Recent legislative developments and IRS guidance impacting tax accounting method issues

Accounting Methods Spotlight / Issue 10 / October 2014
Did you know? p1 / IRS guidance p2
Recent legislative
developments and IRS
guidance impacting tax
accounting method issues
This month’s Accounting Methods Spotlight includes a discussion of the possible need for accounting
method changes as a result of reduced minimum pension contributions following the enactment of
the Highway and Transportation Funding Act of 2014. In addition, this issue includes a discussion of
recent guidance issued by the IRS on: the tax treatment of certain patent infringement litigation costs;
accounting method change procedures for dispositions of tangible depreciable property; the transition
rules and exam moratorium for electric transmission and distribution property expenses; restaurants’
methods for allocating kitchen (or “back of the house”) labor to cost of goods sold for §263A; and the
tax treatment of payments for tenant improvement costs.
Did you know..?
Taxpayers with reduced pension contribution deductions may benefit from
accounting method changes
The Highway and Transportation Funding Act
of 2014 (HATFA), enacted August 8, 2014,
amends the interest rates used for valuing
defined benefit pension plan liabilities. As a
result, many companies will have lower
required minimum contributions in 2014;
meeting this reduced minimum could result in
lower pension deductions for federal tax
purposes than if the company satisfied the
prior-law minimum contribution requirement.
In this situation, companies may wish to
consider accounting method changes to meet
cash-tax planning goals or estimated payment
requirements.
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The Moving Ahead for Progress in the 21st Century Act (MAP-21), enacted in 2012,
eased the requirements of the Pension Protection Act of 2006 by tying the required
interest rates to average rates over a 25-year period. Under MAP-21, the interest rates
must be within a minimum and maximum range of the 25-year average rates (the
‘interest rate corridor’). The corridor was to gradually widen, so that interest rates
would be more reflective of current rates over time. HATFA amends MAP-21 by
deferring the annual widening of the interest rate corridor for five years. The interest
rate corridor remains at the 2012 level through 2017, and then will be gradually
widened. As a result, the minimum required contributions for these years will be
lower than they would have been under MAP-21.
For tax purposes, Section 404 generally provides that taxpayers may deduct actual
cash contributions to defined benefit pension plans, subject to a maximum deduction
limit. Because HATFA reduces the required minimum contributions, the actual cash
contributions to a defined benefit pension plan after HATFA may be less than
companies originally anticipated. As a result, companies may wish to identify
additional tax deductions in order to meet their cash-tax planning goals and/or
estimated tax payment requirements.
Accounting method changes that accelerate deductions or defer income may provide a
vehicle to offset reduced pension deductions in light of the impact of HATFA. The list
below contains common accounting method changes that typically accelerate
deductions or defer income.
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Defer advance payments
Defer unbilled receivables
Deduct deferred costs
Deduct software development costs
Deduct prepaid expenses
Minimize uniform capitalization
Value inventory below cost
Deduct repairs
Claim partial dispositions
Deduct materials and supplies
Maximize depreciation and amortization
Accrue rebates and allowances
Deduct bad debts
Accrue service liabilities
Accrue compensation
Accelerate qualified plan deductions
For more details, see our Tax Insight, Companies with reduced pension contribution
deductions may find help from accounting method changes, October 10, 2014.
IRS Guidance
IRS provides guidance on the tax treatment of patent infringement
litigation costs
In AM 2014-006 (the GLAM), the IRS concluded that where a generic drug
manufacturer (generic company) files an Abbreviated New Drug Application (ANDA)
with a paragraph IV certification, the legal fees the generic company incurs to defend
against a related patent infringement suit must be capitalized under Section 263(a) as
a cost that facilitates obtaining the ANDA. However, the legal fees incurred by the
brand drug manufacturer (brand company) that holds the patent referenced in the
ANDA paragraph IV filing to try to establish that the manufacture, use, or sale of the
drug subject to the ANDA would infringe the brand company’s patent generally are
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not required to be capitalized as a cost to perfect title to the brand company’s patent
under Section 263(a).
An ANDA that is approved by the Food and Drug Administration (FDA) permits a
generic company to manufacture and market a "generic drug" that is the bioequivalent of a branded drug. In addition to expediting the FDA review of the safety
and bioequivalence of generic drugs, the ANDA process is designed to accelerate the
resolution of any patent infringement issues that may arise from the manufacture, use
or sale of a generic equivalent of a branded drug. Thus, an ANDA applicant is
required to make one of four certifications with respect to the listed patents for the
branded drug. An approved ANDA allows generic drugs to be sold prior to the
expiration of the patent on the branded drug only if the generic company files an
ANDA with a paragraph IV certification, where the applicant asserts that the patent is
invalid, unenforceable, or will not be infringed. The first applicant to file a paragraph
IV ANDA for a particular generic drug is eligible for a 180-day exclusivity period
during which the FDA is not authorized to grant approval to any competing generic
drug.
The act of filing a paragraph IV ANDA constitutes an act of patent infringement,
providing courts with the jurisdiction to resolve patent issues before actual sale of the
generic drug. As a result, where a paragraph IV ANDA is filed, the generic company
must provide notice to all patentees of record, who then have 45 days to file a patent
infringement lawsuit. If a lawsuit is filed, FDA final approval of the ANDA is delayed
for 40 months (40-month stay), unless the patent is found to be invalid or not
infringed upon prior to that time. After the 40-month stay, the FDA may approve the
ANDA, subject to confirming bioequivalence, even if the infringement litigation is not
resolved or is resolved in favor of the patent holder (in the latter case, final approval
will take effect when the patent expires). However, FDA final approval may be
withdrawn or altered if a patent infringement suit is filed after the 45-day period or a
court later determines that the patent has been infringed.
In reaching its conclusion in the GLAM, the IRS relied on Sections 162(a) and 263(a),
and the regulations thereunder. Specifically, section 162 generally allows a deduction
for all ordinary and necessary expenses paid or incurred in carrying on a trade or
business. However, section 263(a) and the regulations thereunder require a taxpayer
to capitalize certain intangibles, including a government granted right. The
regulations under section 263(a) also require a taxpayer to capitalize an amount paid
to defend or perfect title to intangible property if the other party challenges the
taxpayer’s title. In addition, a taxpayer is required to capitalize an amount that
facilitates the acquisition or creation of a capitalizable intangible, such as a
government granted right or perfection of title. An amount facilitates the acquisition
or creation of an intangible if the amount is paid in the process of investigating or
otherwise pursuing the transaction.
In the GLAM, the IRS first addressed whether the costs of defending a patent
infringement claim brought after an paragraph IV ANDA notice must be capitalized
as part of the costs to obtain FDA approval to market and sell a generic drug.
Initially, the IRS recognized that costs to defend against a claim of patent
infringement generally are deductible on the theory that the taxpayer it protecting or
maintaining its business. However, otherwise deductible costs must be capitalized if
incurred in a capital transaction.
With respect to the generic company, the IRS stated it was uncontested that direct
costs incurred to obtain FDA approval to market and sell a generic drug are amounts
paid for a government granted right, the ANDA, that must be capitalized. The IRS
then reasoned that the patent infringement defense costs incurred in the ANDA
process would be capitalizable if they are transaction costs that facilitate the creation
of that government granted right. In considering this question, the IRS pointed out
the facilitation standard under the 263(a) regulations is “intentionally broad in scope
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(all costs paid in the process of investigating or otherwise pursuing the transaction),
as is the definition of transaction (all of the factual elements comprising an
acquisition…).” In concluding the amounts are required to be capitalized, the IRS
reasoned that patent claims are an integral step in the process of pursuing FDA
approval of a paragraph IV ANDA and the effective date of FDA approval is
dependent on how the patent infringement litigation is resolved. According to the
IRS, the infringement suit pursuant to a paragraph IV ANDA is so integral to the
process by which a generic company obtains approval to market and sell a generic
drug that the litigation costs to defend the suit are incurred “in the process of
pursuing” such approval. The IRS concluded that patent defense litigation pursuant
to a paragraph IV ANDA originates in a capital transaction, and thus the costs of such
litigation must be capitalized.
The IRS then addressed whether the legal fees the brand company incurred to try to
establish that the manufacture, use or sale of the drug subject to the ANDA would
infringe the brand company’s patent are incurred to defend an existing intellectual
property right, or create a new intangible. Specifically, the IRS considered whether
the brand company must capitalize the litigation costs because the litigation defended
or perfected title to the brand company’s patent. The IRS explained that title is at
issue when there is a question of ownership. In the context of patent infringement
suits arising from a paragraph IV ANDA, the IRS reasoned that costs incurred to
defend against a claim that the patent holder does not have proper ownership are
likely to be rare. Further, paragraph IV certification does not challenge ownership of
a patent, but rather provides that the patent for the listed drug is not valid, or will not
be infringed by the generic drug. Thus, the IRS concluded that the brand company
that holds a patent on the drug for which a paragraph IV ANDA is filed generally is
not required to capitalize legal fees incurred to try to establish that the manufacture,
use, or sale of the generic drug subject to the ANDA would infringe the brand
company’s patent. According to the IRS, it would be highly unusual in the context of
paragraph IV litigation for the ownership or title of the patent to be challenged; but, if
that were the case, then some portion of the legal fees may be capital.
IRS releases accounting method change procedures to comply with
final regulations regarding dispositions of tangible depreciable
property
The IRS recently released Rev. Proc. 2014-54, which provides rules pursuant to which
taxpayers may obtain automatic consent to make accounting method changes related
to dispositions of tangible depreciable property under final regulations issued on
August 14, 2014 (T.D. 9689) (the final disposition regulations).
This revenue procedure modifies Rev. Proc. 2014-17, which provides guidance
regarding changes in method of accounting for dispositions of tangible depreciable
property under proposed regulations issued on September 13, 2013. Rev. Proc. 201417 has been retained to provide automatic consent for certain changes in method
related to the proposed regulations (for fiscal year taxpayers).
Rev. Proc. 2014-54 also modifies certain Sections of Rev. Proc. 2011-14, which
provides the procedures for automatic changes in method of accounting. Rev. Proc.
2014-54 is designed to help taxpayers identify changes in method of accounting that
may be required to comply with the final disposition regulations and to implement
those changes with automatic consent, including:
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Late GAA election (for taxable years beginning before Jan. 1, 2014)
Revocation of a GAA election (for taxable years beginning before Jan. 1, 2015)
Late partial disposition election (for limited period of time)
Change in grouping assets within an multiple asset account (MAA)or general
asset account (GAA)
Change in method of identifying the asset disposed in a MAA or GAA
Change from depreciating a disposed asset (not in a GAA) to claiming a
gain/loss on disposal
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Rev. Proc. 2014-54 explains that all taxpayers will be expected to comply with the
final disposition regulations beginning with their first tax year that begins on or after
January 1, 2014.
IRS issues directive extending transition rules and exam moratorium
for electric transmission and distribution property expenses
The IRS Large Business & International (LB&I) division recently released a directive
(LB&I-04-0814-006) that instructs field agents to extend the transition rules for
determining the percentage of a unit of property replaced that are set forth in Rev.
Proc. 2011-43. The directive also modifies LB&I Directive 4-1111-019 (November 25,
2011) to delay the examination of tangible property for affected taxpayers during the
tax years that the scope limitations for making an accounting method change are
waived under Rev. Proc. 2014-16.
Rev. Proc. 2011-43 provides a safe harbor method that taxpayers may use to
determine whether expenditures to maintain, replace, or improve transmission and
distribution property must be capitalized under Section 263(a) or are deductible
under Section 162. The Rev. Proc. provides a transition rule under which taxpayers
using the safe harbor method may determine the percentage of a unit of linear
property replaced on the basis of an average circuit within a county for the first three
taxable years ending on or after December 31, 2010. LB&I-04-0814-006 directs IRS
agents not to challenge a taxpayer’s use of this transition rule for the first six taxable
years ending on or after December 31, 2010, thus extending the period over which the
transition rule may apply.
Rev. Proc. 2011-43 also waives the scope limitations for changing a method of
accounting that normally apply to a taxpayer under examination for a taxpayer’s first
or second year ending after December 30, 2010. Because some taxpayers that own
transmission and distribution property were unable to adopt the safe harbor method
of accounting under Rev. Proc. 2011-43 within this time period, Rev. Proc. 2012-39
extended the scope limitation to the third taxable year ending after December 30,
2010. Rev. Proc. 2014-16 further extends this scope limitation waiver to the fourth
taxable year. The new directive provides that an IRS examiner should allow a
taxpayer with applicable asset expenditures to adopt the safe harbor for its first,
second, third, or fourth taxable year ending after December 30, 2010. After that time,
if the taxpayer has not changed its method of accounting to adopt the safe harbor
method, the taxpayer’s repair expense will be subject to risk assessment and possible
examination for tax years ending on or after December 31, 2010.
IRS Chief Counsel memo provides favorable treatment for restaurants
under §263A
In ILM 201439001, the IRS Chief Counsel’s office stated that it would not contest a
restaurant’s use of a facts-and-circumstances method to allocate kitchen (or “back of
the house”) labor to cost of goods sold for §263A purposes. The memo alternatively
provided that the IRS would support the treatment of back of the house labor as §471
costs under the simplified production method. Both of these positions provide an
opportunity for restaurants to avoid capitalization of back of the house labor to their
ending inventory, which typically consists entirely, or almost entirely, of raw
materials.
Section 263A requires taxpayers that produce real or tangible personal property to
capitalize all direct and certain indirect costs of producing such property. To
determine capitalizable costs under Section 263A, taxpayers generally first must
identify their ‘Section 471 costs’ (generally the costs that have been capitalized for
financial accounting purposes) and then identify and allocate any additional costs
that must be capitalized under Section 263A between various activities, including
production or resale activities. After these “additional Section 263A costs” are
allocated to the appropriate production or resale activities, these costs generally are
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allocated to the items of property produced or property acquired for resale during the
tax year and capitalized to the items that remain on hand at the end of the tax year.
The regulations provide for various facts-and-circumstances methods of allocating
additional Section 263A costs between ending inventory and cost of goods sold,
including the specific identification, burden rate, and standard cost methods. In lieu
of a facts-and-circumstances method, the regulations also provide “simplified
methods” for allocating additional Section 263A costs to property produced or
acquired for resale. A taxpayer may use a facts-and-circumstances method only if it is
used consistently and is not used to circumvent the requirements of the simplified
methods.
In general, the simplified production method allocates additional Section 263A costs
between ending inventory and cost of goods sold based on an overall turnover ratio.
That method does not distinguish between different types of costs in ending
inventory. Instead, the simplified production method requires additional Section
263A costs to be spread evenly to all inventory acquired or produced regardless of
whether a particular cost relates to a particular item of inventory.
Restaurants that prepare food for sale to customers are considered to be producers
under §263A and therefore are required to capitalize their direct and certain indirect
costs of production. Such costs typically include costs related to the kitchen (“back of
the house”), including kitchen labor, and costs incurred related to the serving area
(“front of the house”). Restaurants typically produce food for immediate
consumption and therefore maintain inventory that consists primarily of raw
materials (ingredients), beverages, and other items that are not created through the
restaurant’s “production” activities.
To avoid capitalizing back-of-the-house costs to raw materials, beverages, and other
inventory items that are unrelated to those kitchen activities, restaurants may utilize a
facts-and-circumstances approach to allocate direct and indirect production costs to
ending inventory. This approach, however, increases the complexity of the Section
263A calculation and therefore increases the associated compliance burden.
Furthermore, because a facts-and-circumstances method cannot be used to
circumvent the requirements of the simplified production method, its use by
restaurants historically attracted IRS scrutiny.
In ILM 201439001, the IRS Chief Counsel’s office indicated that the IRS will not
support in examination or litigation the imposition of the simplified production
method if the restaurant is willing to develop and implement a reasonable facts-andcircumstances method under which kitchen labor will be allocated to the cost of food
produced and included in cost of goods sold. Alternatively, the IRS will support
allowing restaurants that use the simplified production method to treat all direct
production costs (including back-of-the-house labor) as Section 471 costs that are
allocated to the cost of food production and included in cost of goods sold.
Thus, the IRS’s position in the ILM allows a restaurant to take advantage of the less
burdensome simplified production method, while maintaining the benefits of the
facts-and-circumstances methods for allocating back of the house costs entirely to
cost of goods sold.
Payments for tenant improvement costs are not rental income
In ILM201436048, the IRS advised that payments made by a U.S. government agency
(lessee) to reimburse a building owner (the taxpayer or lessor) for the cost of tenant
improvements were not rental income to the taxpayer. The IRS also advised that the
taxpayer was not required to use the alternative depreciation system (ADS) for its
nonresidential real property, but some tangible property placed in service was taxexempt use property under Section 168(h) and therefore must be depreciated under
ADS.
The taxpayer leased a building to a tax-exempt government agency, and paid for
renovations and a building expansion at the request of the lessee. The lease provided
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that the lessee may elect to make a lump sum payment of any portion of the tenant
improvement allowance in exchange for a decrease in rent. The taxpayer received
from the lessee a lump sum reimbursement for the cost of the improvements to the
building. These amounts were not included in the stated rent. The taxpayer did not
include the reimbursed amounts in income and did not reduce the basis of the tenant
improvements by these amounts for purposes of depreciation. A revenue agent
determined that the amount paid by the lessee was rental income to the taxpayer in
the year received, and that the cost of the improvements should be increased by the
amount of the reimbursements. The taxpayer contends that the payments are not a
substitute for rent, but are reimbursements of costs the lessor incurred on behalf of
the lessee.
The regulations under Section 61 provide as a general rule, that if a lessee pays any
expense of his lessor, such payments are additional rental income of the lessor. If a
lessee places improvements on real estate which constitute, in whole or in part, a
substitute for rent, such improvements constitute rental income to the lessor.
Whether or not improvements made by a lessee result in rental income to the lessor
in a particular case depends upon the intention of the parties, which may be indicated
either by the terms of the lease or by the surrounding circumstances. Similarly, the
relevant case law in this area looks to the express terms of the lease and the intent of
the parties to determine whether such payments are considered as a substitute for
rent.
To determine the parties’ intent, the IRS reviewed the terms of the lease between the
two parties, leasing information on the agency's website, as well as other surrounding
circumstances. The terms of the lease included the tenant allowance in the stated
rent, but did not include the lump sum reimbursement amounts for additional
improvements as stated rent. The IRS distinguished the facts in the ILM from case
law, and determined that based on the facts and circumstances, the lessee incurred
the cost of the improvements which were payable by a lump sum reimbursable
amount through a billing arrangement with the lessor. The IRS thus concluded that
the terms of the lease, and surrounding circumstances, did not indicate that the
parties intended the lump sum reimbursements to be rent.
The IRS also addressed several proposed adjustments to depreciation claimed by the
taxpayer, specifically the proper method and recovery period for the assets owned by
the taxpayer and paid for by the tenant improvement allowance. The taxpayer placed
in service certain tenant improvements related to renovations of the original premises
and classified them as qualified leasehold improvement property. For these assets,
the taxpayer claimed additional first year depreciation for the property and
depreciated its remaining cost under the general depreciation system (GDS). The
taxpayer also placed in service additional tenant improvements related to the
expanded premises and allocated the cost of some of the improvements to 5 and 7year property, and to 15 -year property that were not qualified leasehold improvement
property. The taxpayer claimed additional first-year depreciation for these
improvements as well and depreciated their remaining basis under GDS.
Section 168(g)(1)(B) provides that in the case of any tax-exempt use property, the
depreciation deduction allowed under section 167(a) shall be determined using ADS.
Section 168(h)(1)(A) generally provides that the term “tax-exempt use property” for
purposes of Section 168 means that portion of any tangible property (other than
nonresidential real property) leased to a tax-exempt entity. Section 168(h)(1)(B)
provides that, in the case of nonresidential real property, the term “tax-exempt use
property” means that portion of the property leased to a tax exempt entity in a
disqualified lease.
The IRS concluded that the qualified leasehold improvement property placed in
service for the original premises were not tax-exempt use property because the
property was nonresidential real property and the lease was not a disqualified lease.
However, the IRS concluded that the improvements placed in service for the
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expanded premises that were 5 and 7-year property and 15-year property that were
not qualified leasehold improvement property were tax-exempt use property under
Section 168(h), because the assets were tangible property that were not
nonresidential real property, and the assets were part of a lease to a tax-exempt
entity. Such tax-exempt use property therefore must be depreciated using ADS under
Section 168(g)(1)(B), and the taxpayer cannot deduct any additional first-year
depreciation.
Finally, the IRS concluded a change in the depreciation method or period of recovery
of a depreciable asset, and a change from claiming to not claiming the additional first
year depreciation deduction for an asset that does not qualify for the additional first
year depreciation deduction, are changes in method of accounting pursuant to section
446(e) and the regulations thereunder.
Let’s talk
For a deeper discussion of how these issues might affect your business, please
contact:
Annette Smith, Washington, DC
+1 (202) 414-1048
[email protected]
Christine Turgeon, New York
+1 (646) 471-1660
[email protected]
Dennis Tingey, Phoenix
+1 (602) 364-8107
[email protected]
Jennifer Kennedy, Washington, DC
+1 (202) 414-1543
[email protected]
George Manousos, Washington, DC
+1 (202) 414-4317
[email protected]
Ross Margelefsky, New York, NY
+1 (646) 471-5663
[email protected]
© 2014 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a
Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each
member firm of which is a separate legal entity.
SOLICITATION
This content is for general information purposes only, and should not be used as a substitute for consultation with
professional advisors.
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