In a technical advice memorandum (TAM 201638022), the IRS National Office (IRS Chief Counsel) determined a taxpayer's substantial renovation, construction and erection of certain property qualified as the construction of real property under Section 199 such that the gross receipts derived from those activities qualified as domestic production gross receipts (DPGR). In reaching its decision, IRS Chief Counsel determined the property met the definition of "inherently permanent structures" (as provided in Treas. Reg. Section 1.263A-8(c)(3)) under Treas. Reg. Section 1.199-3(m)(3).

Facts

A US construction contractor (Taxpayer), engaged in a trade or business that is considered construction for purposes of the North American Industry Classification System (NAICS) on a regular and ongoing basis, derived gross receipts from the renovation of major components and substantial structural parts of property used in facilities already in existence or being constructed.

The Taxpayer claimed the substantial renovation, construction or erection of the property constituted the construction of real property under Section 199. The Large Business & International (LB&I) examination team, with the assistance of local counsel from LB&I Division Counsel, argued the Taxpayer's activities performed in constructing the property did not qualify as the construction of real property under Section 199, asserting the property was tangible personal property.

The Taxpayer and LB&I requested technical advice from the IRS Chief Counsel on the qualification, under Section 199, of gross receipts that the Taxpayer derived from the projects related to the substantial renovation, construction or erection of the items in the United States.

Law

Section 199(c)(4)(A)(ii) provides that DPGR includes gross receipts derived from, in the case of a taxpayer engaged in the active conduct of a construction trade or business, construction of real property performed in the United States by the taxpayer in the ordinary course of that trade or business. Treas. Reg. Section 1.199(m)(1)(i) defines "construction" as activities and services relating to the construction or erection of real property in the United States. Treas. Reg. Section 1.199-3(m)(2)(i) describes activities constituting construction as activities performed in connection with a project to erect or substantially renovate real property.

Treasury Reg. Section 1.199-3(m)(3) provides that "real property" includes "inherently permanent structures (as defined in Treas. Reg. Section 1.263A-8(c)(3)) other than machinery (as defined in Treas. Reg. Section 1.263A-8(c)(4)) (including items that are structural components of such inherently permanent structures)." Under Treas. Reg. Section 1.263A-8(c)(3), inherently permanent structures include property that is affixed to real property and that will ordinarily remain affixed for an indefinite period. Treas. Reg. Section 1.263A-8(c)(4), however, provides that a structure that is property in the nature of machinery or is essentially an item of machinery or equipment is not an inherently permanent structure and is not real property.

Analysis

Because LB&I and the Taxpayer agreed that, if the property was real property for purposes of Section 199, the activities performed by the Taxpayer would constitute construction activities under Treas. Reg. Section 1.199-3(m)(2)(1), the IRS Chief Counsel focused on the narrow question of whether the property is "real property" as defined under Treas. Reg. Section 1.199-3(m)(3). Because the Section 199 regulations cross reference to Treas. Reg. Section 1.263A-8(c)(3) (inherently permanent structures) and Treas. Reg. Section 1.263A-8(c)(4) (machinery), IRS Chief Counsel stated that "the determination under those Sections controls for purposes of determining whether the [items] are real property for purposes of [Section] 1.199-3(m)(3)." Additionally, IRS Chief Counsel notes that it did not analyze whether the property was another type of real property described in Treas. Reg. Section 1.199-3(m)(3) (such as a building, infrastructure or a utility plant) because LB&I and the Taxpayer agreed that the property did not constitute any other type of property.

IRS Chief Counsel stated in the TAM that there are two basic requirements for an inherently permanent structure under Treas. Reg. Section 1.263A-3(c)(3): (1) the structure must be affixed to real property; and (2) the structure must ordinarily remain affixed for an indefinite period. IRS Chief Counsel concluded the property at issue in this case satisfied the first requirement on the basis of weight alone. Additionally, the IRS Chief Counsel found that the property was affixed to real property through other means that satisfied the requirement for the property to be "affixed."

With respect to the second requirement, IRS Chief Counsel reasoned the term "indefinite" is best interpreted to mean that the property is affixed to real property for the useful life of the property, or the period during which the property remains in operating condition and serves a useful function at its installation site. The property at issue in the TAM remains affixed to real property for the duration of their useful lives; therefore, the IRS Chief Counsel concluded, they are affixed to real property for an "indefinite" period. As such, the property qualified as inherently permanent structures under Treas. Reg. Section 1.263A-8(c)(3).

Thus, because the property satisfied the definition of inherently permanent structures, it is "real property" for purposes of Section 199. Based on this conclusion, the gross receipts from the Taxpayer's activities qualified as DPGR and the Taxpayer may be entitled to the deduction under Section 199 (assuming all other requirements of Section 199 were met).

Moreover, because the IRS Chief Counsel concluded the property qualified as inherently permanent structures, it did not analyze whether the property would be considered machinery under Treas. Reg. Section 1.263A-8(c)(4). Specifically, the TAM states that machinery and inherently permanent structures are mutually exclusive categories of property, i.e., Treas. Reg. Section 1.263A-8(c)(4)(i) does not impose an additional test whereby property that otherwise qualifies as an inherently permanent structure under Treas. Reg. Section 1.263A-8(c)(3) must also not be machinery under Treas. Reg. Section 1.263A-8(c)(4).

The IRS Chief Counsel further noted that its reading of the relationship between Treas. Reg. Section 1.263A-8(c)(3) and Treas. Reg. Section 1.263A-8(c)(4) as clarifying the mutually exclusive nature of machinery and inherently permanent structures is consistent with the Preamble to the final Section 263A regulations. The IRS Chief Counsel stated that its interpretation supports a broad reading of "real property" for purposes of Section 263A(f), consistent with the intent of Section 263A to ensure that taxpayers capitalize the appropriate amount of production costs, including the production of real property. Furthermore, several examples of inherently permanent structures provided in Treas. Reg. Section 1.263A-8(c)(3) have a mechanical function similar to functions of the items at issue in the TAM. IRS Chief Counsel noted it would not be reasonable to include the property as examples of inherently permanent structures only to remove it from that classification by recasting it as machinery under Treas. Reg. Section 1.263A-8(c)(4).

Implications

Notably, the analysis in TAM 201638022 regarding the relationship between Treas. Reg. Sections 1.263A-8(c)(3) and 1.263A-8(c)(4) differs from prior guidance under CCA 201211011. The analysis in CCA20121011 provides that "property that otherwise qualifies as an inherently permanent structure is not real property for purposes of [Section] 263A(f) if it is property in the nature of machinery or equipment." In TAM 201638022, however, IRS Chief Counsel states that it "disagree[s] with the portion of the analysis [from CCA 20121011] that concerns the relationship between [Section] 1.263A-8(c)(3) and 1.263A-8(c)(4)."

Additionally, application of the rationale in TAM 201638022 extends beyond the particular industry that was the subject of the TAM. Understanding the nature of the property is critical to applying the analysis in TAM 201638022.

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