1. Re-proposed Repair Regulations: Implications for Gas Utilities
TAX
Carol Conjura , KPMG LLP, Washington National Tax
Susan Grais, Ernst & Young LLP, Washington National Tax
June 29, 2010

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3. Presenters Carol Conjura, KPMG LLP: 202-533-3040
Susan Grais, Ernst & Young LLP:

4. Agenda Repairs Overview of re-proposed regulations Technical Update
Tier 1 Status and Implications
Retirements
Unit of Property

5. Overview of Re-proposed Rules

6. Capital vs. Repair Analysis
Is the expenditure for new construction, acquisition, expansion, or replacement of entire unit of property?
Is the expenditure for new construction, acquisition, expansion, or replacement of entire unit of property?
YES
Capitalize
Capitalize NO
New or Different Use?
New or Different Use?
YES NO NO
YES
Betterment?
Betterment?
Routine Maintenance?
Routine Maintenance
YES NO
YES
Expense
Restoration?
Restoration?
Expense NO 6

7. What is the Unit of Property?
Buildings and Structural Components
Generally one unit of property, except leasehold improvements
Retail outlets and C stores
General rule for all other property
Functional Interdependence
Exceptions
Plant property
Group of components that performs a discrete and major function
Compare 2006 proposal, which used the Uniform System of Accounts
Network assets [reserved] (pipelines, storage facilities)
Additional rule
Separate financial statement lives
Different and proper MACRS class or method
Have any proposals been considered for defining the unit of property for network assets

8. What is a Betterment?
Amounts paid result in a betterment to the unit of property only if they:
Correct a material condition or defect that existed prior to taxpayer’s acquisition or arose during production
Result in material addition to the unit of property
Result in material increase in capacity, productivity, efficiency, strength, or quality to the unit of property or its output
Focus is on qualitative, not quantitative change in fair market value
Materiality not defined
Unavailability of replacement parts
Compare with status of property prior to last normal repair, or prior to a particular event

9. What is a Restoration? Replace a component deducted as loss
Replace a component and basis adjusted for sale or exchange
Repair after a casualty if basis adjusted
Return the property to operating condition if in a state of disrepair and no longer functional for its intended use
Rebuild the property to like-new condition after the end of economic life
Replace a major component or substantial structural part after the end of the property’s MACRS recovery period
Replace a combination of parts that comprise 50% or more of property’s replacement cost
Replace a combination of parts that comprise 50% or more of property’s physical structure
Can you explain how the ruling in Rev. Rul is impacted by the re-proposed regulations? i.e., why does it not change the result in the ruling.

10. Repairs after a Casualty
Chief Counsel Memo AM
Taxpayer cannot take both a casualty loss and repair deduction as a result of a single casualty
Applies proposed regulations, even though prospective
Inconsistent with CCM , permitting deduction for both casualty loss and restoration expenses
Designated as Tier II LMSB exam issue
Impact of TAM
Unit of property for casualty loss purposes (SIP)
Electric transmission unit of property is each transmission line, substation.
Electric distribution unit of property is each circuit and substation

11. Casualty Loss Example 1 2 3 SIP Adjusted Basis $10,000 $ -0- $5,000
FMV Decline
5,000
10,000
Repair Cost
Deduction
1111

12. Relocation Costs Costs of relocating pipelines and other facilities
Do not result in a betterment or restoration
Consistent with Badger Pipeline v. Commissioner, T.C. Memo 12

13. Removal Costs
Rev. Rul
If retirement and removal of an asset occurs in connection with the installation or production of a replacement asset, removal costs are deductible
Applies to single asset or mass asset accounts
Not applicable to removal of a component of a depreciable asset
If replacement is a repair--removal costs are deductible
If replacement is an improvement—removal costs are capital
Compare re-proposed regulations which treat replacement of component as capital if gain or loss recognized on removal 13

14. Environmental Remediation
Re-proposed regulations are consistent with Rev. Rul
Soil and groundwater cleanup associated with existing business operations are not required to be capitalized
Costs of water treatment facility are capital
But see Rev. Rul : Otherwise deductible environmental remediation costs must be capitalized under section 263A if incident to production of property 14

15. Environmental Remediation (cont’d)
Pre-existing material condition or defect
Remediation of pre-acquisition contamination treated as a betterment
Latent hazardous conditions not treated as a pre-existing material condition or defect
Compare Kerr-McGee v. US, 77 Fed. Cl. (2007)
Application to otherwise periodic maintenance following an acquisition is uncertain
Extension of section 198
Election to expense otherwise capital remediation

16. Spare Parts
Under current law, may be classified as supplies or fixed assets, depending on facts
Expendable parts are generally treated as supplies
Deferred expense, deductible when consumed
Emergency standby parts and repairable parts are generally treated as fixed assets
Depreciation begins when acquired and ready for use
Rotable spare parts
Current law: deductible when placed in service
Re-proposed regulations: deductible when disposed of 16

17. Supplies Definition of supply Not a unit of property
Unit of property with economic useful life of 12 months or less
Unit of property with acquisition or production cost of $100 or less
Identified in published guidance
Election to capitalize and depreciate if supply is a unit of property or a component of a unit of property that is not a supply

18. Optional Regulatory Accounting Method
Simplified method for regulated taxpayers
FERC
FCC
STB
Must follow regulatory method of accounting for tax purposes
Must use for all tangible property subject to regulatory accounting rules 18

19. Routine Maintenance Safe Harbor
Includes recurring activities to keep a unit of property in ordinarily efficient operating condition
Activities are routine if:
Reasonably expected to occur more than once in an asset’s MACRS class life
Gas production—Every 7 years or more frequently
Gas transportation—Every 11 years or more frequently
Not applicable if property restored under tests 1-4
i.e., if replacements are componentized or after a casualty, or dysfunctional state 19

20. Minimum Capitalization Rule
Taxpayer may use financial statement minimum capitalization policy
Requirements/restrictions
Not applicable to repair and improvement costs
Applicable Financial Statement; written accounting procedures; no income distortion
Safe harbor for no distortion--total aggregate amount of expenses does not exceed the lesser of
0.1% of gross receipts
2.0% of total depreciation and amortization expense
Annual, unit-by-unit, election to capitalize and depreciate 20

21. Section 263A Impact
Re-proposed regulations obsolete the general plan of rehabilitation doctrine
See situation 3 of Rev. Rul , requiring otherwise deductible repairs to be capitalized if incurred at same time as capital improvements
Pursuant to section 263A, only repairs that directly benefit or are incurred by reason of an improvement are required to be capitalized
For example, if a utility incurred costs to expand the capacity of a processing plant, contemporaneous repairs to the existing structure would remain deductible 21

22. Section 263A Impact (cont’d)
Repairs in connection with inventory production must be capitalized to current production
Section 481 adjustment for repairs change relates to prior production activities
Impact depends on inventory cost flow assumption
May relate to prior LIFO layer