross receipts from transactions between group members.

6. Final Regulations on the reduced §41 credit election under §280C(c)(3). Proposed regulations were

published on July 16, 2009. 7. Final regulations on the alternative simplified credit under §41(c)(5), as added by the Tax Relief and

Health Care Act of 2006. Proposed regulations were published June 17, 2008. 8. Final regulations under §42 on the requirements for a qualified contract. Proposed regulations were

published June 19, 2007. 9. Guidance concerning the exception under §42(d)(6) for any federally or State assisted building. 10. Regulations concerning utility allowances under §42(g)(2)(B)(ii) for sub-metered buildings. Interim

guidance was issued in Notice 2009-44, 2009-21 I.R.B. 1037. 11. Guidance concerning recapture under §42(j)(6). 12. Guidance under §45 regarding the definition of refined coal.

• PUBLISHED 10/04/10 in IRB 2010-40 as NOT. 2010-54 (RELEASED 09/16/10). 13. Final regulations under §45D on how an entity serving targeted populations meets the requirements to be

a qualified active low-income community business. Proposed regulations were published on September 24, 2008.

14. Final regulations under §45D that revise and clarify certain rules relating to recapture of the new markets

tax credit as well as other issues. Proposed regulations were published August 11, 2008. 15. Guidance regarding the §45D new markets tax credit. 16. Guidance concerning the credit for production from advanced nuclear power facilities under §45J. 17. Guidance under §§48A and 48B regarding the advanced coal project program and the advanced

gasification project program. 18. Guidance under §§48A and 48B regarding the result of Phase II allocation round.

• PUBLISHED 09/27/10 in IRB 2010-39 as ANN. 2010-56 (RELEASED 08/31/10).

19. Regulations under §§108 and 7701 concerning the bankruptcy and insolvency rules and disregarded entities.

20. Guidance under §108(c), including the definition of "secured by real property." 21. Guidance concerning certain battery grants under §118.

• PUBLISHED 12/06/10 in IRB 2010-49 as Rev. Proc. 2010-45 (RELEASED 11/12/10). 22. Guidance concerning certain broadband initiative grants under §118.

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• PUBLISHED 10/12/10 in IRB 2010-41 as Rev. Proc. 2010-34 (RELEASED 09/23/10).

23. Guidance concerning certain high speed rail grants under §118.

• PUBLISHED 12/06/10 in IRB 2010-49 as Rev. Proc. 2010-46 (RELEASED 11/12/10). 24. Regulations under §152 concerning the definition of dependent. 25. Regulations under §§162 and 262 regarding the deductibility of expenses for lodging not incurred in

traveling away from home. 26. Guidance under §163(h)(3) regarding the limitation on the deductibility of home acquisition

indebtedness.

• PUBLISHED 11/01/10 in IRB 2010-44 as REV. RUL. 2010-25 (RELEASED 10/14/10). 27. Guidance under §165 regarding damage to personal residences from corrosive drywall.

• PUBLISHED 10/18/10 in IRB 2010-42 as REV. PROC. 2010-36 (RELEASED 09/30/10). 28. Final regulations under §170 regarding charitable contributions. Proposed regulations were published on

August 7, 2008. 29. Guidance under §172 of the Code and §13 of the Worker, Homeownership, and Business Assistance Act

of 2009 regarding a 5-year carryback of net operating losses.

• PUBLISHED 09/13/10 in IRB 2010-37 as NOT. 2010-58 (RELEASED 08/20/10). 30. Regulations under §174 concerning inventory property. 31. Final regulations under §179B relating to the election to deduct qualified capital costs by a small business

refinery. Temporary and proposed regulations were published on June 27, 2008. 32. Final regulations under §179C relating to the election to expense qualified refinery property. Temporary

and proposed regulations were published on July 9, 2008. 33. Regulations under §199 including amendments by the Tax Extenders and Alternative Minimum Relief

Act of 2008. 34. Guidance under §199 regarding telecommunications. 35. Final regulations under §274 regarding entertainment use of company aircraft. Proposed regulations were

published on June 15, 2007. 36. Regulations regarding the §274(n) limitations in employee leasing arrangements. 37. Final regulations under §468A regarding special rules for nuclear decommissioning costs. Proposed

regulations were published on December 31, 2007. 38. Guidance for late §469(c)(7) elections.

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39. Final regulations under §1221 regarding the election to treat self-created musical compositions or copyrights in musical works as capital assets. Temporary regulations were published on February 8, 2008.

40. Final regulations under §1301(a) regarding income averaging for fishermen. Temporary regulations were

published on July 22, 2008. 41. Guidance concerning the cash grant provisions of §1603 of ARRA 2009. 42. Final regulations under §3402(t) on extension of withholding to certain payments made by government

entities. Proposed regulations were published on December 5, 2008.

• WILL BE PUBLISHED 12/27/10 in IRB 2010-52 as NOT. 2010-91 (RELEASED 12/03/10). 43. Regulations under §7701 regarding Series LLCs and cell companies.

• PUBLISHED 09/14/10 in FR as NPRM REG-119921-09. 44. Final regulations under §7701 regarding disregarded entities and excise taxes. Temporary regulations were

published on September 14, 2009. 45. Guidance regarding the scope and application of the rescission doctrine. 46. Regulations providing criteria for treating an entity as an integral part of a state, local, or tribal

government.