IRS auditors told how to handle telecom capitalization vs deductible repairs issue

LB&I Memo “Telecommunication Carriers Change in Method of Accounting Relating to Conversion of Capitalized Assets to Repair Expense Under I.R.C. Section 263(a)”

IRS's Large Business and International (LB&I) division has issued guidance to examiners on how to review a telecommunications (telecom) company's conversion of previously capitalized assets to a deduction for repair expense under revenue procedures issued earlier this year. Among other information, the new guidance reveals that telecoms will have only two years to adopt safe harbor methods carried in the earlier guidance.

Background. Earlier this year, IRS issued a series of revenue procedures intended to end disputes with the telecom industry involving capitalization and depreciation of network assets versus deduction of certain costs as repairs (see article in Federal Taxes Weekly Alert 04/07/2011).

Rev Proc 2011-27, 2011-18 IRB 740, provided two alternative safe harbor approaches for determining whether expenses to maintain, replace, or improve wireline network assets used primarily to provide wireline telecommunication or broadband services must be capitalized under Code Sec. 263(a). The two alternative safe harbor methods involve a network asset maintenance allowance method or a “units of property” method. Wireline network assets are all personal and real property used by a wireline carrier to provide telecommunication or broadband services, but don't include personal or real property not directly used to provide wireline telecommunication or broadband services, such as a corporate office building and the furniture and equipment used in an office building. Rev Proc 2011-28, 2011-18 IRB 743, provided similar safe harbor approaches for taxpayers providing wireless telecommunication services. Both these Revenue Procedures are effective prospectively, for tax years ending on or after Dec. 31, 2010.

New guidance for examiners for open exam years. The use of the safe harbor approaches in the above Revenue Procedures is only permitted under the terms and conditions specified in them and can't be considered for purposes of resolving capitalization issues in prior open exam years. The new directive provides guidance for addressing prior open exam years.

Tax years ending before Dec. 31, 2010. For tax years ending before Dec. 31, 2010, examiners are told to discontinue any current examination of the conversion of previously capitalized assets to a deduction for repair expense issue. This discontinuation only applies to positions taken on original returns filed for tax years ending before Dec. 31, 2010. The new guidance details the steps examiners should take in discontinuing examinations of repair expenses.

The new guidance says that taxpayers will be allowed a two-year period to adopt one of the safe harbor methods discussed in either Rev Proc 2011-27, for wireline carriers, or Rev Proc 2011-28, for wireless carriers. If the taxpayer has not adopted a safe harbor method for its first or second tax year ending on or after Dec. 31, 2010, examiners are told to follow the guidance below.

Tax years ending on or after Dec. 31, 2010. For tax years ending on or after Dec. 31, 2010, when examining returns of telecommunication carriers, examiners are instructed to determine if a change in method of accounting was made to adopt a safe harbor method described in either Rev Proc 2011-27 or Rev Proc 2011-28. The taxpayer may change its method of accounting to adopt the safe harbor for unit of property for one, some, or all of its assets. If all of the taxpayer's units of property are consistent with the specifications for such units in the applicable revenue procedure, then the examiner should accept the repair expense as filed. If only some, but not all, of the taxpayer's units of property are consistent, then the examiner should perform a risk assessment to determine the materiality of the repair deduction claimed for the network assets, and if the results are material, examiners are told to examine the deduction.

If a taxpayer adopted the network asset maintenance allowance method, examiners are told to ask the taxpayer to provide a breakdown of the computation that is required to be filed with the tax return, by legal entity in order to conduct a risk analysis. Once the examiner ascertains that the taxpayer computed the network asset additions in accordance with Rev Proc 2011-27 or Rev Proc 2011-28 , as appropriate, examiner are advised to accept the additional repair expense as filed.

When performing the risk assessment, examiners are told to also consider if the Code Sec. 481(a) adjustment was computed accurately.
If the taxpayer did not adopt a safe harbor method, then agents are advised to perform a risk assessment to determine the materiality of the repair deduction claimed with respect to the network assets. If the result indicates materiality, examiner are instructed to examine the deduction under Code Sec. 263(a) and its regs.

The LB&I Memo can be viewed on the IRS website at http://www.irs.gov/businesses/article/0,,id=249867,00.html.
RIA Research References: For repairs versus improvements, FTC 2d/FIN ¶ L-6102; United States Tax Reporter ¶ 1624.171; TaxDesk ¶ 308,000.

Source: Federal Tax Updates on Checkpoint News tab 12/1/2011