The IRS has issued an audit technique guide (ATG) on tangible property to provide examiners guidance on identifying potential tax issues related to the final tangible property regulations. The ATG explains all the regulation sections, with examples on some of the issues. Further, in addition to assessing risk in each of the sections and suggesting audit procedures, the ATG emphasizes coordination with other Code sections and topics (e.g., Sections 263A and 199), consistency with cost segregation studies, and the application of statistical sampling. For taxpayers under examination, the three-month window set forth in Revenue Procedure 2013-15 provides an opportunity to correct erroneous methods. This window closes Monday, October 17, 2016, for calendar-year taxpayers (as October 15 is a Saturday).

In addition to providing an outline of the regulations, the ATG sets forth a comprehensive outline of proposed "audit procedures," covering the following topics in discrete "chapters":

— Unit of property
— Amounts paid to acquire or produce property
— De minimis safe harbor (including reliance on case law in lieu of the safe harbor)
— Improvement rules (relating to betterments, restoration and new or different use)
— Safe harbors and other special rules (e.g., routine maintenance safe harbor, small-taxpayer safe harbor, removal costs, optional regulatory accounting method, election to capitalize repair and maintenance costs)
— Materials and supplies
— Leased property
— Modified Accelerated Cost Recovery System (MACRS) rules
— Dispositions in general
— MACRS disposition rules
— General asset account rules
— Accounting method changes (including capitalization, depreciation and dispositions)

Unit of property

When examining a unit of property issue, for example, the ATG advises examiners to request relevant documentation and identify potential issues by considering whether the taxpayer has determined the units of property in accordance with the final regulations. The ATG contains details relating to various property types and an example of units of property in the context of plant property, involving a sawmill, that demonstrates a relatively granular approach to the determination of the unit of property. The example concludes that each conveyor, band saw and gang saw performs a discreet and major function within the plant and comprises a separate unit of property. Taxpayers that have taken a broader approach to unit of property in similar circumstances should consider implications of the ATG provisions.

The ATG also instructs examiners to review annual reports and Forms 10-K to identify new facilities, expansions of old facilities, new equipment, self-constructed assets and acquired tangible property. In addition, the ATG instructs examiners to consider the taxpayer's line of business to determine whether the plant property rules apply, any network assets that are owned and any buildings that are owned or leased.

The ATG further advises examiners to consider how taxpayers account for units of property by determining:

— How taxpayers track additions
— How taxpayers account for dispositions
— How taxpayers determine improvements
— Whether taxpayers have a method to track repairs

Under the examination considerations listed in the ATG, examiners should determine whether a taxpayer changed the basis of fixed assets as a result of the unit of property definition and defined building units of property as building structures and building systems. If taxpayers conducted cost segregation studies, the ATG advises examiners to request copies of all of the studies and review them.

Additionally, examiners should:

— Analyze plant property to determine whether machinery or equipment is functionally interdependent
— Determine whether the taxpayer defined components that are plant property by using the functional interdependence test and then by using the discrete and major function test
— Determine whether changes were made to the unit of property definition for personal property
— Determine whether the taxpayer owns network property and, if so, has the taxpayer considered the unit of property definition
— Consider special unit of property rules for network assets and discuss the unit of property determination for network assets, when no guidance is available, with the Deductible & Capital Expenditures Practice Network

Section 263A and self-constructed assets

Section 263A requires the taxpayer to capitalize all direct and certain indirect costs properly allocable to real and tangible personal property produced by the taxpayer, in addition to addressing allocable inventory costs. The ATG advises examiners to ensure that the taxpayer allocated the correct amount to property produced by the taxpayer under Section 263A. For example, the examiners are instructed to obtain copies of the Section 263A calculations for each period under examination. Section 263A also may be relevant in the context of, for example, allocable inventory costs associated with repairs to manufacturing assets, as well as materials and supplies used in an inventoriable context.

Other topics covered

The ATG also covers:

— De minimis safe harbor (e.g., the ATG notes that examiners may determine that a review of property expensed under the safe harbor is not warranted and, also, may assess whether amounts deducted in excess of the safe harbor clearly reflect income)
— Improvement rules for betterments, restoration, and new or different use
— Materials and supplies
— MACRS disposition rules
— Accounting method changes

Implications

In general

The ATG provides comprehensive insights into how the IRS plans to examine taxpayers to ascertain the extent of compliance with the tangible property regulations. Taxpayers should expect a comprehensive review of their background and activities, as well as a focus on supporting documentation and consistency in applying the final tangible property regulations and other relevant provisions. Importantly, the ATG contains a number of references to cost segregation studies and underscores consistent application of the unit of property/asset definitional rules for purposes of Section 263(a) and Section 168, respectively.

Significant provisions also include a focus throughout the ATG on compliance with Section 263A, including with regard to self-constructed assets such as those relating to building property. The Treasury Department previously eliminated a prior requirement for taxpayers to comply with Section 263A as a condition for eligibility to make various automatic method changes to conform to the tangible property regulations. This generally was due to perceived wide-spread noncompliance with Section 263A principally as it related to self-constructed assets (e.g., building leasehold improvement property). As such, the IRS has included compliance with the uniform capitalization rules as an integral part of examination focus.

Compliance with Section 263A for self-constructed assets (such as leasehold improvements owned by the taxpayer) and other produced property, including allocable inventory costs as applicable, should be an area of focus in light of the ATG. Taxpayers that have not complied, for example, with Section 263A with respect to leasehold improvements and other self-constructed assets should consider filing Form 3115, Application for Change in Accounting Method, as soon as possible to obtain audit protection. An analysis of uniform capitalization methods for property subject to Section 263A, including inventory where applicable, potentially can offset the effect of a positive Section 481(a) adjustment generally associated with the method change for self-constructed assets. Additionally, an analysis of broader uniform capitalization methodologies in general may provide efficiencies and possibly reduced capitalized costs. Further, an assessment of potential tax benefit anticipated by forthcoming final "negative" Section 263A regulations can identify further benefit (see Tax Alert 2012-1498).

Taxpayers also should consider their ability to maintain methods established, generally for 2014 and later tax years, to comply with the tangible property regulations. EY can assist with maintaining methodologies prospectively, including provision of Cost Recovery Outsourcing services that include:

— Depreciation, amortization, and repair expenditure outsourcing, ensuring optimal methods
— Cost segregation, including bonus depreciation and or leasehold improvement analysis
— Fixed asset analysis of tax records including, but not limited to, asset classification and/or dispositions
— Analysis, documentation and/or assistance in implementation of improvement, repair, acquisition and production expenditure rules, de minimis threshold policies, and material and supplies methodologies

As noted above, the ATG includes a chapter devoted to leased property and includes specific audit procedures related to that property. Analysis of leasehold improvement asset classification (e.g., qualified leasehold improvement property) and similar lease-related account/tax methods may provide compliance efficiencies and the opportunity for audit protection, if needed. While voluntary, such analysis of methods can identify opportunities and exposures for which audit protection generally is available prior to contact by the IRS for purposes of scheduling an examination. These methods include, for example, leasehold improvement property depreciation recovery periods, tenant construction allowances, rental income and expense (e.g., under Section 467), advance rental payments, and lease characterization in general related to sale, lease and/or financing transactions.

Three-month window

In the context of any desired accounting method changes, it should be noted that, for calendar-year taxpayers under IRS examination for 12 consecutive months before July 15, 2016, the three-month window affords audit protection as of the date Form 3115 is filed for method changes related to exposure items. This window closes October 17, 2016, for calendar-year taxpayers (as October 15 is a Saturday). Fiscal year January 31 tax-year entities, such as retailers, have until November 15, 2016, to file Forms 3115 within the window. Section 263A compliance, as noted, is among the methods that should be considered in this context.

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