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In Revenue Procedure 2023-15 (Revenue Procedure), the IRS creates a safe harbor that taxpayers may use to determine whether they must capitalize or may immediately deduct expenses to maintain, repair, replace or improve natural gas transmission and distribution property. Taxpayers can either change their method of accounting with an IRC Section 481(a) adjustment or choose to make the change using the cut-off basis if they make the change for their first, second or third tax year ending after May 1, 2023.

This Revenue Procedure is effective for tax years ending after May 1, 2023.

Affected taxpayers

Revenue Procedure 2023-15 applies to taxpayers that transmit and distribute natural gas and incur the costs of maintaining, repairing, replacing and improving natural gas transmission and distribution property.

These expenditures can either be deducted under IRC Section 162 for repairs or maintenance or capitalized under IRC Section 263(a) as improvements depending on whether the expenditures result in a betterment or restoration of a unit of property or adapt a unit of property to a new or different use.

Property involved in gas transmission and distribution usually consists of a network of interconnected assets, so it can be difficult to identify which costs are capital expenditures and which are allowable as deductions. The "natural gas transmission and distribution property safe harbor method of accounting" (NGSH Method) was created to determine how the costs are categorized, according to the Revenue Procedure.

Applying the NGSH Method

The NGSH Method can be applied to linear or non-linear property. The Revenue Procedure gives detailed definitions of what constitutes linear (pipes, fittings, valves, etc.) and non-linear (compressors, regulators, meters, etc.) property.

Taxpayers that choose to use the NGSH Method for linear property may also use it for non-linear property but are not required to do so. Taxpayers that choose to use the NGSH Method for non-linear property, however, must also use it for their linear property.

To avoid conflict with the tangible property regulations' rule that requires capitalization of restorations, a taxpayer using the NGSH Method must include costs capitalized under the NGSH Method in general asset accounts, consistent with IRC Section 168(i)(4) and Treas. Reg. Section 1.168(i)-1(l). The use of general asset accounts limits (1) the circumstances under which a taxpayer is required to recognize a loss on the disposition of property and (2) the circumstances under which a taxpayer is required to take a casualty loss or a basis adjustment as a result of a casualty event. Therefore, the inclusion of transmission and distribution property in general asset accounts allows a taxpayer to avoid triggering the disposition/loss provisions of the capitalization rules. The use of general asset accounts also allows a taxpayer to continue to depreciate this property after its disposition.

Linear property

Linear gas transmission property

Linear gas transmission property is used in transmitting natural gas from production facilities to local distribution systems. The NGSH Method applies to expenditures related to units of property within each hydraulic subsystem and provides rules for determining whether replacing a portion of a unit of property must be capitalized. Under this method, taxpayers replacing more than 10% of the length of the unit of linear transmission property must capitalize the costs as improvements.

Linear distribution property

Linear distribution property is used to distribute natural gas to local customers. The Revenue Procedure does not define a unit of property for this purpose but instead divides distribution property into "distribution mains" and "distribution service lines." Under the NGSH Method, taxpayers must capitalize the costs if it is replacing more than four miles of mains.

For both linear gas transmission and distribution property, the "cost of the replacement includes the direct and indirect costs of replacing the pipe and any associated linear property, including, but not limited to, connectors, cathodic protection, valves, casing, tunnels, instrumentation and controls, and structural supports for such property."

For distribution service line costs, the general rule is that the tax treatment should follow the treatment of any associated main line replacement. If a main line is not being replaced, then the service line does not need to be capitalized. If the service projects cannot be traced to associated main projects through the records, a simplified allocation methodology is prescribed.

Blanket work orders

The Revenue Procedure addresses blanket work orders for both types of linear property. Blanket work orders authorize a project over a period of time, usually less than one year. If taxpayers cannot identify whether costs charged to a blanket work order meet the applicable test for capitalization, then they can treat the repair in question the same as those for corresponding main lines or use the allocation approach. Additionally, if the blanket work order limits replacements to $50,000 or less, then those costs can be deducted and not capitalized.

Non-linear property

Taxpayers that do not use the NGSH Method for non-linear property must apply IRC Sections 162, 263(a), 263A and the relevant regulations to determine the appropriate units of property and whether the costs paid or incurred to repair, maintain, replace or improve those units of property must be capitalized.

Taxpayers that choose to use the NGSH Method for non-linear property can refer to Appendix A of the Revenue Procedure for the units of property and major components that fall under the safe harbor. Taxpayers that replace units of property or major components thereof must capitalize those costs. Taxpayers that repair units of property or major components, however, can deduct the costs under IRC Section 162.

Per se capitalization rules

The Revenue Procedure establishes "per se capitalization rules" that apply to both linear and non-linear property. When applying the NGSH Method, taxpayers generally must capitalize the costs of: "(1) replacing all or part of property if the taxpayer deducts a loss for the replaced property (other than a casualty loss) or takes the adjusted basis of the replaced property into account in realizing gain or loss resulting from a sale or exchange of the replaced property; and (2) repairing and replacing all or part of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss or relating to a casualty event."

In addition to the general rule, there are specific activities that are included as per se, including adding more customers, extending the lines, increasing capacity and adding new equipment. The Revenue Procedure also defines an increase in capacity, which will make the determination of what constitutes materially increasing capacity more objective. Probably the most significant addition to the per se listing is the cost of adding cathodic protection, protective wrapping or protective coating, which has been treated by many companies as a repair in the past and, therefore, deductible under IRC Section 162.

Accounting method change

Under the Revenue Procedure, a change to the safe harbor method for linear property and/or non-linear property is an accounting method change to which IRC Sections 446 and 481 apply. For a limited time, taxpayers can choose to (1) calculate an IRC Section 481(a) adjustment (utilizing sampling and or extrapolation) or (2) use the cut-off method, as described herein.

Cut-off method

Taxpayers that change to the NGSH Method for linear property for their first, second or third tax year ending after May 1, 2023, may choose to change to this accounting method on a cut-off basis.

Taxpayers that choose to change to the safe harbor method for linear property on a cut-off basis and change to the safe harbor method for non-linear property for their first, second or third tax year ending after May 1, 2023, also must change to the safe harbor method for non-linear property on a cut-off basis, regardless of the year of change.

Taxpayers that change to the safe harbor method for linear property for their first, second or third tax year ending after May 1, 2023, and do not make this change on a cut-off basis are not permitted to change to the safe harbor method for non-linear property on a cut-off basis.

A taxpayer that changes to the NGSH Method of accounting on a cut-off basis or with an IRC Section 481(a) adjustment must also make a late general asset account election to include certain transmission and distribution property in general asset accounts.

Implications

Revenue Procedure 2023-15 allows taxpayers that have either adopted facts and circumstances methods or deferred a decision of whether to make a method change in earlier years to apply the safe harbor to receive more certainty around deductions for repairs and associated activities addressed by the Revenue Procedure. Adopting the safe harbor with an IRC Section 481(a) adjustment may provide audit protection as outlined in Revenue Procedure 2015-13, Section 8. Flexibility in utilizing an IRC Section 481(a) or cut-off approach, coupled with the ability to use sampling and or extrapolation, allows taxpayers options in determining how to best implement this guidance.

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Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor