Bulletin No. 2006-39September 25, 2006

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2006–46, page 511.Conservation Security Program (CSP). This ruling holdsthat the Conservation Security Program is substantially similarto the type of programs described in section 126(a)(1) through(8) of the Code within the meaning of section 126(a)(9). As aresult, all or a portion of cost-share payments received underthe CSP is eligible for exclusion from gross income to the extentpermitted by section 126.

Rev. Rul. 2006–47, page 511.Fringe benefits aircraft valuation formula. The StandardIndustry Fare Level (SIFL) cents-per-mile rates and terminalcharge in effect for the second half of 2006 are set forth forpurposes of determining the value of noncommercial flightson employer-provided aircraft under section 1.61–21(g) of theregulations.

Rev. Rul. 2006–48, page 516.LIFO; price indexes; department stores. The July 2006Bureau of Labor Statistics price indexes are accepted for useby department stores employing the retail inventory and last-in,first-out inventory methods for valuing inventories for tax yearsended on, or with reference to, July 31, 2006.

T.D. 9281, page 517.REG–120509–06, page 570.Final, temporary, and proposed regulations under sections 882and 884 of the Code state that foreign corporations engagedin a trade or business within the United States are subject to taxon their income that is treated as effectively connected with thetrade or business. Expenses related to that income are alloca-ble and deductible against the effectively connected income todetermine the foreign corporation’s net U.S. taxable income.

Special rules apply to the allocable amount of interest expenseallowed in determining the net U.S. taxable income. Additionalrules for foreign banking corporations are also applicable. Cer-tain clarifications and conforming updates are also made to the1996 final regulations under section 1.882–5.

T.D. 9282, page 512.Final regulations under sections 162(k) and 404(k) of the Codeprovide that a payment in redemption of employer securitiesheld by an employee stock ownership plan (ESOP) is not de-ductible.

REG–168745–03, page 532.Proposed regulations under section 263 of the Code explainhow section 263(a) applies to amounts paid to acquire, pro-duce, or improve tangible property. The proposed regula-tions clarify what amounts must be capitalized, rather than de-ducted currently, and how those capitalized amounts should betreated. A public hearing is scheduled for December 19, 2006.

Notice 2006–82, page 529.Extension of replacement period for livestock sold onaccount of drought. This notice explains the circumstancesunder which the 4-year replacement period under section1033(e)(2) of the Code is extended for livestock sold onaccount of drought. The notice informs taxpayers that theService will publish an annual list of counties that experiencedexceptional, extreme, or severe drought conditions, which ataxpayer can use to determine if an extension is available.

(Continued on the next page)

Announcements of Disbarments and Suspensions begin on page 572.Finding Lists begin on page ii.Index for July through September begins on page iv.

EMPLOYEE PLANS

T.D. 9282, page 512.Final regulations under sections 162(k) and 404(k) of the Codeprovide that a payment in redemption of employer securitiesheld by an employee stock ownership plan (ESOP) is not de-ductible.

ADMINISTRATIVE

REG–145154–05, page 567.Proposed regulations under 31 USC 9701 implement new userfees for the Special Enrollment Examination (SEE) for enrolledagents, the application for enrollment of enrolled agents, andthe renewal of such enrollment. The user fee that the IRS cur-rently charges applicants in order to take the SEE is being mod-ified to reflect the change in the IRS costs of administering theexam program as a result of the contracting out of the exam.The regulations establish an $11 per applicant user fee for theSEE and separate $125 user fees for the enrollment and re-newal of enrollment process. A public hearing is scheduled forSeptember 29, 2006.

Rev. Proc. 2006–38, page 530.Low-income housing credit. This procedure publishes theamounts of unused housing credit carryovers allocated to qual-ified states under section 42(h)(3)(D) of the Code for calendaryear 2006.

September 25, 2006 2006–39 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents are compiled semiannually into Cumulative Bulletins,which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2006–39 I.R.B. September 25, 2006

Place missing child here.

September 25, 2006 2006–39 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 42.—Low-IncomeHousing Credit26 CFR 1.42–14: Allocation rules for post-1989State housing credit ceiling amounts.

Guidance is provided to state housing credit agen-cies of qualified states that request an allocationof unused housing credit carryover under section42(h)(3)(D) of the Internal Revenue Code. See Rev.Proc. 2006-38, page 530.

Section 61.—Gross IncomeDefined26 CFR 1.61–21: Taxation of fringe benefits.

Fringe benefits aircraft valuation for-mula. The Standard Industry Fare Level

(SIFL) cents-per-mile rates and terminalcharge in effect for the second half of 2006are set forth for purposes of determiningthe value of noncommercial flights onemployer-provided aircraft under section1.61–21(g) of the regulations.

Rev. Rul. 2006–47

For purposes of the taxation of fringebenefits under section 61 of the Inter-nal Revenue Code, section 1.61–21(g) ofthe Income Tax Regulations provides arule for valuing noncommercial flightson employer-provided aircraft. Section1.61–21(g)(5) provides an aircraft valua-tion formula to determine the value of suchflights. The value of a flight is determined

under the base aircraft valuation formula(also known as the Standard Industry FareLevel formula or SIFL) by multiplyingthe SIFL cents-per-mile rates applicablefor the period during which the flight wastaken by the appropriate aircraft multipleprovided in section 1.61–21(g)(7) and thenadding the applicable terminal charge. TheSIFL cents-per-mile rates in the formulaand the terminal charge are calculated bythe Department of Transportation and arereviewed semi-annually.

The following chart sets forth the termi-nal charges and SIFL mileage rates:

Period During Whichthe Flight Is Taken

TerminalCharge

SIFL MileageRates

7/1/06 - 12/31/06 $37.85 Up to 500 miles= $.2071 per mile

501–1500 miles= $.1579 per mile

Over 1500 miles= $.1518 per mile

DRAFTING INFORMATION

The principal author of this revenueruling is Kathleen Edmondson of theOffice of Division Counsel/AssociateChief Counsel (Tax Exempt/Govern-ment Entities). For further informationregarding this revenue ruling, contactMs. Edmondson at (202) 622–0047 (not atoll-free call).

Section 126.—CertainCost-Sharing Payments

Conservation Security Program(CSP). This ruling holds that the Con-servation Security Program is substan-tially similar to the type of programsdescribed in section 126(a)(1) through (8)of the Code within the meaning of section126(a)(9). As a result, all or a portion ofcost-share payments received under theCSP is eligible for exclusion from gross

income to the extent permitted by section126.

Rev. Rul. 2006–46

ISSUE

Is the Conservation Security Program(CSP) within the scope of § 126(a)(9) sothat cost-share payments received underthe CSP are eligible for exclusion fromgross income to the extent permitted by§ 126?

FACTS

The CSP, authorized under the provi-sions of §§ 1238–1238C of the Food Secu-rity Act of 1985, Pub. L. No. 99–198, 99Stat. 1354, as amended by the Farm Se-curity and Rural Investment Act of 2002,Pub. L. No. 107–171, 116 Stat. 134, 16U.S.C. §§ 3838–3838c, is a voluntary pro-gram that supports ongoing conservation

stewardship of agricultural lands by pro-viding financial assistance to agriculturalproducers who maintain and enhance nat-ural resources. The CSP is administeredby the U.S. Department of Agriculture(USDA). An agricultural producer whowishes to participate in the CSP must enterinto a long-term conservation security con-tract with the USDA’s Natural ResourcesConservation Service (NRCS). The CSP isavailable to agricultural producers owningprivate agricultural land (including crop-land, grassland, prairie land, improvedpasture land, rangeland, land under thejurisdiction of an Indian tribe, or forestedland that is an incidental part of an agri-cultural operation). The NRCS, usingthe USDA’s Commodity Credit Corpo-ration, provides contract payments thatmay include (1) an annual stewardshipcomponent for the existing base level con-servation treatment; (2) an annual existingpractice component for maintaining exist-ing conservation practices; (3) a one-time

2006–39 I.R.B. 511 September 25, 2006

new practice component for additionalneeded practices; and (4) an enhancementcomponent for exceptional conservationeffort and additional conservation prac-tices or activities that provide increasedresource benefits beyond the prescribedlevel. Payments for practices includedin the existing practice and new practicecomponents are limited, under 16 U.S.C.§ 3838c, to 75 percent (or, in the case of abeginning farmer or rancher, 90 percent)of the average county costs of the practicesfor the 2001 crop year. Payments underthe stewardship component are not limitedto the taxpayer’s costs but are instead apercentage of the rental rate applicable tothe land, as determined by the NRCS. Pay-ments under the enhancement componentmay be based either on an activity’s costor on its expected conservation benefits.

The Secretary of Agriculture has deter-mined that payments under the CSP areprimarily for the purpose of conservingsoil and water resources or protecting andrestoring the environment. In addition, theSecretary of Agriculture has informed theTreasury Department that USDA believesthe CSP is a small watershed program.

LAW AND ANALYSIS

Under § 126(a), gross income does notinclude the excludable portion of pay-ments received under certain conservationprograms set forth in § 126(a)(1) through(8). Section 126(a)(9) provides that asmall watershed program administered bythe Secretary of Agriculture also is eligi-ble for § 126 treatment if the Secretary ofthe Treasury determines that the programis substantially similar to the type of pro-grams described in § 126(a)(1) through(8). See § 16A.126–1(d) of the TemporaryIncome Regulations Relating To The Par-tial Exclusion For Certain Cost-SharingPayments for rules permitting the Com-missioner to make these determinationsand announce them in the Internal Rev-enue Bulletin and for the definition of“small watershed.”

If the Commissioner has determinedthat a program is substantially similarto the types of programs described in§ 126(a)(1) through (8), taxpayers re-ceiving cost-share payments under thatprogram must determine what portionof the cost-share payments is excludablefrom gross income under § 126. Under

§ 126(b), the excludable portion of a pay-ment is limited to the portion that (1) isdetermined by the Secretary of Agricul-ture to be made primarily for the purposeof conserving soil and water resources,protecting or restoring the environment,improving forests, or providing a habitatfor wildlife, (2) does not substantiallyincrease the income derived from theproperty, and (3) is not properly associ-ated with a deductible expense. Paymentsin the nature of rent or compensation forservices do not qualify for the exclusion.See § 126(b) and § 16A.126–1, relating tothe partial exclusion of certain cost-sharepayments, to determine what portion of thecost-share payments is excludable fromgross income under § 126.

HOLDING

The Internal Revenue Service acceptsUSDA’s conclusion that the CSP is a smallwatershed program. Accordingly, the CSPwill be treated for purposes of § 126 as asmall watershed program administered bythe Secretary of Agriculture. In addition,the Commissioner has determined that theCSP is substantially similar to the type ofprograms described in § 126(a)(1) through(8).

Payments for practices included in theexisting practice and new practice com-ponents are limited to a percentage of theaverage county costs of the practices andqualify as cost-share payments. The cost-share payments received under the exist-ing practice and new practice componentsof the CSP are eligible for exclusion fromgross income to the extent permitted by§ 126.

Payments under the stewardship com-ponent are based on the rental rate applica-ble to the land and are not cost-share pay-ments that are excludable from gross in-come.

Payments under the enhancement com-ponent qualify as cost-share payments ifthey are based on an activity’s cost ratherthan on its expected conservation benefits.The cost-share payments received underthe enhancement component are eligiblefor exclusion from gross income to the ex-tent permitted by § 126. Payments underthe enhancement component based on theactivity’s expected conservation benefitsrather than on its cost are not cost-share

payments and are not excludable fromgross income.

See § 126(b) and § 16A.126–1 to de-termine the extent to which cost-sharepayments under the existing practice, newpractice, and enhancement componentsare excludable from gross income under§ 126.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Jennifer C. Bernardini of the Officeof Associate Chief Counsel (Passthroughs& Special Industries). For further informa-tion regarding this revenue ruling, contactJennifer C. Bernardini at (202) 622–3120(not a toll-free call).

Section 162.—Trade orBusiness Expenses26 CFR 1.162(k)–1: Disallowance of deduction forreacquisition payments.

26 CFR 1.404(k)–3: Disallowance of deduction forreacquisition payments.

T.D. 9282

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Dividends Paid Deduction forStock Held in Employee StockOwnership Plan

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document containsfinal regulations under sections 162(k)and 404(k) of the Internal Revenue Code(Code) providing that a payment in re-demption of employer securities held byan employee stock ownership plan (ESOP)is not deductible. These regulations gen-erally affect administrators of, employersmaintaining, participants in, and benefi-ciaries of ESOPs. In addition, they willaffect corporations that make distributionsin redemption of stock held in an ESOP.

DATES: Effective Date: These regulationsare effective on August 30, 2006.

September 25, 2006 512 2006–39 I.R.B.

Applicability Dates: These regulationsapply with respect to payments to reac-quire stock that are made on or after andamounts paid or incurred on or after Au-gust 30, 2006. See §§1.162(k)–1(c) and1.404(k)–3, Q&A–2.

FOR FURTHER INFORMATIONCONTACT: John T. Ricotta at (202)622–6060 with respect to section 404(k)or Jean R. Brenner at (202) 622–7790 withrespect to section 162(k) (not toll-freenumbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains final regu-lations (26 CFR Part 1) under sections162(k) and 404(k) of the Code.

Section 162(k)(1) generally providesthat no deduction otherwise allowable un-der chapter 1 of the Code is allowed forany amount paid or incurred by a corpora-tion in connection with the reacquisition ofits stock or the stock of any related person(as defined in section 465(b)(3)(C)). Thelegislative history of section 162(k) statesthat the phrase “in connection with” is“intended to be construed broadly.” H.R.Conf. Rep. No. 99–841, at 168 (1986).

Section 404(k)(1) provides a deductionfor an applicable dividend paid in cash bya C corporation with respect to applica-ble employer securities held by an ESOP,as defined in section 4975(e)(7). Section404(k)(2) generally provides that the termapplicable dividend means any dividendwhich, in accordance with the plan provi-sions, is either paid in cash to plan partic-ipants or beneficiaries or paid to the planand distributed in cash to participants orbeneficiaries not later than 90 days afterthe close of the plan year in which paid.An applicable dividend also includes a div-idend which, at the election of participantsor their beneficiaries, is payable as pro-vided in the preceding sentence or paid tothe plan and reinvested in qualifying em-ployer securities. Finally, an applicabledividend also includes a dividend that isused to make payments on a loan describedin section 404(a)(9), the proceeds of whichwere used to acquire the employer secu-rities (whether or not allocated to partici-

pants) with respect to which the dividend ispaid. Under section 404(k)(4), the deduc-tion is allowable in the taxable year of thecorporation in which the dividend is paidor distributed to the participant or benefi-ciary.

Prior to 2002, section 404(k)(5)(A) pro-vided that the Secretary may disallow thededuction under section 404(k) for anydividend if the Secretary determines thatsuch dividend constitutes, in substance, anevasion of taxation. Section 662(b) of theEconomic Growth and Tax Relief Recon-ciliation Act of 2001 (115 Stat. 38, 2001)amended section 404(k)(5)(A) to providethat the Secretary may disallow a deduc-tion under section 404(k) for any divi-dend the Secretary determines constitutes,in substance, an avoidance or evasion oftaxation.

Rev. Rul. 2001–6, 2001–1 C.B.491 (see §601.601(d)(2) of this chapter),states that distributions to participants ofamounts paid by an employer to reacquireshares of its stock from the employer’sESOP (redemption proceeds) are madein connection with the reacquisition ofthe employer’s stock and that section162(k)(1) therefore bars the deductionunder these circumstances regardless ofwhether the distributions to participantswould otherwise be deductible under sec-tion 404(k). The revenue ruling also statesthat the treatment of redemption proceedsas “applicable dividends” under section404(k) would produce such anomalousresults that the section cannot reasonablybe construed as encompassing such pay-ments. The revenue ruling states that theapplication of section 404(k) to redemp-tion proceeds not only would allow em-ployers to claim deductions for paymentsthat do not represent true economic costs,but also, as further explained below, wouldvitiate important rights and protections forrecipients of ESOP distributions. Finally,the ruling states that a deduction wouldbe disallowed under section 404(k)(5)(A)because a deduction under these circum-stances would constitute, in substance, anevasion of taxation.

These positions were reiterated inNotice 2002–2, Q&A–11, 2002–2 C.B.285 (See §601.601(d)(2) of this chapter),which states that, in accordance with Rev.

Rul. 2001–6, payments in redemption ofstock held by an ESOP that are used tomake distributions to terminating ESOPparticipants constitute an evasion of tax-ation under section 404(k)(5)(A) and arenot applicable dividends under section404(k)(1). Moreover, the notice states thatany deduction for such payments in re-demption of stock is barred under section162(k).

Notice 2002–2 (Q&A–7) also discussesthe tax treatment of section 404(k) divi-dend distributions, stating that dividendspaid in cash to a participant (rather thanreinvested at the option of the partici-pant under section 404(k)(2)(A)(iii)) aretaxable without regard to the return ofbasis provisions under section 72, and arenot subject to the consent requirementsof section 411(a)(11) or the distributionrestrictions of section 401(k)(2)(B). In ad-dition, the notice provides that dividendspaid to participants under section 404(k)are not eligible rollover distributions undersection 402(c), even if the dividends aredistributed at the same time as amountsthat do constitute an eligible rollover dis-tribution (or are reported on Form 1099-R(Distributions From Pensions, Annuities,Retirement or Profit-Sharing Plans, IRAs,Insurance Contracts, etc.) in accordancewith Announcement 85–168).1 See also§ 1.402(c)–2, Q&A–4(e), under whichdividends paid on employer securities un-der section 404(k) are not eligible rolloverdistributions under section 402(c).

In Boise Cascade Corporation v.United States, 329 F.3d 751 (9th Cir.2003), the Court of Appeals for the NinthCircuit held that payments made by theissuer of stock to redeem its stock heldby its ESOP were deductible as dividendspaid under section 404(k), and that thededuction was not precluded by section162(k). The IRS issued Chief Coun-sel Notice 2004–038 (October 1, 2004)(available at www.irs.gov/foia through theelectronic reading room) to indicate that itdisagreed with the Court’s interpretationand would continue to assert in any matterin controversy outside the Ninth Circuitthat sections 162(k) and 404(k) disallowa deduction for payments to reacquireemployer securities held by an ESOP. Forany matter in controversy within the Ninth

1 Announcement 85–168, 1985–48 I.R.B. 40, states that section 404(k) distributions are reportable as dividends on a recipient’s tax return and that such distributions are fully taxable withoutregard to return of basis.

2006–39 I.R.B. 513 September 25, 2006

Circuit, agents or district counsel attorneysare to consult the National Office.

A notice of proposed rulemaking con-taining proposed regulations under sec-tions 162(k) and 404(k) was issued on Au-gust 25, 2005 (REG–133578–05, 2005–39I.R.B. 610 [70 FR 49897]) to address twoissues: 1) which corporation is entitledto the deduction for applicable dividendsunder section 404(k) where the payorand employer are different entities; and2) whether a payment in redemption ofemployer securities held by an ESOP isdeductible. The issue in the proposedregulations concerning which corporationis entitled to the deduction for applicabledividends under section 404(k) is expectedto be addressed in future regulations.

The notice of proposed rulemaking in-cluded proposed regulations under section404(k) that would provide that paymentsmade to reacquire stock held by an ESOPare not deductible under section 404(k)because such payments would not con-stitute applicable dividends under section404(k)(2) and a deduction for such pay-ments would constitute, in substance, anavoidance or evasion of taxation withinthe meaning of section 404(k)(5) becauseit would allow a corporation to claimtwo deductions for the same economiccost. It also included proposed regula-tions under section 162(k) providing thatsection 162(k), subject to certain excep-tions, would disallow any deduction foramounts paid or incurred by a corporationin connection with the reacquisition of itsstock or the stock of any related person(as defined in section 465(b)(3)(C)). Fi-nally, the proposed regulations providedthat amounts paid or incurred in connec-tion with the reacquisition of stock includeamounts paid by a corporation to reacquireits stock from an ESOP that are then dis-tributed by the ESOP to its participants (ortheir beneficiaries) or otherwise used in amanner described in section 404(k)(2)(A).

A public hearing on the proposed reg-ulations was held on January 18, 2006.After consideration of the commentsreceived, these final regulations adoptwithout material change the provisionsof the proposed regulations concerningpayments in redemption of employer se-curities held by an ESOP.

Explanation of Provisions

With respect to the treatment of pay-ments in redemption of employer securi-ties, these final regulations adopt the ruleof the proposed regulations under whichpayments made to reacquire stock held byan ESOP are not deductible under section404(k) because such payments do not con-stitute applicable dividends under section404(k)(2) and a deduction for such pay-ments would constitute, in substance, anavoidance or evasion of taxation within themeaning of section 404(k)(5). These finalregulations also adopt the rule of the pro-posed regulations that explicitly providesthat section 162(k) disallows any deduc-tion, including any deduction under sec-tion 404(k), for amounts paid or incurredby a corporation in connection with thereacquisition of its stock or the stock ofany related person (as defined in section465(b)(3)(C)). In addition, these final reg-ulations adopt the rule of the proposed reg-ulations providing that amounts paid or in-curred in connection with the reacquisitionof stock include amounts paid by a corpo-ration to reacquire its stock from an ESOPthat are then distributed by the ESOP to itsparticipants (or their beneficiaries) or oth-erwise used in a manner described in sec-tion 404(k)(2)(A).

These provisions aroused little opposi-tion and only two comments were receivedregarding the treatment of payments madeto reacquire stock. A trade association rep-resenting companies that sponsor ESOPssupported the position of the proposedregulations that a repurchase of shares ofESOP stock from ESOP participants ina stock redemption does not qualify as adeductible dividend under section 404(k).

The other commentator disagreed withthe position in the proposed regulations,arguing that redemptions of stock held byan ESOP that are recharacterized as divi-dends under section 302 nevertheless areproper dividends that should be treated thesame as ordinary dividends paid with re-spect to stock held by an ESOP. The com-mentator argued that, by enacting section404(k), Congress intended to allow a dou-ble deduction for contributions to purchaseemployer stock because the value of stockpurchased with employer contributionsincludes the present value of expectedfuture dividends. Thus, the commentatorargued, a deduction for redemptive pro-

ceeds should not be characterized as anavoidance or evasion of taxation withinthe meaning of section 404(k)(5). Finally,the commentator argued that, because thelegislative history to section 162(k) doesnot specifically refer to section 404(k)dividends and section 162(k) was enactedonly two years after section 404(k), sec-tion 162(k) does not preclude a deductionfor a redemptive dividend under section404(k).

These arguments are unpersuasive. Al-though the present value of expected fu-ture dividends is an element of the valueof shares of stock at any point in time, andCongress did authorize a current deduc-tion for the value of stock contributionsto qualified plans, as well as a later de-duction for certain dividends paid on thoseshares under section 404(k), these deduc-tions are carefully limited to dividends ac-tually paid in certain specified ways whilethe stock is held by the ESOP. There isno evidence that Congress intended to au-thorize yet another deduction for the fullvalue of the shares upon their redemption.To allow a deduction for redemption pro-ceeds would be to allow a second deduc-tion that includes the present value of div-idends that are paid out after the date ofdistribution from the ESOP, contrary to theintent of the statute. Moreover, the amountof the deduction with respect to a redemp-tion could be many times the amount thatwould be deducted for that year for a con-ventional dividend. (In fact, permitting asecond deduction for the full value of theshares would allow a corporation to claimone deduction for a share of stock con-tributed to an ESOP and allocated to anemployee early in a tax year and anotherdeduction if the share is redeemed to makea distribution to the employee later in thesame tax year.) There is a no indicationthat such a result was intended and there isno obvious purpose that would be servedby such a result.

Congress recognized that an arrange-ment that might be argued to come withinthe literal language of section 404(k) mightnevertheless be inconsistent with its pur-pose. Congress therefore granted authorityto the Secretary, in section 404(k)(5)(A),to disallow a deduction for any dividendthat the Secretary finds to be, in substance,an evasion of taxation. The statute wasclarified, for years beginning in 2002, toexplicitly broaden that authority to permit

September 25, 2006 514 2006–39 I.R.B.

the Service to disallow any deduction thatis an avoidance or evasion of taxation. Adeduction for redemption proceeds is bothexcessive in amount and inconsistent withthe purpose of section 404(k), so that this isclearly an appropriate case for the author-ity under section 404(k)(5)(A) to be exer-cised.2

The IRS and Treasury Departmentalso continue to believe, as provided inRev. Rul. 2001–6, that a deduction forredemption of benefit distributions isappropriately disallowed under section404(k)(5)(A) because a deduction underthese circumstances would constitute, insubstance, an evasion of taxation. Asstated in Rev. Rul. 2001–6, the treatmentof redemption proceeds as “applicabledividends” under section 404(k) wouldproduce such anomalous results that thesection cannot reasonably be construedas encompassing such payments. As oneexample, if a redemption of a benefitdistribution were an applicable dividendunder section 404(k), there would be noreason why such a redemption could onlyoccur once with respect to a participant, sothat multiple redemptions (or theoreticallyeven an unlimited number of redemp-tions3) might be possible, a result that isclearly not consistent with the intent ofsection 404(k).

Further, as described in Rev. Rul.2001–6, the application of section 404(k)to redemption amounts also would viti-ate important rights and protections forrecipients of ESOP distributions. Theseimportant rights and protections includethe right to apply the return of basis pro-visions under section 72 (whereas anapplicable dividend under section 404(k)is includible in gross income without re-gard to return of basis under section 72),and the protection against involuntarycash-outs (section 411(a)(11)). See sec-tion 72(e)(5)(D), and Q&A–7 of Notice2002–2, 2002–1 C.B. 285. Similarly, ifredemption amounts distributed as a nor-mal benefit distribution were treated as anapplicable dividend under section 404(k),then a participant would not have the rightto elect a direct or indirect rollover withrespect to redemption proceeds that aredistributed from the ESOP, and any notice

provided to the employee as required bysection 402(f) would have to identify theloss of this valuable right to the partici-pant. See §1.402(c)–2, Q&A–4(e).

Congress also provided for other spe-cial treatment for applicable dividends un-der section 404(k) that would be incon-sistent with redemption of a normal bene-fit distribution being treated as an applica-ble dividend under section 404(k). Section72(t)(2)(A)(vi) provides for an exceptionto the 10 percent additional income tax forearly distributions for dividends paid withrespect to stock of a corporation which aredescribed in section 404(k). Further, sec-tion 404(k)(5)(B) provides that a plan willnot violate the requirements of sections401, 409, or 4975(e)(7) or be engaging in aprohibited transaction merely by reason ofdistributing an applicable dividend undersection 404(k). Thus, for example, a distri-bution of an applicable dividend under sec-tion 404(k) is not subject to the prohibitionagainst in-service distributions of amountsattributable to elective deferrals under sec-tion 401(k)(2). Clearly, these broad ex-ceptions under section 72(t)(2)(A)(vi) and404(k)(5)(B) were not intended to apply tonormal benefit distributions from ESOPs,essentially at the election of the employeror distributee.

Finally, even if the IRS declinedto exercise its authority under section404(k)(5)(A), the plain language of sec-tion 162(k) precludes the deduction forpayments by a corporation to redeem itsstock including deductions otherwise al-lowed under section 404(k). As describedunder the Background section of this pre-amble, section 162(k) provides that “nodeduction otherwise allowable shall beallowed under this chapter for any amountpaid or incurred by a corporation in con-nection with the reacquisition of its stock”(emphasis added) and section 404(k) is inthe same chapter as section 162(k). Thecommentator’s attempt to avoid the effectof the plain language of the statute by ref-erence to a supposed negative inference inthe legislative history is unavailing.

Accordingly, these regulations adoptthe rule in the proposed regulations with-out material change.

Effective Date

Section 1.162(k)–1 applies with respectto amounts paid or incurred on or afterAugust 30, 2006.

Section 1.404(k)–3 applies with respectto payments to reacquire stock that aremade on or after August 30, 2006. Rev.Rul. 2001–6 remains in effect for all peri-ods, including periods before the effectivedate of this regulation.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been deter-mined that section 553(b) of the Admin-istrative Procedure Act (5 U.S.C. chapter5) does not apply to these regulations, andbecause the regulations do not impose acollection of information on small entities,the Regulatory Flexibility Act (5 U.S.C.chapter 6) does not apply. Pursuant to sec-tion 7805(f) of the Code, the proposed reg-ulations preceding these regulations weresubmitted to the Chief Counsel for Advo-cacy of the Small Business Administrationfor comment on its impact on small busi-ness.

Drafting Information

The principal authors of these reg-ulations are John T. Ricotta, Office ofDivision Counsel/Associate Chief Coun-sel (Tax Exempt and Government Entities)and Jennifer D. Sledge, Office of Asso-ciate Chief Counsel (Corporate). How-ever, other personnel from the IRS and theTreasury Department participated in thedevelopment of these regulations.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR part 1 is amendedas follows:

2 Given the special rules of section 409(h) which generally entitle participants to receive cash for employer securities that are not publicly traded, if Congress had so intended, it would likelyhave identified the interaction of these provisions in light of the potentially large additional deductions such a rule would permit. Cf., Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934).

3 For example, a plan participant might elect to have his or her account balance redeemed to the extent invested in employer securities, and then promptly have the cash reinvested in employersecurities, and then could immediately repeat this redemption/reinvestment process with no theoretical limit.

2006–39 I.R.B. 515 September 25, 2006

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding entries in nu-merical order to read as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.162(k)–1 is also issued under

section 26 U.S.C. 162(k). * * *Section 1.404(k)–3 is also issued

under sections 26 U.S.C. 162(k) and404(k)(5)(A). * * *

Par. 2. Section 1.162(k)–1 is added toread as follows:

§1.162(k)–1 Disallowance of deductionfor reacquisition payments.

(a) In general. Except as providedin paragraph (b) of this section, no de-duction otherwise allowable is allowedunder Chapter 1 of the Internal RevenueCode for any amount paid or incurredby a corporation in connection with thereacquisition of its stock or the stock ofany related person (as defined in section465(b)(3)(C)). Amounts paid or incurredin connection with the reacquisition ofstock include amounts paid by a corpora-tion to reacquire its stock from an ESOPthat are used in a manner described insection 404(k)(2)(A). See §1.404(k)–3.

(b) Exceptions. Paragraph (a) of thissection does not apply to any—

(1) Deduction allowable under section163 (relating to interest);

(2) Deduction for amounts that areproperly allocable to indebtedness andamortized over the term of such indebted-ness;

(3) Deduction for dividends paid(within the meaning of section 561); or

(4) Amount paid or incurred in connec-tion with the redemption of any stock in aregulated investment company that issues

only stock which is redeemable upon thedemand of the shareholder.

(c) Effective date. This section applieswith respect to amounts paid or incurred onor after August 30, 2006.

Par. 3. Section 1.404(k)–3 is added toread as follows:

§1.404(k)–3 Disallowance of deductionfor reacquisition payments.

Q–1: Are payments to reacquire stockheld by an ESOP applicable dividends thatare deductible under section 404(k)(1)?

A–1: (a) Payments to reacquire stockheld by an ESOP, including reacquisitionpayments that are used to make benefit dis-tributions to participants or beneficiaries,are not deductible under section 404(k) be-cause—

(1) Those payments do not consti-tute applicable dividends under section404(k)(2); and

(2) The treatment of those paymentsas applicable dividends would constitute,in substance, an avoidance or evasion oftaxation within the meaning of section404(k)(5).

(b) See also §1.162(k)–1 concerning thedisallowance of deductions for amountspaid or incurred by a corporation in con-nection with the reacquisition of its stockfrom an ESOP.

Q–2: What is the effective date of thissection?

A–2: This section applies with respectto payments to reacquire stock that aremade on or after August 30, 2006.

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

Approved August 22, 2006.

Eric Solomon,Acting Deputy Assistant Secretary

of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on August 29,2006, 8:45 a.m., and published in the issue of the FederalRegister for August 30, 2006, 71 F.R. 51471)

Section 472.—Last-in,First-out Inventories26 CFR 1.472–1: Last-in, first-out inventories.

LIFO; price indexes; departmentstores. The July 2006 Bureau of LaborStatistics price indexes are accepted foruse by department stores employing theretail inventory and last-in, first-out in-ventory methods for valuing inventoriesfor tax years ended on, or with referenceto, July 31, 2006.

Rev. Rul. 2006–48

The following Department Store In-ventory Price Indexes for July 2006 wereissued by the Bureau of Labor Statistics.The indexes are accepted by the Inter-nal Revenue Service, under § 1.472–1(k)of the Income Tax Regulations and Rev.Proc. 86–46, 1986–2 C.B. 739, for ap-propriate application to inventories ofdepartment stores employing the retailinventory and last-in, first-out inventorymethods for tax years ended on, or withreference to, July 31, 2006.

The Department Store Inventory PriceIndexes are prepared on a national basisand include (a) 23 major groups of depart-ments, (b) three special combinations ofthe major groups — soft goods, durablegoods, and miscellaneous goods, and (c) astore total, which covers all departments,including some not listed separately, ex-cept for the following: candy, food, liquor,tobacco, and contract departments.

BUREAU OF LABOR STATISTICS, DEPARTMENT STOREINVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Groups July 2005 July 2006

Percent Changefrom July 2005to July 20061

1. Piece Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 495.0 465.0 -6.12. Domestics and Draperies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 517.7 488.7 -5.63. Women’s and Children’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . 629.0 655.7 4.24. Men’s Shoes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 867.0 875.4 1.05. Infants’ Wear . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 548.0 557.7 1.8

September 25, 2006 516 2006–39 I.R.B.

BUREAU OF LABOR STATISTICS, DEPARTMENT STOREINVENTORY PRICE INDEXES BY DEPARTMENT GROUPS

(January 1941 = 100, unless otherwise noted)

Groups July 2005 July 2006

Percent Changefrom July 2005to July 20061

6. Women’s Underwear. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541.2 546.8 1.07. Women’s Hosiery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 339.7 343.8 1.28. Women’s and Girls’ Accessories . . . . . . . . . . . . . . . . . . . . . . . . . . . 580.5 544.5 -6.29. Women’s Outerwear and Girls’ Wear . . . . . . . . . . . . . . . . . . . . . . . 321.7 327.3 1.710. Men’s Clothing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 520.6 514.2 -1.211. Men’s Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 552.6 550.3 -0.412. Boys’ Clothing and Furnishings . . . . . . . . . . . . . . . . . . . . . . . . . . . . 386.1 371.3 -3.813. Jewelry. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 870.2 898.0 3.214. Notions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 809.2 822.9 1.715. Toilet Articles and Drugs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 997.1 995.1 -0.216. Furniture and Bedding . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 599.1 602.4 0.617. Floor Coverings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609.8 614.1 0.718. Housewares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 712.2 697.1 -2.119. Major Appliances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 203.5 204.2 0.320. Radio and Television. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38.9 35.8 -8.021. Recreation and Education2. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77.9 76.3 -2.122. Home Improvements2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 137.6 139.6 1.523. Automotive Accessories2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 115.1 120.7 4.9

Groups 1–15: Soft Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 537.3 538.3 0.2Groups 16–20: Durable Goods . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379.6 373.2 -1.7Groups 21–23: Misc. Goods2 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93.0 93.4 0.4

Store Total3 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481.6 480.8 -0.2

1Absence of a minus sign before the percentage change in this column signifies a price increase.2Indexes on a January 1986 = 100 base.3The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor,tobacco and contract departments.

DRAFTING INFORMATION

The principal author of this revenueruling is Michael Burkom of the Officeof Associate Chief Counsel (Income Taxand Accounting). For further informa-tion regarding this revenue ruling, contactMr. Burkom at (202) 622–7924 (not atoll-free call).

Section 882.—Tax onIncome of ForeignCorporations ConnectedWith United States Business26 CFR 1.882–5: Determination of interest deduc-tion.

T.D. 9281

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Parts 1 and 602

Determination of InterestExpense Deduction of ForeignCorporations

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final and temporary regula-tions.

SUMMARY: This document contains re-vised Income Tax Regulations relating tothe determination of the interest expensededuction of foreign corporations andapplies to foreign corporations engagedin a trade or business within the UnitedStates. This action is necessary to conformthe rules to subsequent U.S. Income TaxTreaty agreements and to adopt changesto facilitate improved administrability fortaxpayers and the IRS.

DATES: Effective Date: These regula-tions are effective starting the tax year endfor which the original tax return due date(including extensions) is after August 17,2006.

Applicability Date: These regulationsare applicable starting the tax year end

2006–39 I.R.B. 517 September 25, 2006

for which the original tax return due date(including extensions) is after August 17,2006.

FOR FURTHER INFORMATIONCONTACT: Gregory Spring orPaul Epstein, (202) 622–3870 (not atoll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

These temporary regulations are beingissued without prior notice and public pro-cedure pursuant to the Administrative Pro-cedure Act (5 U.S.C. 553). For this reason,the collection of information contained inthese regulations has been reviewed andpending receipt and evaluation of publiccomments, approved by the Office of Man-agement and Budget under control number1545–2030. Responses to this collectionof information are mandatory.

An agency may not conduct or sponsor,and a person is not required to respondto, a collection of information unless thecollection of information displays a validcontrol number.

For further information concerningthese collections of information, andwhere to submit comments on the col-lection of information and the accuracy ofthe estimated burden, and suggestions forreducing this burden, please refer to thepreamble of the cross-referencing notice ofproposed rulemaking (REG–120509–06)published in this issue of the Bulletin.

Books and records relating to a collec-tion of information must be retained aslong as their contents may become mate-rial in the administration of any internalrevenue law. Generally, tax returns and taxreturn information are confidential, as re-quired by 26 U.S.C. 6103.

Background

On December 30, 1980, the TreasuryDepartment and the IRS published finalregulations T.D. 7749, 1981–1 C.B. 390[46 FR 16100 (see §601.601(d)(2) of thischapter)] under section 882(c) of the In-ternal Revenue Code (Code) regardingthe determination of a foreign corpora-tion’s interest expense allocable to incomeeffectively connected with the conductof a trade or business within the United

States. On March 8, 1996, the TreasuryDepartment and the IRS published finalregulations T.D. 8658, 1996–1 C.B. 161[61 FR 15891 (see §601.601(d)(2) of thischapter)], and new proposed amendmentsINTL–0054–95, 1996–1 C.B. 844 [61FR 28118) (see §601.601(d)(2) of thischapter)]. The 1996 amendments imple-mented certain statutory changes enactedin the Tax Reform Act of 1986, Public Law99–514 (100 Stat. 2085), and took accountof developments in international financialmarkets. Comments were received onboth the final and proposed 1996 regula-tions. Since then, two new U.S. income taxtreaties have entered into force that followa different approach for determining thelimit on profits attributable to a permanentestablishment in a contracting state andfor determining interest expense allowedin computing such profits. On July 14,2005, the Treasury Department and theIRS published Notice 2005–53, 2005–2C.B. 32, see §601.601(d)(2)), which de-scribed those new treaties and announcedthe intention to update the final §1.882–5regulations to take account of changes inthe international banking sector and topromote both ease of administration andcertainty of application.

These temporary regulations in thisdocument implement Notice 2005–53,make effective one part of the 1996 pro-posed regulations, make miscellaneousclarifications to the 1996 final regu-lations, and modify the branch profitstax liability reduction regulations under§1.884–1(e)(3).

Explanation of Provisions

The following discussion is dividedinto several parts. Section 1 of the fol-lowing discussion summarizes Notice2005–53. Section 2 addresses the coordi-nation of §1.882–5 with U.S. tax treatiesand discusses other modifications madeby these temporary regulations to thethree-step calculation of interest expenseunder §1.882–5. Section 3 addresseschanges made to the branch profits taxregulations under section 884. Section4 then addresses miscellaneous technicalmodifications made by these temporaryregulations that clarify application ofthe existing final regulations. Section 5describes the effective date of these regu-lations.

1. Notice 2005–53

Notice 2005–53 provided guidance re-garding the interaction of §1.882–5 andU.S. income tax treaties and explained thatsince the recent treaties with the UnitedKingdom and Japan entered into force,§1.882–5 no longer provides the exclusiverules for determining the interest expenseattributable to the business profits of aU.S. permanent establishment. The no-tice also provided guidance and requestedcomments regarding certain potentialmodifications to certain elements of thethree-step calculation of interest expenseunder §1.882–5. More specifically, thenotice requested information regarding apossible increase to the existing 93-per-cent fixed ratio in Step 2 of the calculationand announced the intention to allow theuse of a safe-harbor interest rate for deter-mining excess interest under the “adjustedU.S.-booked liabilities” method in Step3. The notice also requested commentsregarding the effect of intangibles on theStep–1 determination of U.S. assets underthe elective fair market value method andthe Step–2 determination of U.S. liabilitiesusing the fixed or actual ratio.

2. Modifications to Three-StepCalculation Under §1.882–5

a. Introduction/background

Section 1.882–5 generally requires aforeign corporation to use a three-step cal-culation to determine the amount of inter-est expense that is allocable under section882(c) to income effectively connected (ortreated as effectively connected) with theforeign corporation’s conduct of a trade orbusiness within the United States.

Step 1 determines the total value of aforeign corporation’s U.S. assets, whichgenerally are the assets that produce (orwould produce) income effectively con-nected with the foreign corporation’s con-duct of its U.S. trade or business. Thevalue of the U.S. assets for this purposeis their adjusted basis, or, if the taxpayermakes an election, their fair market value.

Step 2 determines the “U.S.-connectedliabilities” of a foreign corporation as theproduct of the foreign corporation’s U.S.assets multiplied either by the actual ratioof the foreign corporation’s worldwide li-abilities to worldwide assets, or by a fixed

September 25, 2006 518 2006–39 I.R.B.

ratio. In the case of a bank, the fixed ratiois 93 percent. If a taxpayer elects to valueits assets at fair market value for purposesof Step 1, then the taxpayer must valueworldwide assets at fair market value forpurposes of Step 2, as well.

Step 3 determines the allocable amountof interest expense under either the ad-justed U.S.-booked liabilities (AUSBL)method or the separate currency poolsmethod. Under the AUSBL method, aforeign bank’s interest expense alloca-ble to effectively connected income isdetermined by comparing “U.S.-bookedliabilities” with U.S.-connected liabilitiesand making appropriate adjustments asnecessary. For this purpose, U.S.-bookedliabilities generally include liabilities thatare both entered on books relating to anactivity that produces effectively con-nected income before the close of theday on which the liability is incurred andare directly connected to that activity.In consequence, U.S.-booked liabilitiesare not limited to liabilities reflected onbooks within the United States. If a tax-payer’s U.S.-booked liabilities exceedits U.S.-connected liabilities, then itsU.S-booked interest expense is propor-tionately disallowed under a “scale down”ratio. If a taxpayer’s U.S.-connected lia-bilities exceed its U.S.-booked liabilities,then interest expense in addition to theU.S.-booked interest expense is allocatedin an amount equal to the product of theexcess U.S.-connected liabilities multi-plied by the borrowing rate on U.S.-dollarliabilities that are not U.S.-booked liabil-ities.

Under the separate currency poolsmethod, a foreign corporation’s interestexpense allocable to income effectivelyconnected with the conduct of a trade orbusiness within the United States is thesum of the separate interest deductions foreach of the currencies in which the foreigncorporation has U.S. assets. The separateinterest deductions generally are deter-mined using a three-step calculation thatmultiplies the worldwide borrowing rateby the U.S.-connected liabilities relevantto U.S. assets denominated in each foreigncurrency.

Elections under §1.882–5T, as underthe 1996 final regulations, generally arebinding for a minimum of five years unlessspecifically provided otherwise. For ex-ample, consistent with the binding nature

of a domestic corporation’s fair marketvalue election under section 861, a fairmarket value election under §1.882–5Tmay be changed only with consent of theCommissioner.

b. Treaty coordination — modification of§1.882–5 exclusivity rule

The preamble to the 1996 final regula-tions states that §1.882–5 was fully consis-tent with all of the United States’ then-ex-isting treaty obligations, including Busi-ness Profits articles, and the 1996 final reg-ulations state that §1.882–5 provides theexclusive rules for determining the interestexpense attributable to the business profitsof a U.S. permanent establishment under aU.S. income tax treaty. However, the Trea-sury Department Technical Explanation toArticle 7 of the United States-United King-dom income tax treaty which entered intoforce on March 31, 2003, and the TreasuryDepartment Technical Explanation to Arti-cle 7 of the United States-Japan income taxtreaty which entered into force on March30, 2004, note that §1.882–5 may pro-duce an inappropriate result in some cases.As a result, the implementing documen-tation of these treaties provides that the1995 Organization for Economic Co-Op-eration and Development (OECD) Trans-fer Pricing Guidelines will apply by anal-ogy for the purpose of determining thebusiness profits attributable to a permanentestablishment. Thus, as noted in Notice2005–53, the exclusivity provision in the1996 final regulations is no longer accu-rate.

These temporary regulations modifythe exclusivity provision by recognizingthat express provision may be made by orpursuant to an income tax treaty or accom-panying documents (such as exchange ofnotes) that alternative principles will ap-ply by analogy to determine the businessprofits attributable to a permanent estab-lishment. Such treaty provisions may beused to determine the limit on the businessprofits attributable to a U.S. permanent es-tablishment, but taxpayers remain eligibleto use §1.882–5, as explained in the Trea-sury Department Technical Explanationsto Article 7(3) of the United States-UnitedKingdom and United States-Japan incometax treaties. The Treasury Departmentand the IRS believe that these treatiesand agreements provide that a taxpayer

must apply either the domestic law or thealternative rules expressly provided inthe treaty in their entirety, in accordancewith the consistency principle articulatedin Rev. Rul. 84–17, 1984–1 C.B. 308(see §601.601(d)(2) of this chapter), anddescribed in the Treasury DepartmentTechnical Explanation to Article 1(2) ofthe United States-United Kingdom andUnited States-Japan income tax treaties.The Treasury Department and the IRSare continuing to consider the specificapplication of this consistency principleincluding the application of §1.882–5, theinteraction of §1.882–5 with other U.S. in-come tax treaties (particularly those beingrenegotiated in whole or in part), and theapplication of the branch profits tax underalternative rules for determining interestexpense attributable to business profits.

c. Modifications to step one

Consistency Requirement for Fair MarketValue Election

Under the 1996 final regulations, ataxpayer that uses the fair market valuemethod for Step 1 must also use the fairmarket value method for Step 2. Notice2005–53 clarified that this consistencyrule applies only when the taxpayer haselected to use the actual ratio in Step 2,because assets are not valued when thefixed ratio is used. Accordingly, under thefinal regulations, electing the fair marketvalue method under Step 1 does not ob-ligate a taxpayer to elect the actual ratiounder Step 2.

Notice 2005–53 also stated that theprevalence and significance of intangiblesin the banking industry warrants reevalu-ating the right to elect both the fair marketvalue method in Step 1 and the fixed ratioin Step 2. The Treasury Department andthe IRS are concerned that applying thefixed ratio to intangibles when a Step 1 fairmarket value election is in place wouldhave the effect of treating existing intan-gibles as highly leveraged assets when infact such items often are more properlyreflected in the taxpayer’s equity accountsunder U.S. tax principles. Comments wererequested.

The single comment received in re-sponse to this request stated that distor-tions could result either by failing to takethe value of intangibles into account when

2006–39 I.R.B. 519 September 25, 2006

revising the fixed ratio for banks or by ap-plying the fixed ratio to directly purchasedintangibles that are valued at tax basis.

As further discussed in this section inconnection with modifications to Step 2,these temporary regulations adopt a fixedratio that is believed to represent an ap-proximation of current average banking-industry balance-sheet ratios estimated un-der U.S. tax principles. Following dueconsideration of the comment, these tem-porary regulations require that the fair mar-ket value method may be elected in Step 1only if a taxpayer is eligible to elect andin fact uses the actual ratio in Step 2. Theconsistency rule continues to require thatthe fair market value method, once elected,must be used in both Step 1 and Step 2.This consistency rule applies to all foreigncorporations that are subject to §1.882–5.

Conforming-Election Requirement

A taxpayer that has both a valid fairmarket value method election for Step1 and a valid fixed ratio method elec-tion for Step 2 in effect on the date thesetemporary regulations are effective mustconform those elections to the new rules.Accordingly, such a taxpayer either maymaintain the fixed ratio method for Step2 and elect the adjusted basis method forStep 1, or may maintain the fair mar-ket value method for Step 1 and electthe actual ratio method for Step 2. Suchconforming elections must be made forthe first year these temporary regulationsare effective, on either an original timelyfiled return (including extensions) or anamended return within 180 days afterthe extended due date. If a conformingelection is not made by the extended duedate for filing the amended return, theDirector of Field Operations may make abinding conforming election on the tax-payer’s behalf. Conforming elections aresubject to the minimum five-year periodapplicable to the adjusted basis method,fixed ratio and actual ratio method elec-tions. Elections with respect to Step 1and Step 2, whether made by the taxpayer(either under the terms of the regulationsor pursuant to the Commissioner’s grantof consent within what would otherwisebe a five-year minimum period) or im-posed by the Commissioner, are separate.Thus, for example, the Commissioner mayconsent to a taxpayer’s request to move

from the fair market value method to theadjusted basis method for Step 1 withoutgranting consent to move from the actualratio method to the fixed ratio method forStep 2.

Average Value of Securities Subject toSection 475 or Section 1256

The 1996 proposed regulations providethat financial instruments that are subjectto mark-to-market valuation under section475 or section 1256 must be valued forpurposes of §1.882–5 on each “determina-tion date” (as defined) within the taxableyear. Taxpayers generally assess fundingneeds throughout the year, and this rule isintended to reflect such assessments moreaccurately than a single year-end valuationwould do.

These temporary regulations adopt thisrule from the 1996 proposed regulations.The rule applies solely to determine the av-erage values of relevant assets for purposesof computing the average valuation of U.S.assets in Step 1 of the formula. The ruledoes not determine the actual tax basis ofan asset for any other purpose. “Determi-nation dates” for purposes of the rule aredefined as the most frequent regular inter-vals for which data are reasonably avail-able. These temporary regulations pro-vide that a taxpayer that has elected the ac-tual ratio in Step 2 must also take interimmark-to-market values into account usingthe most frequently available data but in noevent less frequently than actual-ratio tax-payers are required to do.

d. Modifications to step two

New Fixed Ratio

The 1996 final regulations revised thefixed ratio for banks downward to 93 per-cent. Since then, foreign bank taxpayershave commented that 93 percent is not rep-resentative of regulated banking industrycapital structures. Foreign bank taxpay-ers also have commented that use of theactual ratio in Step 2 presents the poten-tial for significant tax risk and uncertaintyof results, particularly when adjusting theirbooks to conform to U.S. tax principles.It appears that many foreign banks haveadopted the 93-percent fixed ratio despiteindications that many operate on a smallerequity capital structure.

Notice 2005–53 indicated that the Trea-sury Department and the IRS were con-sidering increasing the fixed ratio. In or-der to improve administration by aligningthe fixed ratio more closely with an ap-proximation of current average banking in-dustry balance sheet ratios estimated un-der U.S. tax principles, these temporaryregulations revise the fixed ratio for for-eign banks upward to 95 percent. Thenew fixed ratio may be adopted by for-eign banks for the first year in which theoriginal tax return due date (including ex-tensions) is after August 17, 2006, or forany subsequent year. The ratio may beadopted, for example, for the 2005 calen-dar year even if the original return wasfiled before these regulations were pub-lished. Taxpayers that want to try to sup-port any further revision to the fixed ra-tio would have to submit detailed, specific,compelling evidence to that effect.

Branch Profits Tax Consequences ofFixed-Ratio Election

Use of the new 95-percent fixed ratioin Step 2 conceivably could give rise tobranch profits tax consequences. For ex-ample, a taxpayer that elects the new fixedratio and that had been using either the93-percent fixed ratio or an actual ratio thatis less than 95 percent could be viewedunder the branch profits tax rules as hav-ing experienced a decrease in net equity,thus giving rise to a dividend equivalentamount. One comment received in re-sponse to Notice 2005–53 requested thatregulations implementing the notice pro-vide special immunity from branch profitstax consequences except to the extent thata taxpayer benefited from the 1996 reduc-tion of the fixed ratio from 95 percent to93 percent.

Such consequences under the branchprofits tax rules should arise only to theextent a taxpayer uses a 95-percent ra-tio that is substantially higher than the ra-tio used in the prior year, and the tax-payer’s asset base has not increased suf-ficiently in the ordinary course of busi-ness to cause current and accumulated ef-fectively connected earnings and profitsto be treated as reinvested. The 1996 fi-nal regulations identify the actual ratio asthe preferred method, and taxpayers havealways been entitled to elect their actualratio. Accordingly, the Treasury Depart-

September 25, 2006 520 2006–39 I.R.B.

ment and the IRS believe that granting thecommenter’s request is unnecessary and insome cases could produce an inappropri-ate windfall. In addition, considerable ad-ministrative difficulties would complicateefforts to identify and recapture prior taxbenefits that may have resulted from theincrease in net equity when the fixed ra-tio was reduced in the 1996 final regula-tions and to track the deferred componentof the computation through the interveningyears up to and including the effective dateof the new fixed ratio. Further, a specialrule of the type requested is inconsistentwith the expectation of reduced effectivelyconnected income through increased inter-est expense allocations that result from thehigher ratio. Finally, any branch profitstax consequences of a new fixed-ratio elec-tion may be mitigated by applicable taxtreaties and by the expanded availability ofthe liability-reduction election under sec-tion 884, as further discussed in Section 3.Accordingly, the comment is not adopted.

Elections

Taxpayers that currently have electedthe fixed ratio for Step 2 may use the re-vised 95-percent ratio for the first tax yearfor which the original tax return due date(including extensions) is after August 17,2006. Remaining on the fixed ratio doesnot constitute the election of a new five-year minimum period. For example, a tax-payer that used the 93-percent fixed ratiofor three years preceding the publication ofthese regulations and used the 95-percentfixed ratio for three more years would beentitled to elect the actual ratio method inthe following year.

Foreign bank taxpayers that currentlyuse the actual ratio for Step 2 may makea binding five-year election to use the new95-percent fixed ratio for the first year thisamendment is effective, on either an orig-inal return or on an amended return filedwithin 180 days of the extended due date.An amended return election may not bemade for any year where the extended duedate for a timely filing is after December31, 2006. If a fixed-ratio election is notmade for the first year these regulations areeffective, a taxpayer using the actual ratiomay make the fixed-ratio election in anysubsequent year, but only on a timely filedreturn.

Eligibility

Under the 1996 final regulations, the93-percent fixed ratio is available to for-eign banks, which are defined for thispurpose as banks within the meaning ofsection 585(a)(2)(B), without regard to thesecond sentence thereof. This definitionexcludes foreign banking corporationsthat are not engaged in a banking businesswithin the United States. This has theeffect of excluding a foreign corporationthat is engaged in the banking businessoutside the United States but terminatesits U.S. banking licenses and continues toengage in a nonregulated trade or businesswithin the United States.

The Treasury Department and the IRSintend that a taxpayer that meets the re-quirements of section 581 when consid-ered on a worldwide basis should be eli-gible to elect the fixed ratio applicable tobanks under §1.882–5 without regard towhether it remains engaged in a bankingbusiness within the United States. There-fore, a taxpayer that is regulated as a bankin its home country, takes deposits, andmakes loans as a substantial part of itsbusiness outside the United States will beeligible to elect the 95-percent fixed ratio.

e. Modifications to step three

Excess Interest

A foreign bank that uses the AUSBLmethod to determine its allocable inter-est expense may be required to allocateinterest expense in addition to its U.S.-booked interest expense if U.S.-connectedliabilities exceed U.S.-booked liabilities.The 1996 final regulations provide thatthe interest rate required to be applied toexcess U.S.-connected liabilities is gener-ally the foreign bank’s average U.S.-dollarborrowing rate outside the United States.This rule was a change from the 1981regulations, which had allowed taxpayersto use published rates under certain con-ditions. Taxpayers have commented in-formally that using actual non-U.S. dollarborrowing costs in all circumstances im-poses significant administrative burdens.

The Treasury Department and the IRSagree that the use of published data ratherthan the actual borrowing rate requirementwould simplify administration of the ex-cess-interest computation both for taxpay-ers and for the IRS. Notice 2005–53 an-

nounced the intention to permit the useof the published 30-day average LondonInterbank Offering Rate (LIBOR) for taxyears beginning after the date the noticewas published.

In response to Notice 2005–53, twocomments were received. One commentstated that the proposal to use published30-day LIBOR rates would make sense ifit has been difficult for banks to calculatetheir actual rate of interest and that con-sideration might be given to making sucha rule available for prior years. The othercomment stated that a small sample ofavailable information suggested that the90-day LIBOR rate rather than the 30-dayrate may be more representative of thesampled banks and suggested that the IRSreview tax returns with excess interest.

IRS experience in actual cases involv-ing excess interest supports the adoption ofa 30-day LIBOR rate rather than a 90-dayLIBOR rate. In view of IRS experienceand the absence of contrary data, thesetemporary regulations allow an annualbinding election to use a published 30-dayaverage LIBOR rate beginning with thefirst tax year in which an original tax re-turn is due (including extensions) afterAugust 17, 2006. Taxpayers may continueto use their actual U.S.-dollar borrowingrate in lieu of the 30-day LIBOR rate.

Relevant excess U.S.-connected liabilities

These temporary and proposed regu-lations provide that the determination ofthe actual U.S.-dollar borrowing rate ap-plicable to excess U.S.-connected liabil-ities is made with regard only to U.S.-dollar liabilities that are booked outsidethe United States and that do not con-stitute U.S.-booked liabilities as defined.The rate applicable to excess U.S.-con-nected liabilities is intended to reflect therate applicable to relevant borrowings andbook interest expense that has not other-wise been allocated. Because interest withrespect to U.S.-booked liabilities is alloca-ble under Step 3 of the AUSBL method,including such interest expense in the de-termination of the rate applicable to excessU.S.-connected liabilities could distort thecalculation.

Elections

The 30-day LIBOR election may beadopted on a year-to-year basis. For the

2006–39 I.R.B. 521 September 25, 2006

first tax year in which the original tax-re-turn due date (including extensions) is af-ter August 17, 2006 and not later than De-cember 31, 2006, taxpayers may make the30-day LIBOR election on an original re-turn, or on an amended return within 180days of the original extended due date.For subsequent years, the election must bemade on an original tax return timely filed(including extensions). The election ismade by attaching a statement to the returnidentifying the three-steps of the AUSBLcalculation and the published rate used.An election to use a 30-day LIBOR rate isbinding for such taxable year and may notbe changed on an amended return for anyyear. Accordingly, a taxpayer is bound bythe published rate used on its original re-turn. If a taxpayer does not timely file anincome tax return, then the opportunity tomake a timely 30-day LIBOR election willbe forfeited for the tax year. Consistentwith the general rules for untimely elec-tions, in such circumstances, the Directorof Field Operations may require a taxpayerto use the actual U.S.-dollar borrowing rateor apply a published 30-day LIBOR ratefor the year.

3. Liability Reduction Election UnderBranch Profits Tax

In general, the branch profits tax isimposed under section 884(a) in additionto the corporate income tax under section882 and applies only to amounts that aretreated as repatriated from the branch.These amounts are determined by refer-ence to a foreign corporation’s effectivelyconnected earnings and profits for a yearand accumulated effectively connectedearnings and profits, adjusted upward toreflect decreases in U.S. net equity andadjusted downward to reflect increases inU.S. net equity. Adjustments to net equitygenerally are made by comparing U.S. netequity at the end of a taxable year to U.S.net equity at the beginning of a taxableyear.

The branch profits tax rules imputeequity capital to a branch according to aformula that treats a portion of reinvestedamounts as having been funded by in-debtedness. This generally reduces U.S.net equity and so gives rise to a dividendequivalent amount. Regulations providethat a taxpayer may elect to treat reinvestedearnings as equity capital (rather than as

debt-funded capital) by reducing U.S. lia-bilities as of the determination date. Theamount of liabilities eligible for reductionunder this election is limited to the ex-cess of U.S. liabilities (which is generallybased on U.S.-connected liabilities, as de-fined under §1.882–5) over U.S.-bookedliabilities (as defined under §1.882–5) asof the determination date. An electionto reduce liabilities under §1.884–1 alsoreduces the interest deduction availableunder §1.882–5.

Taxpayers have expressed uncertaintyregarding the policy served by settingU.S.-booked liabilities as a floor for liabil-ity reduction and have requested greaterlatitude to treat earnings as reinvested.For example, taxpayers have noted thatthe amount of U.S.-booked liabilities isnot relevant to the §1.882–5 allocationunder the separate currency pools method.They have noted also that the amount ofU.S.-booked liabilities taken into accountunder the AUSBL method is an averagebalance for the year that may differ signif-icantly from a year-end balance.

The Treasury Department and the IRSbelieve that it is desirable to more nearlyalign the branch profits tax treatment ofdistributed earnings with the tax treatmentof a subsidiary’s distributed earnings whileretaining integration with the interest al-location rules provided in §1.882–5. Inview of taxpayer comments, these tempo-rary regulations permit a taxpayer to re-duce U.S. liabilities to the extent neces-sary to prevent recognition of a dividendequivalent amount. However, this elec-tion may not reduce U.S. liabilities belowzero. The other liability-reduction rules of§1.884–1(e)(3) continue to apply in theirentirety. An example in the final regula-tions is amended in the temporary regula-tions to reflect the new limitation rule. Thenew liability reduction election is effectivefor the first year for which the original taxreturn due date (including extensions) isafter August 17, 2006. For tax years forwhich the first original tax return due date(including extensions) is not later than De-cember 31, 2006, a liability reduction elec-tion may be made on an amended returnwithin 180 days after the original extendeddue date for filing the original return.

4. Clarifications of 1996 FinalRegulations

Questions have arisen regarding the ap-plication of certain rules contained in the1996 final regulations. These temporaryregulations clarify the application of the1996 final regulations with respect to cer-tain direct interest allocations, certain re-quirements applicable to elections gener-ally under §1.882–5, the definition of U.S.-booked liability, and the treatment of cer-tain currency gain and loss for purposes of§1.882–5.

a. Direct interest allocations

The direct interest allocation rules un-der §1.882–5 provide generally that a for-eign taxpayer with both a U.S. asset andindebtedness that meet the requirementsof both §1.861–10T(b) and (c) may treatthe asset and the indebtedness as an inte-grated financial transaction and so may al-locate interest expense with respect to theindebtedness directly to income from theasset. In general, §1.861–10T(b) providesrules for certain nonrecourse indebtedness,and §1.861–10T(c) provides rules for cer-tain integrated financial transactions. Fi-nancial institutions may allocate interestdirectly only to the extent provided bythe nonrecourse indebtedness rules. Thesetemporary regulations clarify that a finan-cial institution is not disqualified from di-rect allocation treatment by satisfying onlythe rules provided in §1.861–10T(b) withrespect to particular nonrecourse indebted-ness transactions. These temporary regu-lations also clarify that direct allocation ismandatory for eligible taxpayers if the re-quirements of either §1.861–10T(b) or (c)are satisfied.

b. General election requirements

The 1996 final regulations specifythe time, place, and manner for makingelections under each step of the formula.These temporary regulations clarify that ataxpayer eligible to change an election asof right after the minimum five-year pe-riod may do so only on an original timelyfiled return. These temporary regulationsalso clarify that the election proceduresprohibit relief under §301.9100 for futureelections as well as the elections in thefirst year a taxpayer is subject to the rules.These temporary regulations also clarify

September 25, 2006 522 2006–39 I.R.B.

that after the minimum five-year period,a taxpayer may change an election on atimely filed return for any subsequent year.For example, leaving an election in placein the sixth year after the election wasmade does not constitute a new electionsubject to a new 5-year minimum period.The general election provision is updatedto provide expressly that the elections touse the fair market value method elec-tion and the 30-day LIBOR rate electionare subject to their own specific periodrequirements instead of the five-year min-imum period.

c. U.S.-booked liabilities

The definition of U.S.-booked liabilityhas changed over time. The 1981 finalregulations defined U.S.-booked liabili-ties to include only liabilities shown onthe books and records of the U.S. tradeor business. This definition excluded as-sets that produced effectively connectedincome but were booked and maintainedin a foreign branch. The 1996 final regu-lations modified the definition to includegenerally, for non banks, liabilities that arerecorded reasonably contemporaneouslywith their acquisition on a set of booksthat has a direct relationship to an activitythat gives rise to effectively connected in-come. For banks, liabilities generally mustbe recorded contemporaneously with theiracquisition. These rules do not requiretracing of specific borrowings to specificeffectively connected uses. Whether thereis a direct connection between the liabilityand an activity that produces effectivelyconnected income is determined under allthe facts and circumstances.

These temporary regulations amend thedefinition of U.S.-booked liability and pro-vide an example to clarify that in the caseof a bank, the liability must be recorded ona set of books before the end of the dayon which it is incurred, and the liabilityrelates to an activity that produces effec-tively connected income. The reasonablycontemporaneous booking rule is retainedfor non banks and the language clarifiedto reassert that the liability must relate toan activity that produces effectively con-nected income.

d. Currency gain and loss

A foreign bank’s U.S. branch com-monly books third-party liabilities de-

nominated in non-dollar currencies anduses the proceeds to make interbranchloans. Because interbranch transactionsgenerally are not recognized for U.S. taxpurposes, the third-party liability is treatedas unhedged. As noted in the pream-ble to the 1996 final regulations, foreigncurrency gain or loss from an unhedgedliability remains subject to the rules of sec-tion 988. As a result, the U.S. branch mayhave currency gain or loss with respect tothe third-party borrowing but may not beentitled to recognize currency gain or losswith respect to the offsetting interbranchtransaction. In addition, any scaling downof interest expense that might otherwise berequired under the AUSBL method doesnot apply to foreign currency gain or loss.

Some taxpayers have suggested infor-mally that, despite the absence of a gen-eral tracing principle in the interest allo-cation rules, currency gain and loss fromsuch third-party liabilities should be trace-able to currency gains and losses with re-spect to specific interbranch and noneffec-tively connected assets. The Treasury De-partment and the IRS solicit comments re-garding the allocation, sourcing, and ap-portionment of currency gain or loss fromunhedged third-party borrowings betweeneffectively connected and non-effectivelyconnected income. Comments are specif-ically requested regarding the viability ofa tracing principle for this purpose andthe extent to which current booking prac-tices may provide an administrable basisfor such rules in accordance with existingauthority.

5. Effective Date

The temporary regulations are applica-ble for the first tax year end for whichthe original tax return due date (includ-ing extensions) is after August 17, 2006.Accordingly, for calendar-year taxpayers,the applicability date is for the tax yearended December 31, 2005. The rules pro-vide an additional 180 days to make certainone-time special elections on an amendedreturn for tax years for which the originaltax return due date is not later than Decem-ber 31, 2006.

Special Analyses

It has been determined that this Treasurydecision is not a significant regulatory ac-tion as defined in Executive Order 12866.

Therefore, a regulatory assessment is notrequired. It also has been determined thatsection 553(b) of the Administrative Pro-cedure Act (5 U.S.C. chapter 5) does notapply to these regulations. For applica-bility of the Regulatory Flexibility Act(5 U.S.C. chapter 6) please refer to thecross reference notice of proposed rule-making published elsewhere in this issueof the Bulletin. Pursuant to section 7805(f)of the Code, this regulation has been sub-mitted to the Chief Counsel for Advocacyof the Small Business Administration forcomment on its impact on small business.

Drafting Information

The principal authors of theseregulations are Paul S. Epstein andGregory A. Spring of the Office of As-sociate Chief Counsel (International).

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding entries in nu-merical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.882–5 also issued un-

der 26 U.S.C. 882, 26 U.S.C. 864(e),26 U.S.C. 988(d), and 26 U.S.C. 7701(l).* * *

Section 1.884–1 is also issued under26 U.S.C. 884. * * *

Par. 2. Section 1.882–0 is amended by:1. Revising the entries for §1.882–

5(a)(1), (a)(1)(i), (a)(1)(ii), (a)(1)(ii)(A),(a)(1)(ii)(B), (a)(2), (a)(7), (a)(7)(i),(a)(7)(ii), (b)(2)(ii)(A), (b)(3), (c)(2)(iv),(c)(4), (d)(2)(iii)(A), and (d)(5)(ii).

2. Removing the entry for §1.882–5(b)(2)(iv).

3. Adding entries for §1.882–5T. Therevisions and additions read as follows:

§1.882–0 Table of contents.

* * * * *

§1.882–5 Determination of interestdeduction.

* * * * *(a)(1) through (a)(2) [Reserved].

2006–39 I.R.B. 523 September 25, 2006

* * * * *(a)(7) through (a)(7)(iii) [Reserved].

* * * * *(b)(2)(ii)(A) [Reserved].

* * * * *(b)(3) [Reserved].

* * * * *(c)(2)(iv) [Reserved].

* * * * *(c)(4) [Reserved].

* * * * *(d)(2)(iii)(A) [Reserved].

* * * * *(d)(5)(ii) [Reserved].

* * * * *

§1.882–5T Determination of interestdeduction (temporary).

(a) [Reserved].(1) Overview.(i) In general.(ii) Direct allocations.(A) In general.(B) Partnership interests.(2) Coordination with tax treaties.(3) through (6) [Reserved].(7) Elections under §1.882–5.(i) In general.(ii) Failure to make the proper election.(iii) Step 2 special election for banks.(8) through (b)(2)(ii) [Reserved].(A) In general.(b)(2)(ii)(B) through (b)(2)(iii)(B) [Re-

served].(3) Computation of total value of U.S.

assets.(i) General rule.(ii) Adjustment to basis of financial in-

struments.(c) through (c)(2)(iii) [Reserved].(iv) Determination of value of world-

wide assets.(c)(2)(v) through (c)(3) [Reserved].(4) Elective fixed ratio method of deter-

mining U.S. liabilities.(c)(5) through (d)(2)(iii) [Reserved].(A) In general.(B) through (d)(5)(i) [Reserved].(ii) Interest rate on excess U.S.-con-

nected liabilities.(A) General rule.(B) Annual published rate election.(6) through (f)(2) [Reserved].

Par. 3. Section 1.882–5 is amended by:1. Revising paragraphs (a)(1)

through (a)(2), (a)(7) through (a)(7)(ii),(b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4),(d)(2)(ii)(A)(2), (d)(2)(ii)(A)(3),(d)(2)(iii)(A), and (d)(5)(ii).

2. Removing paragraph (b)(2)(iv).3. Adding paragraph (d)(6) Example 5.The revisions and additions read as fol-

lows:

§1.882–5 Determination of interestdeduction.

(a)(1) through (a)(2) [Reserved].For further guidance, see entry in§1.882–5T(a)(1) through (a)(2).

* * * * *(a)(7)(ii) [Reserved]. For further

guidance, see §1.882–5T(a)(7) through(a)(7)(ii).

* * * * *(b)(2)(ii)(A) [Reserved]. For further

guidance, see §1.882–5T(b)(2)(ii)(A).

* * * * *(b)(3) [Reserved]. For further guid-

ance, see §1.882–5T(b)(3).

* * * * *(c)(2)(iv) [Reserved]. For further guid-

ance, see §1.882–5T(c)(2)(iv).

* * * * *(c)(4) [Reserved]. For further guid-

ance, see §1.882–5T(c)(4).

* * * * *(d)(2)(ii)(A)(2) through (3) [Re-

served]. For further guidance, see§1.882–5T(d)(2)(ii)(A)(2) through (3).

* * * * *(d)(2)(iii)(A) [Reserved]. For further

guidance, see §1.882–5T(d)(2)(iii)(A).

* * * * *(d)(5)(ii) [Reserved]. For further guid-

ance, see §1.882–5T(d)(5)(ii).

* * * * *(d)(6) Example 5 [Reserved]. For fur-

ther guidance, see §1.882–5T(d)(6) Exam-ple 5.

Par. 4. Section 1.882–5T is added toread as follows:

§1.882–5T Determination of interestdeduction (temporary).

(a) [Reserved]. For further guidance,see §1.882–5(a).

(1) Overview—(i) In general. Theamount of interest expense of a foreigncorporation that is allocable under section882(c) to income which is (or is treatedas) effectively connected with the conductof a trade or business within the UnitedStates (ECI) is the sum of the interest al-locable by the foreign corporation underthe three-step process set forth in para-graphs (b), (c), and (d) of this section andthe specially allocated interest expensedetermined under paragraph (a)(1)(ii) ofthis section. The provisions of this sectionprovide the exclusive rules for allocatinginterest expense to the ECI of a foreigncorporation under section 882(c). Un-der the three-step process, the total valueof the U.S. assets of a foreign corpora-tion is first determined under paragraph(b) of this section (Step 1). Next, theamount of U.S.-connected liabilities isdetermined under paragraph (c) of thissection (Step 2). Finally, the amount ofinterest paid or accrued on U.S.-bookedliabilities, as determined under paragraph(d)(2) of this section, is adjusted for inter-est expense attributable to the differencebetween U.S.-connected liabilities andU.S.-booked liabilities (Step 3). Alterna-tively, a foreign corporation may elect todetermine its interest rate on U.S.-con-nected liabilities by reference to its U.S.assets, using the separate currency poolsmethod described in paragraph (e) of thissection.

(ii) Direct allocations—(A) In gen-eral. A foreign corporation that has aU.S. asset and indebtedness that meet therequirements of §1.861–10T(b) or (c), aslimited by §1.861–10T(d)(1), shall di-rectly allocate interest expense from suchindebtedness to income from such assetin the manner and to the extent providedin §1.861–10T. For purposes of paragraph(b)(1) or (c)(2) of this section, a foreigncorporation that allocates its interest ex-pense under the direct allocation rule ofthis paragraph (a)(1)(ii)(A) shall reducethe basis of the asset that meets the re-quirements of §1.861–10T(b) or (c) by theprincipal amount of the indebtedness thatmeets the requirements of §1.861–10T(b)or (c). The foreign corporation shall alsodisregard any indebtedness that meets therequirements of §1.861–10T(b) or (c) indetermining the amount of the foreigncorporation’s liabilities under paragraphs(c)(2) and (d)(2) of this section and shall

September 25, 2006 524 2006–39 I.R.B.

not take into account any interest expensepaid or accrued with respect to such a lia-bility for purposes of paragraph (d) or (e)of this section.

(B) Partnership interest. A foreign cor-poration that is a partner in a partnershipthat has a U.S. asset and indebtedness thatmeet the requirements of §1.861–10T(b)or (c), as limited by §1.861–10T(d)(1),shall directly allocate its distributive shareof interest expense from that indebtednessto its distributive share of income fromthat asset in the manner and to the extentprovided in §1.861–10T. A foreign corpo-ration that allocates its distributive shareof interest expense under the direct allo-cation rule of this paragraph (a)(1)(ii)(B)shall disregard any partnership indebt-edness that meets the requirements of§1.861–10T(b) or (c) in determining theamount of its distributive share of part-nership liabilities for purposes of para-graphs (b)(1), (c)(2)(vi), and (d)(2)(vii)or (e)(1)(ii) of this section, and shall nottake into account any partnership interestexpense paid or accrued with respect tosuch a liability for purposes of paragraph(d) or (e) of this section. For purposes ofparagraph (b)(1) of this section, a foreigncorporation that directly allocates its dis-tributive share of interest expense underthis paragraph (a)(1)(ii)(B) shall—

(1) Reduce the partnership’s basis insuch asset by the amount of such indebt-edness in allocating its basis in the partner-ship under §1.884–1(d)(3)(ii); or

(2) Reduce the partnership’s incomefrom such asset by the partnership’s inter-est expense from such indebtedness under§1.884–1(d)(3)(iii).

(2) Coordination with tax treaties. Ex-cept as expressly provided by or pursuantto a U.S. income tax treaty or accompa-nying documents (such as an exchangeof notes), the provisions of this sectionprovide the exclusive rules for determin-ing the interest expense attributable to thebusiness profits of a permanent establish-ment under a U.S. income tax treaty.

(3) through (a)(6) [Reserved]. For fur-ther guidance, see §1.882–5(a)(3) through(a)(6).

(7) Elections under §1.882–5—(i) Ingeneral. A corporation must make eachelection provided in this section on thecorporation’s original timely filed Fed-eral income tax return for the first taxableyear it is subject to the rules of this sec-

tion. An amended return does not qualifyfor this purpose, nor shall the provisionsof §301.9100–1 of this chapter and anyguidance promulgated thereunder apply.Except as provided elsewhere in this sec-tion, each election under this section,whether an election for the first taxableyear or a subsequent change of election,shall be made by the corporation calcu-lating its interest expense deduction inaccordance with the methods elected. Anelected method (other than the fair marketvalue method under §1.882–5(b)(2)(ii), orthe annual 30-day London Interbank Of-fered Rate (LIBOR) election in paragraph(d)(5)(ii) of this section) must be used fora minimum period of five years before thetaxpayer may elect a different method. Tochange an election before the end of therequisite five-year period, a taxpayer mustobtain the consent of the Commissioneror his delegate. The Commissioner orhis delegate will generally consent to ataxpayer’s request to change its electiononly in rare and unusual circumstances.After the five-year minimum period, anelected method may be changed for anysubsequent year on the foreign corpora-tion’s original timely filed tax return forthe first year to which the changed electionapplies.

(ii) Failure to make the proper election.If a taxpayer, for any reason, fails to makean election provided in this section in atimely fashion, the Director of Field Oper-ations may make any or all of the electionsprovided in this section on behalf of thetaxpayer, and such elections shall be bind-ing as if made by the taxpayer.

(iii) Step 2 special election for banks.For the first tax year for which an origi-nal income tax return is due (including ex-tensions) after August 17, 2006 and notlater than December 31, 2006, in whicha taxpayer that is a bank as described in§1.882–5(c)(4) is subject to the require-ments of this section, a taxpayer may makea new election to use the fixed ratio on ei-ther an original timely filed return, or onan amended return filed within 180 daysafter the original due date (including ex-tensions). A new fixed ratio election maybe made in any subsequent year subject tothe timely filing and five-year minimumperiod requirements of paragraph (a)(7)(i)of this section. A new fixed ratio electionunder this paragraph (a)(7)(iii) is subjectto the adjusted basis or fair market value

conforming election requirements of para-graph (b)(2)(ii)(A)(2) of this section andmay not be made if a taxpayer elects ormaintains a fair market value election forpurposes of §1.882–5(b). Taxpayers thatalready use the fixed ratio method underan existing election may continue to usethe new fixed ratio at the higher percentagewithout having to make a new five-yearelection in the first year that the higher per-centage is effective.

(8) through (b)(2)(ii) [Reserved]. Forfurther guidance, see §1.882–5(a)(8)through (b)(2)(ii) .

(A) In general—(1) Fair market valueconformity requirement. A taxpayer mayelect to value all of its U.S. assets onthe basis of fair market value, subject tothe requirements of §1.861–9T(g)(1)(iii),and provided the taxpayer is eligibleand uses the actual ratio method under§1.882–5(c)(2) and the methodology pre-scribed in §1.861–9T(h). Once elected,the fair market value must be used by thetaxpayer for both Step 1 and Step 2 de-scribed in §§1.882–5(b) and (c), and mustbe used in all subsequent taxable yearsunless the Commissioner or his delegateconsents to a change.

(2) Conforming election requirement.Taxpayers that as of the effective dateof this paragraph (b)(2)(ii)(A)(2) haveelected and currently use both the fairmarket value method for purposes of§1.882–5(b) and a fixed ratio for purposesof paragraph (c)(4) of this section mustconform either the adjusted basis or fairmarket value methods in Step 1 and Step2 of the allocation formula by making anadjusted basis election for §1.882–5(b)purposes while continuing the fixed ratiofor Step 2, or by making an actual ratioelection under §1.882–5(c)(2) while re-maining on the fair market value methodunder §1.882–5(b). Taxpayers who electto conform Step 1 and Step 2 of the for-mula to the adjusted basis method mustremain on both methods for the minimumfive-year period in accordance with theprovisions of paragraph (a)(7) of this sec-tion. Taxpayers that elect to conform Step1 and Step 2 of the formula to the fairmarket value method must remain on theactual ratio method until the consent of theCommissioner or his delegate is obtainedto switch to the adjusted basis method. Ifconsent to use the adjusted basis methodin Step 1 is granted in a later year, the

2006–39 I.R.B. 525 September 25, 2006

taxpayer must remain on the actual ratiomethod for the minimum five-year periodunless consent to use the fixed ratio isindependently obtained under the require-ments of paragraph (a)(7) of this section.For the first tax year for which an originalincome tax return is due (including exten-sions) after August 17, 2006 and not laterthan December 31, 2006, taxpayers thatare required to make a conforming elec-tion under this paragraph (b)(2)(ii)(A)(2),may do so either on a timely filed originalreturn or on an amended return within 180days after the original due date (includingextensions). If a conforming election isnot made within the timeframe providedin this paragraph, the Director of FieldOperations or his delegate may make theconforming elections in accordance withthe provisions of paragraph (a)(7)(ii) ofthis section.

(B) through (b)(2)(iii)(B) [Re-served]. For further guidance,see §1.882–5(b)(2)(ii)(B) through(b)(2)(iii)(B).

(3) Computation of total value of U.S.assets—(i) General rule. The total valueof U.S. assets for the taxable year is theaverage of the sums of the values (deter-mined under paragraph (b)(2) of this sec-tion) of U.S. assets. For each U.S. asset,value shall be computed at the most fre-quent regular intervals for which data arereasonably available. In no event shallthe value of any U.S. asset be computedless frequently than monthly (beginning oftaxable year and monthly thereafter) by alarge bank (as defined in section 585(c)(2))or a dealer in securities (within the mean-ing of section 475) and semi-annually (be-ginning, middle and end of taxable year)by any other taxpayer.

(ii) Adjustment to basis of financial in-struments. For purposes of determiningthe total average value of U.S. assets inthis paragraph (b)(3), the value of a se-curity or contract that is marked to mar-ket pursuant to section 475 or section 1256will be determined as if each determina-tion date is the most frequent regular inter-val for which data are reasonably availablethat reflects the taxpayer’s consistent busi-ness practices for reflecting mark-to-mar-ket valuations on its books and records.

(c) through (c)(2)(iii) [Reserved]. Forfurther guidance, see §1.882–5(c) through(c)(2)(iii).

(iv) Determination of value of world-wide assets. The value of an asset must bedetermined consistently from year to yearand must be substantially in accordancewith U.S. tax principles. To be substan-tially in accordance with U.S. tax princi-ples, the principles used to determine thevalue of an asset must not differ from U.S.tax principles to a degree that will ma-terially affect the value of the taxpayer’sworldwide assets or the taxpayer’s actualratio. The value of an asset is the adjustedbasis of that asset for determining the gainor loss from the sale or other disposition ofthat asset, adjusted in the same manner asthe basis of U.S. assets are adjusted underparagraphs (b)(2)(ii) through (iv) of thissection. The rules of §1.882–5(b)(3)(ii)apply in determining the total value ofapplicable worldwide assets for the tax-able year, except that the minimum num-ber of determination dates are those statedin §1.882–5(c)(2)(i).

(c)(2)(v) through (c)(3) [Reserved]. Forfurther guidance, see §1.882–5(c)(2)(v)through (c)(3).

(4) Elective fixed ratio method of deter-mining U.S. liabilities. A taxpayer that isa bank as defined in section 585(a)(2)(B)(without regard to the second sentencethereof or whether any such activities areeffectively connected with a trade or busi-ness within the United States) may elect touse a fixed ratio of 95 percent in lieu of theactual ratio. A taxpayer that is neither abank nor an insurance company may electto use a fixed ratio of 50 percent in lieu ofthe actual ratio.

(5) through (d)(2)(ii)(A)(1) [Reserved].For further guidance, see §1.882–5(c)(5)through (d)(2)(ii)(A)(1).

(2) The foreign corporation enters theliability on a set of books reasonably con-temporaneous with the time at which theliability is incurred and the liability relatesto an activity that produces ECI.

(3) The foreign corporation maintains aset of books and records relating to an ac-tivity that produces ECI and the Director ofField Operations determines that there is adirect connection or relationship betweenthe liability and that activity. Whetherthere is a direct connection between the li-ability and an activity that produces ECIdepends on the facts and circumstances ofeach case.

(d)(2)(ii)(B) through (d)(2)(iii) [Re-served]. For further guidance, see§1.882–5(d)(2)(ii)(B) through (d)(2)(iii).

(A) In general. A liability, whetherinterest bearing or non-interest bearing,is properly reflected on the books of theU.S. trade or business of a foreign corpo-ration that is a bank as described in section585(a)(2)(B) (without regard to the secondsentence thereof) if—

(1) The bank enters the liability on aset of books before the close of the dayon which the liability is incurred, and theliability relates to an activity that producesECI; and

(2) There is a direct connection or rela-tionship between the liability and that ac-tivity. Whether there is a direct connectionbetween the liability and an activity thatproduces ECI depends on the facts and cir-cumstances of each case. For example, aliability that is used to fund an interbranchor other asset that produces non-ECI mayhave a direct connection to an ECI pro-ducing activity and may constitute a U.S.-booked liability if both the interbranch ornon-ECI activity is the same type of activ-ity in which ECI assets are also reflectedon the set of books (for example, lendingor money market interbank placements),and such ECI activities are not de minimis.Such U.S. booked liabilities may still besubject to §1.882–5(d)(2)(v).

(B) through (d)(5)(i) [Re-served]. For further guidance, see§1.882–5(d)(2)(iii)(B) through (d)(5)(i).

(ii) Interest rate on excess U.S.-con-nected liabilities—(A) General rule.The applicable interest rate on excessU.S.-connected liabilities is determined bydividing the total interest expense paid oraccrued for the taxable year on U.S.-dol-lar liabilities that are not U.S.-bookedliabilities (as defined in §1.882–5(d)(2))and that are shown on the books of theoffices or branches of the foreign corpo-ration outside the United States by theaverage U.S.-dollar denominated liabili-ties (whether interest-bearing or not) thatare not U.S.-booked liabilities and thatare shown on the books of the offices orbranches of the foreign corporation out-side the United States for the taxable year.

(B) Annual published rate election.For each taxable year beginning with thefirst year end for which the original taxreturn due date (including extensions) isafter August 17, 2006, in which a tax-

September 25, 2006 526 2006–39 I.R.B.

payer is a bank within the meaning ofsection 585(a)(2)(B) (without regard tothe second sentence thereof or whetherany such activities are effectively con-nected with a trade or business within theUnited States), such taxpayer may elect tocompute its excess interest by referenceto a published average 30-day LondonInterbank Offering Rate (LIBOR) for theyear. The election may be made for anyeligible year by attaching a statement toa timely filed tax return (including exten-sions) that shows the 3-step components ofthe taxpayer’s interest expense allocationunder the adjusted U.S.-booked liabilitiesmethod and identifies the provider (forexample, International Monetary Fundstatistics) of the 30-day LIBOR rate se-lected. Once selected, the provider and therate may not be changed by the taxpayer.If a taxpayer that is eligible to make the30-day LIBOR election either does notfile a timely return or files a calculationthat allocates interest expense under thescaling ratio in §1.882–5(d)(4) and it isdetermined by the Director of Field Oper-ations that the taxpayer’s U.S.-connectedliabilities exceed its U.S.-booked liabili-ties, then the Director of Field Operations,and not the taxpayer, may choose whetherto determine the taxpayer’s excess interestrate under paragraph (d)(5)(ii)(A) or (B) ofthis section and may select the published30-day LIBOR rate. For the first taxableyear for which an original tax return duedate (including extensions) is after August17, 2006 and not later than December 31,2006, an eligible taxpayer may make the30-day LIBOR election one time for thetaxable year on an amended return within180 days after the original due date (in-cluding extensions).

(d)(6) through (d)(6) Example 4[Reserved]. For further guidance, see§1.882–5(d)(6) through (d)(6) Example 4.

Example 5. U.S. booked liabilities— direct rela-tionship. (i) Facts. Bank A, a resident of Country Xmaintains a banking office in the U.S. that recordstransactions on three sets of books for State A, anInternational Banking Facility (IBF) for its bankregulatory approved international transactions, and ashell branch licensed operation in Country C. Bank Arecords substantial ECI assets from its bank lendingand placement activities and a mix of interbranchand non-ECI producing assets from the same orsimilar activities on the books of State A branchand on its IBF. Bank A’s Country C branch borrowssubstantially from third parties, as well as from itshome office, and lends all of its funding to its State Abranch and IBF to fund the mix of ECI, interbranch

and non-ECI activities on those two books. The con-solidated books of State A branch and IBF indicatethat a substantial amount of the total book assetsconstitute U.S. assets under §1.882–5(b). Some ofthe third-party borrowings on the books of the StateA branch are used to lend directly to Bank A’s homeoffice in Country X. These borrowings reflect theaverage borrowing rate of the State A branch, IBFand Country C branches as a whole. All third-partyborrowings reflected on the books of State A branch,the IBF and Country C branch were recorded on suchbooks before the close of business on the day theliabilities were acquired by Bank A.

(ii) U.S. booked liabilities. The facts demonstratethat the separate State A branch, IBF and Country Cbranch books taken together, constitute a set of bookswithin the meaning of (d)(2)(iii)(A)(1) of this sec-tion. Such set of books as a whole has a direct rela-tionship to an ECI activity under (d)(2)(iii)(A)(2) ofthis section even though the Country C branch booksstanding alone would not. The third-party liabilitiesrecorded on the books of Country C constitute U.S.booked liabilities because they were timely recordedand the overall set of books on which they were re-flected has a direct relationship to a bank lendingand interbank placement ECI producing activity. Thethird-party liabilities that were recorded on the booksof State A branch that were used to lend funds to BankA’s home office also constitute U.S. booked liabili-ties because the interbranch activity the funds wereused for is a lending activity of a type that also givesrise to a substantial amount of ECI that is properlyreflected on the same set of books as the interbranchloans. Accordingly, the liabilities are not traced totheir specific interbranch use but to the overall activ-ity of bank lending and interbank placements whichgives rise to substantial ECI. The facts show that theliabilities were not acquired to increase artificially theinterest expense of Bank A’s U.S. booked liabilities asa whole under §1.882–5(d)(2)(v). The third-party lia-bilities also constitute U.S. booked liabilities for pur-poses of determining Bank A’s branch interest under§1.884–4(b)(1)(i)(A) regardless of whether Bank Auses the Adjusted U.S. booked liability method, orthe Separate Currency Pool method to allocate its in-terest expense under §1.882–5(e).

(e) through (f)(2) [Reserved]. For fur-ther guidance, see §1.882–5(e) through(f)(2).

(g) Effective date. (1) This section isapplicable for the first tax year in whichan original tax return due date (includingextensions) is after August 17, 2006.

(2) The applicability of this section ex-pires on or before August 14, 2009.

Par. 5. Section 1.884–1 is amendedby revising the entries for paragraphs(e)(3)(ii), (e)(3)(iv) and (e)(5) Example 2.

§1.884–1 Branch profits tax.

* * * * *(e)(3)(ii) [Reserved]. For further guid-

ance, see entry in §1.884–1T(e)(3)(ii).

* * * * *

(e)(3)(iv) [Reserved]. For further guid-ance, see entry in §1.884–1T(e)(3)(iv).

* * * * *(e)(5) Example 2 [Reserved].

For further guidance, see entry in§1.884–1T(e)(5) Example 2.

* * * * *Par. 6. Section 1.884–1T is added to

read as follows:

§1.884–1T Branch profits tax (temporary).

(a) through (e)(3)(i) [Reserved]. Forfurther guidance, see §1.884–1(a) through(e)(3)(i).

(ii) Limitation. For any taxable year,a foreign corporation may elect to reducethe amount of its liabilities determined un-der paragraph §1.884–1(e)(1) of this sec-tion by an amount that does not exceed thelesser of the amount of U.S. liabilities asof the determination date, or the amount ofU.S. liability reduction needed to reduce adividend equivalent amount as of the de-termination date to zero.

(iii) [Reserved]. For further guidance,see §1.884–1(e)(3)(iii).

(iv) Method of election. A foreign cor-poration that elects the benefits of thisparagraph (e)(3) for a taxable year shallstate on its return for the taxable year (oron a statement attached to the return) thatit has elected to reduce its liabilities for thetaxable year under this paragraph (e)(3)and that it has reduced the amount of itsU.S.-connected liabilities as provided in§1.884–1(e)(3)(iii), and shall indicate theamount of such reductions on the return orattachment. An election under this para-graph (e)(3) must be made before the duedate (including extensions) for the foreigncorporation’s income tax return for thetaxable year, except that for the first taxyear for which the original tax return duedate (including extensions) is after August17, 2006 and not later than December 31,2006, an election under this paragraph(e)(3) may be made on an amended returnwithin 180 days after the original due date(including extensions).

(v) through (e)(5) Example 1 [Re-served]. For further guidance, see§1.884–1(e)(3)(v) through (e)(5) Example1.

Example 2. Election made to reduce liabilities.(i) As of the close of 2007, foreign corporation A, areal estate company, owns U.S. assets with an E&P

2006–39 I.R.B. 527 September 25, 2006

basis of $1000. A has $800 of liabilities under para-graph (e)(1) of this section. A has accumulated ECEPof $500 and in 2008, A has $60 of ECEP that it in-tends to retain for future expansion of its U.S. tradeor business. A elects under paragraph (e)(3) of thissection to reduce its liabilities by $60 from $800 to$740. As a result of the election, assuming A’s U.S.assets and U.S. liabilities would otherwise have re-mained constant, A’s U.S. net equity as of the closeof 1994 will increase by the amount of the decreasein liabilities ($60) from $200 to $260 and its ECEPwill be reduced to zero. Under §1.884–1(e)(3)(iii),A’s interest expense for the taxable year is reducedby the amount of interest attributable to $60 of liabil-ities and A’s excess interest is reduced by the sameamount. A’s taxable income and ECEP are increasedby the amount of the reduction in interest expense at-tributable to the liabilities, and A may make an elec-tion under paragraph (e)(3) of this section to furtherreduce its liabilities, thus increasing its U.S. net eq-uity and reducing the amount of additional ECEP cre-ated for the election.

(ii) In 2009, assuming A again has $60 of ECEP,A may again make the election under paragraph (e)(3)to reduce its liabilities. However, assuming A’s U.S.assets and liabilities under paragraph (e)(1) of thissection remain constant, A will need to make an elec-

tion to reduce its liabilities by $120 to reduce to zeroits ECEP in 2009 and to continue to retain for expan-sion (without the payment of the branch profits tax)the $60 of ECEP earned in 2008. Without an electionto reduce liabilities, A’s dividend equivalent amountfor 2009 would be $120 ($60 of ECEP plus the $60reduction in U.S. net equity from $260 to $200). If Amakes the election to reduce liabilities by $120 (from$800 to $680), A’s U.S. net equity will increase by$60 (from $260 at the end of the previous year to$320), the amount necessary to reduce its ECEP to $0.However, the reduction of liabilities will itself createadditional ECEP subject to section 884 because of thereduction in interest expense attributable to the $120of liabilities. A can make the election to reduce liabil-ities by $120 without exceeding the limitation on theelection provided in paragraph (e)(3)(ii) of this sec-tion because the $120 reduction does not exceed theamount needed to treat the 2009 and 2008 ECEP asreinvested in the net equity of the trade or businesswithin the United States.

(iii) If A terminates its U.S. trade or business in2009 in accordance with the rules in §1.884–2T(a), Awould not be subject to the branch profits tax on the$60 of ECEP earned in that year. Under paragraph§1.884–1(e)(3)(v) of this section, however, it wouldbe subject to the branch profits tax on the portion of

the $60 of ECEP that it earned in 2008 that becameaccumulated ECEP because of an election to reduceliabilities.

(f) through (j)(2)(ii) [Reserved]. Forfurther guidance, see §1.884–1(f) through(j)(2)(ii).

PART 602—OMB CONTROLNUMBER UNDER THE PAPERWORKREDUCTION ACT

Par. 7. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.Par. 8. In §602.101, paragraph

(b) is amended by adding an entry for“§1.882–5T” to the table to read as fol-lows:

§601.101 OMB Control numbers.

* * * * *(b) * * *

CFR part or section whereidentified and described

Current OMBControl No.

* * * * *

1.882–5T . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–2030

* * * * *

Mark E. Matthews,Deputy Commissioner

for Services and Enforcement.

Approved August 2, 2006.

Eric Solomon,Acting Deputy Assistant Secretary

of the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on August 15,2006, 8:45 a.m., and published in the issue of the FederalRegister for August 17, 2006, 71 F.R. 47443)

September 25, 2006 528 2006–39 I.R.B.

Part III. Administrative, Procedural, and MiscellaneousExtension of ReplacementPeriod for Livestock Sold onAccount of Drought

Notice 2006–82

SECTION 1. PURPOSE

This notice provides guidance regard-ing the replacement period under § 1033(e)of the Internal Revenue Code for livestocksold on account of drought.

SECTION 2. BACKGROUND

.01 Nonrecognition of Gain on Invol-untary Conversion of Livestock. Section1033(a) generally provides for nonrecog-nition of gain when property is involun-tarily converted and replaced with prop-erty that is similar or related in service oruse. Section 1033(e)(1) provides that asale or exchange of livestock (other thanpoultry) held by a taxpayer for draft, breed-ing, or dairy purposes in excess of the num-ber that would be sold following the tax-payer’s usual business practices is treatedas an involuntary conversion if the live-stock is sold or exchanged solely on ac-count of drought, flood, or other weather-related conditions.

.02 Replacement Period. Section1033(a)(2)(A) generally provides thatgain from an involuntary conversion isrecognized only to the extent the amountrealized on the conversion exceeds thecost of replacement property purchasedduring the replacement period. If a saleor exchange of livestock is treated as aninvoluntary conversion under § 1033(e)(1)and is solely on account of drought, flood,or other weather-related conditions that re-sult in the area being designated as eligiblefor assistance by the federal government,§ 1033(e)(2)(A) provides that the replace-ment period ends four years after the closeof the first taxable year in which any partof the gain from the conversion is realized.Section 1033(e)(2)(B) provides that theSecretary may extend this replacement pe-riod on a regional basis for such additionaltime as the Secretary determines appro-priate if the weather-related conditionsthat resulted in the area being designatedas eligible for assistance by the federalgovernment continue for more than three

years. Section 1033(e)(2) is effective forany taxable year with respect to which thedue date (without regard to extensions) fora taxpayer’s return is after December 31,2002.

SECTION 3. EXTENSION OFREPLACEMENT PERIOD FORPERSISTENT DROUGHT

.01 In General. If a sale or exchangeof livestock is treated as an involun-tary conversion on account of droughtand the taxpayer’s replacement period isdetermined under § 1033(e)(2)(A), thereplacement period will be extended un-der § 1033(e)(2)(B) until the end of thetaxpayer’s first taxable year ending afterthe first drought-free year for the appli-cable region. For this purpose, the firstdrought-free year for the applicable regionis the first 12-month period that—

(1) Ends on August 31;(2) Ends in or after the last year of the

taxpayer’s 4-year replacement period de-termined under § 1033(e)(2)(A); and

(3) Does not include any weekly periodfor which exceptional, extreme, or severedrought is reported for any location in theapplicable region.

.02 Applicable Region. The applicableregion with respect to a sale or exchange oflivestock on account of drought conditionsis the county that experienced the droughtconditions on account of which the live-stock was sold or exchanged and all coun-ties that are contiguous to that county.

.03 Exceptional, Extreme, or SevereDrought. (1) U.S. Drought Monitor Maps.A taxpayer may determine whether ex-ceptional, extreme, or severe drought isreported for any location in the applica-ble region by reference to U.S. DroughtMonitor maps produced by the NationalDrought Mitigation Center. In determin-ing whether a 12-month period ending onAugust 31 of a calendar year includes anyperiod for which exceptional, extreme,or severe drought is reported, all mapswith dates before September 8 of thatyear and after August 31 of the preced-ing calendar year are taken into account.U.S. Drought Monitor maps are archivedat http://www.drought.unl.edu/dm/archive.html.

(2) Publication of List of DroughtCounties. Taxpayers can generally deter-mine on the basis of a visual inspectionof U.S. Drought Monitor maps whetherexceptional, extreme, or severe droughtis reported for all or part of a county. Insome cases, however, on the borders ofa drought zone, it may not be clear onthe basis of a visual inspection whether acounty is within or partly within the zone.Accordingly, the Internal Revenue Ser-vice, after consultation with the NationalDrought Mitigation Center, will publish inSeptember of each year a list of countiesfor which exceptional, extreme, or severedrought was reported during the preceding12 months. Taxpayers may use this listinstead of U.S. Drought Monitor Mapsto determine whether a 12-month periodending on August 31 of a calendar yearincludes any period for which exceptional,extreme, or severe drought is reported fora location in the applicable region.

SECTION 4. EXAMPLE

The following example illustrates theapplication of the rules in this notice.Drought conditions and designations ofeligibility for federal assistance are de-scribed in this example solely for illus-trative purposes and are not intended toreflect actual conditions and designations.

Example. (i) Taxpayer A, a calendar year tax-payer, raises cattle in Keith County, Nebraska. In2002, all of A’s cattle held for breeding purposes aresold solely on account of drought conditions in KeithCounty. Under A’s normal business practices, only25 percent of A’s cattle held for breeding purposeswould have been sold in 2002. In 2003, the Secre-tary of Agriculture designates Keith County as eligi-ble for federal assistance on account of the droughtconditions.

(ii) Under § 1033(e)(1), the sale of 75 percentof the cattle held for breeding purposes is treated asan involuntary conversion. Section 1033(a) providesthat the gain from this portion of A’s sale is not rec-ognized except to the extent it exceeds the cost ofreplacement property (property that is related in ser-vice or use) purchased during the replacement period.Because the Secretary of Agriculture has designatedKeith County as being eligible for federal assistanceon account of the drought conditions, A’s replace-ment period is determined under § 1033(e)(2)(A) andends on December 31, 2006.

(iii) Under § 1033(e)(2) and this notice, A’s re-placement period is extended until the end of A’sfirst taxable year ending after the first drought-freeyear for the applicable region. For this purpose, theapplicable region is the county that experienced thedrought conditions on account of which the livestock

2006–39 I.R.B. 529 September 25, 2006

was sold (Keith County) and all counties contiguousto Keith County (Deuel, Garden, Arthur, McPher-son, Lincoln, and Perkins Counties, Nebraska, andSedgwick County, Colorado). Sedgwick County iscontiguous even though it is in a different state andtouches Keith County only at Keith County’s south-west corner.

(iv) For the 12-month period ending on August31, 2006, severe drought conditions are reported onU.S. Drought Monitor maps for all counties in the ap-plicable region, and all of those counties are includedon the list published by the IRS. For the 12-monthperiod ending on August 31, 2007, the only droughtconditions reported for the applicable region on U.S.Drought Monitor maps are severe drought conditionsfor Sedgwick County for the first week in Septem-ber 2006. A is unable to determine from the mapswhether drought conditions have been reported forthe applicable region, but the list published by the IRSfor the 12-month period ending on August 31, 2007,includes Sedgwick County. For the 12-month periodending August 31, 2008, U.S. Drought Monitor mapsdo not report drought conditions for any county inthe applicable region and none of the counties are in-cluded on the list published by the IRS.

(v) Neither the 12-month period ending on Au-gust 31, 2006, nor the 12-month period ending onAugust 31, 2007, is a drought-free year for the ap-plicable region because, in each of the 12-monthperiods, severe drought conditions have been re-ported for at least one county in the applicable regionfor a part of the 12-month period. Accordingly,the 12-month period ending on August 31, 2008, isthe first drought-free year for the applicable region.Under § 1033(e)(2) and this notice, A’s replacement

period is extended through December 31, 2008 (thelast day of A’s first taxable year ending after the firstdrought-free year for the applicable region).

SECTION 5. EFFECTIVE DATE

This notice applies to taxable years end-ing after September 25, 2006.

SECTION 6. DRAFTINGINFORMATION

The principal author of this notice isJeffrey Marshall of the Office of AssociateChief Counsel (Income Tax and Account-ing). For further information regardingthis notice, contact Mr. Marshall at (202)622–7287 (not a toll-free call).

26 CFR 601.105: Examination of returns and claimsfor refund, credit, or abatement; determination ofcorrect tax liability.(Also Part I, § 42; 1.42–14.)

Rev. Proc. 2006–38

SECTION 1. PURPOSE

This revenue procedure publishes theamounts of unused housing credit carry-

overs allocated to qualified states under§ 42(h)(3)(D) of the Internal RevenueCode for calendar year 2006.

SECTION 2. BACKGROUND

Rev. Proc. 92–31, 1992–1 C.B. 775,provides guidance to state housing creditagencies of qualified states on the pro-cedure for requesting an allocation ofunused housing credit carryovers under§ 42(h)(3)(D). Section 4.06 of Rev. Proc.92–31 provides that the Internal Rev-enue Service will publish in the InternalRevenue Bulletin the amount of unusedhousing credit carryovers allocated toqualified states for a calendar year froma national pool of unused credit authority(the National Pool). This revenue proce-dure publishes these amounts for calendaryear 2006.

SECTION 3. PROCEDURE

The unused housing credit carryoveramount allocated from the National Poolby the Secretary to each qualified state forcalendar year 2006 is as follows:

Qualified State Amount Allocated

Alabama $119,717Arizona 156,003California 949,059Connecticut 92,203Delaware 22,156Florida 467,274Georgia 238,303Illinois 335,247Indiana 164,742Kansas 72,093Kentucky 109,620Maine 34,711Maryland 147,102Massachusetts 168,072Michigan 265,838Minnesota 134,820Missouri 152,353Nebraska 46,197New Jersey 228,988New York 505,748North Dakota 16,723Oregon 95,637Pennsylvania 326,480Rhode Island 28,268

September 25, 2006 530 2006–39 I.R.B.

Qualified State Amount Allocated

Tennessee 156,625Texas 600,447Utah 64,867Vermont 16,365Virginia 198,770Washington 165,156Wisconsin 145,416

SECTION 4. EFFECTIVE DATE

This revenue procedure is effectivefor allocations of housing credit dollaramounts attributable to the National Poolcomponent of a qualified state’s housingcredit ceiling for calendar year 2006.

DRAFTING INFORMATION

The principal author of this revenueprocedure is Christopher J. Wilson ofthe Office of Associate Chief Counsel(Passthroughs and Special Industries). Forfurther information regarding this revenue

procedure, contact Mr. Wilson at (202)622–3040 (not a toll-free call).

2006–39 I.R.B. 531 September 25, 2006

Part IV. Items of General InterestNotice of ProposedRulemaking and Notice ofPublic Hearing

Guidance RegardingDeduction and Capitalizationof Expenditures Related toTangible Property

REG–168745–03

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemakingand notice of public hearing.

SUMMARY: This document containsproposed regulations that explain howsection 263(a) of the Internal RevenueCode (Code) applies to amounts paid toacquire, produce, or improve tangibleproperty. The proposed regulations clarifyand expand the standards in the currentregulations under section 263(a), as wellas provide some bright-line tests (for ex-ample, a 12-month rule for acquisitionsand a repair allowance for improvements).The proposed regulations will affect alltaxpayers that acquire, produce, or im-prove tangible property. This documentalso provides a notice of public hearing onthe proposed regulations.

DATES: Written or electronic commentsmust be received by November 20, 2006.Requests to speak and outlines of topics tobe discussed at the public hearing sched-uled for Tuesday, December 19, 2006, at10:00 a.m., must be received by Novem-ber 28, 2006.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–168745–03),room 5203, Internal Revenue Ser-vice, POB 7604, Ben Franklin Sta-tion, Washington, DC 20044. Alter-natively, comments may be sent elec-tronically, via the IRS Internet site atwww.irs.gov/regs or via the Federal eRule-making Portal at www.regulations.gov(IRS–REG–168745–03). The public hear-ing will be held in the auditorium of theNew Carrollton Federal Building, 5000Ellin Road, Lanham, MD 20706 at 10:00a.m.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposedregulations, Kimberly L. Koch, (202)622–7739; concerning submission ofcomments, the hearing, and/or to beplaced on the building access list to at-tend the hearing, Richard A. Hurst atRichard.A.Hurst@irscounsel.treas.gov orat (202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

In recent years, much debate has fo-cused on the extent to which section 263(a)of the Code requires taxpayers to capital-ize as an improvement amounts paid to re-store property to its former working con-dition; that is, whether, or the extent towhich, the amounts paid to restore or im-prove the property are capital expendituresor deductible ordinary and necessary re-pair and maintenance expenses. Therehas been controversy, for example, regard-ing what tests to apply for determiningcapitalization or expensing, how to ap-ply the tests, and the appropriate unit ofproperty with respect to which to applythe tests. On January 20, 2004, the IRSand Treasury Department published No-tice 2004–6, 2004–1 C.B. 308, announc-ing an intention to propose regulations pro-viding guidance in this area. The noticeidentified issues under consideration bythe IRS and Treasury Department and in-vited public comment on whether these orother issues should be addressed in the reg-ulations and, if so, what specific rules andprinciples should be provided. To respondto various comments and provide a morecomprehensive set of rules regarding tan-gible property, the proposed regulations in-clude the treatment of amounts paid to ac-quire or produce tangible property.

Explanation of Provisions

I. Introduction

The proposed regulations under section263(a) of the Code set forth the generalstatutory principles of capitalization andprovide that capital expenditures generallyinclude amounts paid to sell, acquire, pro-duce, or improve tangible property. Theproposed regulations, if promulgated as

final regulations, would replace current§§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3of the Income Tax Regulations. The treat-ment of amounts paid to acquire or createintangibles was addressed with the pub-lication of §§1.263(a)–4 and 1.263(a)–5in the Federal Register on January 5,2004 (T.D. 9107, 2004–1 C.B. 447 [69 FR436]).

Certain sections of the current regula-tions under section 263(a) are proposedto be removed entirely and are not re-stated in the proposed regulations. Section1.263(a)–1(c) of the current regulationslists several Code and regulation sectionsto which the capitalization provisions donot apply. Section 1.263(a)–3 (election todeduct or capitalize certain expenditures)lists several Code sections under whicha taxpayer may elect to treat certain cap-ital expenditures as either deductible ordeferred expenses, or to treat deductibleexpenses as capital expenditures. Thesetwo sections have not been carried overto the proposed regulations because thelists of items in these sections are outdated.This language is intended to have the samegeneral effect as current §§1.263(a)–1(c)and 1.263(a)–3, without citing to specificCode and regulation sections that mayhave been repealed and without omittingspecific Code and regulation sections thatmay have been added.

Certain portions of §1.263(a)–2 of thecurrent regulations (examples of capitalexpenditures) also are not restated in theproposed regulations, or are incorporatedinto other sections of the proposed regu-lations. Section 1.263(a)–2(a) of the cur-rent regulations (the cost of acquisition ofproperty with a useful life substantially be-yond the taxable year) is incorporated intoand expanded upon in §1.263(a)–2 of theproposed regulations (amounts paid to ac-quire or produce tangible property). Sec-tion 1.263(a)–2(b) of the current regula-tions (amounts expended for securing acopyright and plates) is proposed to beremoved because these amounts are nowaddressed by §1.263(a)–4(d)(5) and sec-tion 263A. The rules in §1.263(a)–2(c) ofthe current regulations (the cost of defend-ing or perfecting title to property) are ad-dressed in §1.263(a)–4(d)(9) of the currentregulations with regard to intangibles and

September 25, 2006 532 2006–39 I.R.B.

in §1.263(a)–2(d)(2) of the proposed reg-ulations with regard to tangible property.Section 1.263(a)–2(d) of the current regu-lations (amounts expended for architect’sservices) is proposed to be removed be-cause those amounts are now included insection 263A. The rules in §1.263(a)–2(f)and (g) of the current regulations (relatingto certain capital contributions) essentiallyare restated in §1.263(a)–1(b) of the pro-posed regulations. Finally, §1.263(a)–2(h)of the current regulations (the cost of good-will in connection with the acquisition ofthe assets of a going concern) is proposedto be removed because this cost is now ad-dressed by §1.263(a)–4(c)(1)(x).

Taking into account the provisions thatare proposed to be removed and othermodifications to the current regulationsnoted above, the remaining guidance inthe current regulations is contained in§1.263(a)–1(a) and (b) of the proposedregulations. Section 1.263(a)–1(a) of thecurrent regulations restates the statutoryrules from section 263(a), which are car-ried over in §1.263(a)–1(a) of the proposedregulations. The rules in §1.263(a)–1(b)of the current regulations address amountspaid to add to the value, or substantiallyprolong the useful life, of property ownedby the taxpayer, and amounts paid to adaptproperty to a new or different use. Theyalso address the treatment of those cap-italized expenditures, for example, as acharge to capital account or basis. Theserules are incorporated into and expandedupon in §1.263(a)–3 of the proposed reg-ulations. The proposed regulations alsorevise §1.162–4 of the current regulations(allowing a deduction for the cost of inci-dental repairs) to provide rules consistentwith §1.263(a)–3 of the proposed regula-tions (requiring capitalization of amountspaid to improve property).

The proposed regulations do not ad-dress amounts paid to acquire or cre-ate intangible interests in land, such aseasements, life estates, mineral interests,timber rights, zoning variances, or otherintangible interests in land. The IRS andTreasury Department request commentson whether these and similar amounts, orcertain of these amounts, should be ad-dressed in the final regulations and, if so,what rules should be provided. The pro-posed regulations also do not address thetreatment of software development costs.

II. General Principle of Capitalization

A. Overview

The proposed regulations require capi-talization of amounts paid to acquire, pro-duce, or improve tangible real and personalproperty, including amounts paid to facil-itate the acquisition of tangible property.The proposed regulations do not addressamounts paid to facilitate an acquisition ofa trade or business because those amountsare addressed in §1.263(a)–5 of the currentregulations.

The proposed regulations clarify thatthey do not change the treatment of anyamount that is specifically provided forunder any provision of the Code or regula-tions other than section 162(a) or section212 and the regulations under those sec-tions. This rule applies regardless ofwhether that specific provision is moreor less favorable to the taxpayer thanthe treatment in the proposed regula-tions. Thus, where another section of theCode or regulations prescribes a specifictreatment of an amount, the provisionsof that section apply and not the rulescontained in the proposed regulations.This rule is the same as that containedin §§1.263(a)–4(b)(4) and 1.263(a)–5(j)of the current regulations. The proposedregulations, for example, do not precludetaxpayers from deducting the cost of cer-tain depreciable business assets under sec-tion 179. On the other hand, the proposedregulations do not exempt taxpayers fromapplying the uniform capitalization rulesunder section 263A when applicable, nordo they exempt taxpayers from complyingwith the timing rules regarding incurringa liability under section 461 (includingeconomic performance).

The rule clarifying that the proposedregulations do not change the treatment ofany other amount that is specifically pro-vided for under any other provision of theCode or regulations provides an excep-tion for the treatment of any amount thatis specifically provided for under section162(a) or section 212 or the regulationsunder those sections. Thus, the proposedregulations override any conflicting pro-visions in the regulations under sections162(a) and 212. For this reason, the pro-posed regulations amend the current rulefor deductible repairs under §1.162–4 toprovide that amounts paid for repairs and

maintenance to tangible property are de-ductible if the amounts paid are not re-quired to be capitalized under §1.263(a)–3of the proposed regulations. The proposedregulations, however, do not amend or re-move any other provisions of the currentregulations under section 162(a), includ-ing §§1.162–6 (regarding professional ex-penses) and 1.162–12 (regarding certainexpenses of farmers). Section 1.162–6permits a deduction for amounts paid forbooks, furniture, and professional instru-ments and equipment, the useful life ofwhich is short, while §1.162–12 permits adeduction for the cost of ordinary tools ofshort life or small cost. The rules in cur-rent §§1.162–6 and 1.162–12 are consis-tent with the rules in the proposed regula-tions and are not revised.

B. Amounts paid to sell property

The proposed regulations provide that,except in the case of dealers in property,commissions and other transaction costspaid to facilitate the sale of property gen-erally must be capitalized and treated as areduction in the amount realized. Dealersin property include taxpayers that main-tain and sell inventories and taxpayers thatproduce property for sale in the ordinarycourse of business, for example, the homeconstruction business. The language inthis section is slightly broader than thecurrent language of §1.263(a)–2(e), whichrefers only to commissions paid in sell-ing securities. However, the language inthe proposed regulations is consistent withcase law that generally treats all trans-action costs paid in connection with thesale of any property as capitalized andoffset against the amount realized. See,Wilson v. Commissioner, 49 T.C. 406, 414(1968); rev’d on other grounds, 412 F.2d314 (6th Cir. 1969) (“The rule is thor-oughly engrained that commissions andsimilar charges must be treated as capi-tal expenditures which reduce the sellingprice when gain or loss is computed onthe transaction”); Frick v. Commissioner,T.C. Memo 1983–733, aff’d without opin-ion, 774 F.2d 1168 (7th Cir. 1985) (“Feespaid in connection with the disposition ofreal property are capital expenditures andare deductible from the selling price in de-termining gain or loss on the ultimate dis-position”); Hindes v. United States, 246F. Supp. 147, 150 (W.D. Tex. 1965); affd.

2006–39 I.R.B. 533 September 25, 2006

in part, revd. in part on other grounds,371 F.2d 650 (5th Cir. 1967) (“Fees andexpenses paid in connection with the ac-quisition or disposition of property, realor personal, are capital expenditures, and,in the case of a taxpayer not engaged inthe business of buying and selling real es-tate, are deductible from the selling pricein determining gain or loss on the ulti-mate disposition”). The sales cost rule inthe proposed regulations, however, appliesonly to transaction costs and does not in-clude other amounts that might be paidfor the purpose of selling property, suchas amounts paid to repair or improve theproperty in preparation for a sale. Thetreatment of those amounts is governed bythe general rules under §1.263(a)–3 of theproposed regulations relating to improve-ments.

III. Amounts Paid to Acquire or ProduceTangible Property

A. In general

The current regulations under section263(a) require capitalization of amountspaid for the acquisition, construction,or erection of buildings, machinery andequipment, furniture and fixtures, andsimilar property having a useful life sub-stantially beyond the taxable year. See§1.263(a)–2(a) of the current regulations.The proposed regulations are consistentwith this rule, but treat amounts paid toconstruct or erect property as productioncosts. Specifically, the proposed regu-lations require capitalization of amountspaid for property having a useful life sub-stantially beyond the taxable year, includ-ing land and land improvements, build-ings, machinery and equipment, and fur-niture and fixtures, and a unit of property(as determined under §1.263(a)–3(d)(2)),having a useful life substantially beyondthe taxable year. See §1.263(a)–2(d) of theproposed regulations. Thus, §1.263(a)–2of the proposed regulations requires cap-italization of amounts paid for propertythat is not itself a unit of property, suchas property (not treated as a material orsupply under §1.162–3) that is intendedto be used as a component in the repairor improvement of a unit of property.Additionally, the current regulations at§1.263(a)–1(b) list inventory costs as cap-ital expenditures under §1.263(a)–1(a).

Therefore, §1.263(a)–2 of the proposedregulations also requires capitalization ofamounts paid to acquire real or personalproperty for resale and to produce real orpersonal property for sale.

The proposed regulations provide thatthe terms amounts paid and paymentmean, in the case of a taxpayer usingan accrual method of accounting, a li-ability incurred (within the meaning of§1.446–1(c)(1)(ii)). The definitions ofreal and tangible personal property areintended to be the same as the defini-tions used for depreciation purposes asderived from the language in the regula-tions at §1.48–1. Thus, for purposes of theproposed regulations, tangible personalproperty means any tangible propertyexcept land and improvements thereto,such as buildings or other inherently per-manent structures (including items thatare structural components of buildings orstructures). See, Whiteco Indus., Inc. v.Commissioner, 65 T.C. 664 (1975) (ap-plying six factors in determining whetherproperty is an inherently permanent struc-ture). Under the proposed regulations,the definitions of building and structuralcomponents are the definitions providedin §1.48–1(e). The IRS and Treasury De-partment considered other definitions ofreal and tangible personal property, in-cluding the definitions in the regulationsunder section 263A(f), but believe that thedefinitions used for depreciation purposesare the definitions most consistent withthe purposes of the proposed regulations.

The definition of produce in§1.263(a)–2(b)(4) of the proposed reg-ulations is intended to be the same asthe definition used for purposes of sec-tion 263A(g)(1) and §1.263A–2(a)(1)(i),except that improvements are separatelydefined in §1.263(a)–3 of the proposedregulations. The costs that are requiredto be capitalized to property producedor to any improvement are the costs thatmust be capitalized under section 263A.Thus, for example, all direct materialsand direct labor, and all indirect costs thatdirectly benefit or are incurred by reasonof production/improvement activities arerequired to be capitalized to the propertybeing produced or improved.

The proposed regulations require tax-payers to capitalize an amount paid to de-fend or perfect title to tangible property.This rule is consistent with the current reg-

ulations at §1.263(a)–2(c) and parallels therule in §1.263(a)–4(d)(9) with regard to in-tangible property. The proposed regula-tions also require capitalization of amountspaid to facilitate the acquisition of real orpersonal property. The IRS and TreasuryDepartment request comments on whetherany specific guidance is needed with re-gard to employee compensation and over-head costs that facilitate the acquisition oftangible property and, if so, what that guid-ance should provide. The proposed reg-ulations do not address transaction costsrelated to the production or improvementof tangible property because those costsare subject to capitalization under section263A.

B. Materials and supplies

As noted in section II.A. above, theproposed regulations generally do notchange the treatment of any amount that isspecifically provided for under any provi-sion of the Code or regulations other thansection 162(a) or section 212 and the reg-ulations under those sections. However,with regard to section 162(a), the pro-posed regulations provide an exception foramounts paid for materials and suppliesthat are properly treated as deductions ordeferred expenses, as appropriate, under§1.162–3. Thus, the proposed regulationsdo not change the treatment of materialsand supplies under §1.162–3, includingproperty that is treated as a material andsupply that is not incidental under Rev.Proc. 2002–28, 2002–1 C.B. 815 (regard-ing the use of the cash method by certainqualifying small business taxpayers), Rev.Proc. 2002–12, 2002–1 C.B. 374 (regard-ing smallwares), and Rev. Proc. 2001–10,2001–1 C.B 272 (regarding inventory ofcertain qualifying taxpayers).

C. 12-month rule

The current regulations under sec-tions 263(a), 446, and 461 require tax-payers to capitalize amounts paid to ac-quire property having a useful life sub-stantially beyond the taxable year. See§§1.263(a)–2(a), 1.446–1(c)(1)(ii), and1.461–1(a)(2)(i) of the current regulations.Section 1.263(a)–2(d) of the proposed reg-ulations retains this general rule. Somecourts have adopted a 12-month rule fordetermining whether property has a use-ful life substantially beyond the taxable

September 25, 2006 534 2006–39 I.R.B.

year. See Mennuto v. Commissioner, 56T.C. 910 (1971), acq. (1973–2 C.B. 2);Zelco, Inc. v. Commissioner, 331 F.2d 418(1st Cir. 1964); International Shoe Co.v. Commissioner, 38 B.T.A. 81 (1938).Under the 12-month rule adopted by somecourts, a taxpayer may deduct currentlyan amount paid for a benefit or paid forproperty having a useful life that doesnot extend beyond one year. This rulewas adopted in the regulations relatingto intangibles. See §1.263(a)–4(f). Theproposed regulations provide a similar12-month rule for amounts paid to acquireor produce certain tangible property.

The proposed regulations generallyprovide that an amount (including trans-action costs) paid for the acquisition orproduction of a unit of property with aneconomic useful life of 12 months or lessis not a capital expenditure. The unit ofproperty and economic useful life determi-nations are made under the rules describedin §1.263(a)–3 for improved property.The 12-month rule generally applies un-less the taxpayer elects not to apply the12-month rule, which election may bemade with regard to each unit of propertythat the taxpayer acquires or produces. Anelection not to apply the 12-month rulemay not be revoked. Taxpayers that haveelected to use the original tire capitaliza-tion method of accounting for the cost ofcertain tires under Rev. Proc. 2002–27,2002–1 C.B. 802, must use that methodfor the original and replacement tires ofall their qualifying vehicles. See section5.01 of Rev. Proc. 2002–27. Therefore,taxpayers that use that method cannot usethe 12-month rule provided under the pro-posed regulations to deduct amounts paidto acquire original or replacement tires.

The proposed regulations clarify the in-teraction of the 12-month rule with the tim-ing rules contained in section 461 of theCode. Nothing in the proposed regula-tions is intended to change the applicationof section 461, including the applicationof the economic performance rules in sec-tion 461(h). This coordination rule is thesame as that provided in the regulationsunder section 263(a) relating to intangi-bles. See §1.263(a)–4(f). In the case ofa taxpayer using an accrual method of ac-counting, section 461 requires that an itembe incurred before it is taken into accountthrough capitalization or deduction. Forexample, under §1.461–1(a)(2), a liabil-

ity generally is not incurred until the tax-able year in which all the events have oc-curred that establish the fact of the liabil-ity, the amount of the liability can be deter-mined with reasonable accuracy, and eco-nomic performance has occurred with re-spect to the liability. Thus, the 12-monthrule provided by the proposed regulationsdoes not permit an accrual method tax-payer to deduct an amount paid for tan-gible property if the amount has not beenincurred under section 461 (for example,if the taxpayer does not have a fixed lia-bility to acquire the property). The pro-posed regulations contain examples illus-trating the interaction of the 12-month rulewith section 461.

The proposed regulations provide that,upon a sale or other disposition, property towhich a taxpayer applies the 12-month ruleis not treated as a capital asset under sec-tion 1221 or as property used in the tradeor business under section 1231. Thus,12-month property is not of a charactersubject to depreciation and any amount re-alized upon disposition of 12-month prop-erty is ordinary income to the taxpayer.

The IRS and Treasury Department donot believe that it is appropriate to applythe 12-month rule to certain types of prop-erty. Thus, the proposed regulations pro-vide that the 12-month rule does not applyto property that is or will be included inproperty produced for sale or property ac-quired for resale, improvements to a unitof property, land, or a component of a unitof property.

D. De minimis rule

In Notice 2004–6, the IRS and Trea-sury Department requested comments onwhether the regulations should providea de minimis rule. Because the noticerefers to the application of section 263(a)to amounts paid to repair, improve, orrehabilitate tangible property, most com-mentators focused on a de minimis rulefor the cost of repairs rather than the costto acquire property. However, one com-mentator requested that the regulationsspecifically provide a de minimis rule foracquisition costs, but allow taxpayers tocontinue to use their current method ifthey have reached a working agreementwith their IRS examining agent regardinga de minimis rule.

The IRS and Treasury Department rec-ognize that for regulatory or financial ac-counting purposes, taxpayers often have apolicy for deducting an amount paid belowa certain dollar threshold for the acquisi-tion of tangible property (de minimis rule).For Federal income tax purposes, the tax-payer generally would be required to capi-talize the amount paid if the property has auseful life substantially beyond the taxableyear. However, in this context some courtshave permitted the use of a de minimisrule for Federal income tax purposes. SeeUnion Pacific R.R. Co. v. United States,524 F.2d 1343 (Ct. Cl. 1975) (permittingthe use of the taxpayer’s $500 de minimisrule, which was in accordance with theInterstate Commerce Commission (ICC)minimum rule and generally accepted ac-counting principles); Cincinnati, N.O. &Tex. Pac. Ry. v. United States, 424F.2d 563 (Ct. Cl. 1970) (same). Butsee Alacare Home Health Services, Inc. v.Commissioner, T.C. Memo 2001–149 (dis-allowing the taxpayer’s use of a $500 deminimis rule because it distorted income).

The proposed regulations do not in-clude a de minimis rule for acquisitioncosts. However, the IRS and TreasuryDepartment recognize that taxpayers oftenreach an agreement with IRS examiningagents that, as an administrative matter,based on risk analysis and/or materiality,the IRS examining agents do not selectcertain items for review such as the ac-quisition of tangible assets with a smallcost. This often is referred to by taxpayersand IRS examining agents as a de minimisrule. The absence of a de minimis rule inthe proposed regulations is not intended tochange this practice.

The IRS and Treasury Department con-sidered including a de minimis rule in theproposed regulations. The de minimis ruleconsidered would have provided that tax-payers are not required to capitalize cer-tain de minimis amounts paid for the acqui-sition or production of a unit of property.Under the rule considered, if a taxpayerhad written accounting procedures in placetreating as an expense on its applicable fi-nancial statement (AFS) amounts paid forproperty costing less than a certain dollaramount, and treated the amounts paid dur-ing the taxable year as an expense on itsAFS in accordance with those written ac-counting procedures, the taxpayer wouldnot have been required to capitalize those

2006–39 I.R.B. 535 September 25, 2006

amounts if they did not exceed a certaindollar threshold. A taxpayer that did notmeet these criteria (for example, a taxpayerthat did not have an AFS) would not havebeen required to capitalize amounts paidfor a unit of property that did not exceedthe established dollar threshold. Becausetaxpayers without an AFS generally aresmaller than taxpayers with an AFS, thedollar threshold for the de minimis rule thatwould have applied to them would havebeen lower than the threshold for taxpay-ers with an AFS (although the de minimisrule for taxpayers with an AFS also wouldhave been limited to the amount treated asan expense on their AFS). The de minimisrule considered by the IRS and TreasuryDepartment would not have applied to in-ventory property, improvements, land, or acomponent of a unit of property.

The de minimis rule considered alsowould have provided that property towhich a taxpayer applies the de minimisrule is treated upon sale or dispositionsimilar to section 179 property. Thus, deminimis property would have been prop-erty of a character subject to depreciationand amounts paid that were not capital-ized under the de minimis rule would havebeen treated as amortization subject torecapture under section 1245. Thus, gainon disposition of the property would havebeen ordinary income to the taxpayer tothe extent of the amount treated as amorti-zation for purposes of section 1245.

The IRS and Treasury Department de-cided to not include a de minimis rulein the proposed regulations but insteadto request comments on whether such arule should be included in the final regu-lations or whether to continue to rely onthe current administrative practice of IRSexamining agents. Therefore, the IRS andTreasury Department request commentson whether a de minimis rule for acquisi-tion costs should be included in the finalregulations, and, if so, whether the deminimis rule should be the rule describedabove and what dollar thresholds are ap-propriate.

The IRS and Treasury Department alsorequest comments on the scope of coststhat should be included in a de minimisrule if one is provided in the final regula-tions and on the character of de minimisrule property. For example, the de min-imis rule considered by the IRS and Trea-sury Department would have applied to the

aggregate of amounts paid for the acquisi-tion or production (including any amountspaid to facilitate the acquisition or produc-tion) of a unit of property and includingamounts paid for improvements prior tothe unit of property being placed in service.If a de minimis rule should be provided inthe final regulations, the IRS and TreasuryDepartment request comments on what, ifany, type of rule should be provided to pre-vent a distortion of income when taxpay-ers acquire a large number of assets, eachof which individually is within the de min-imis rule (for example, the purchase by ataxpayer of 2,000 personal computers).

If a de minimis rule for acquisition costsshould be provided in the final regulations,the IRS and Treasury Department requestcomments on whether the rule should per-mit IRS examining agents and taxpayersto agree to the use of higher de minimisthresholds on the basis of materiality andrisk analysis and, if so, under what circum-stances a higher threshold should be al-lowed. The IRS and Treasury Departmentalso request comments on whether, if a deminimis rule should be provided in the fi-nal regulations, changes to begin using a deminimis rule or changes to a higher dollaramount within a de minimis rule should betreated as changes in a method of account-ing.

E. Recovery of costs when property isused in a repair

As noted in section III.A. of this pre-amble, §1.263(a)–2 of the proposed regu-lations generally requires capitalization ofamounts paid for the acquisition or produc-tion of property having a useful life sub-stantially beyond the taxable year. Thus,§1.263(a)–2(d) of the proposed regulationsapplies to property that is not itself a unitof property, such as property (not treatedas a material or supply under §1.162–3)that is intended to be used as a componentin the repair or improvement of a unit ofproperty. It must be determined whetherthe subsequent use of the component prop-erty results in an improvement to the unitof property under §1.263(a)–3 or an oth-erwise deductible repair or maintenancecost under §1.162–4. Even if the subse-quent use of the component is an otherwisedeductible expense under §1.162–4, theamount paid nonetheless may be requiredto be capitalized. For example, it must be

determined whether the amount paid forthe component property is required to becapitalized under section 263A as an indi-rect cost that directly benefits or is incurredby reason of property produced or acquiredfor resale. The proposed regulations illus-trate this concept in an example of a man-ufacturer that replaces one window in abuilding. The taxpayer initially must cap-italize under §1.263(a)–2(d) amounts paidto acquire the window. The replacementof the window subsequently is determinedto be a repair to the building rather thanan improvement. Amounts paid for the re-pair (or an allocable portion thereof) mustthen be capitalized under section 263A tothe inventory that the taxpayer produces tothe extent that the repair directly benefitsor is incurred by reason of the taxpayer’sproduction activities.

IV. Amounts Paid to Improve TangibleProperty

A. In general

In response to Notice 2004–6, the IRSand Treasury Department received severalcomments on the issues that should be ad-dressed in the proposed regulations to pro-vide guidance on amounts paid to repair,improve, and rehabilitate tangible prop-erty. These comments have been takeninto account in drafting §1.263(a)–3 of theproposed regulations. That section ad-dresses amounts paid to improve tangibleproperty and includes the following pro-visions: (1) rules for determining the ap-propriate unit of property to which the im-provement provisions apply; (2) generalrules for improvements; (3) rules for de-termining whether an amount paid mate-rially increases the value of the unit ofproperty; (4) rules for determining whetheran amount paid restores the unit of prop-erty; and (5) an optional repair allowancemethod.

B. Unit of property rules

1. In general

A threshold issue in applying the im-provement rules under §1.263(a)–3 of theproposed regulations is determining theappropriate unit of property to which therules should be applied. For example, todetermine whether an amount paid ma-terially increases the value of property, it

September 25, 2006 536 2006–39 I.R.B.

is necessary to know what property is atissue. The smaller the unit of property,the more likely it is that amounts paidin connection with that unit of propertywill materially increase the value of, orrestore, the property. Taxpayers and theIRS frequently disagree on the unit ofproperty to which the capitalization rulesshould be applied. Thus, the unit of prop-erty rules in the proposed regulations areintended to provide guidance in deter-mining whether an amount paid improvesthe unit of property under §1.263(a)–3.The unit of property rules also apply forpurposes of §1.263(a)–1 of the proposedregulations (which references the rules in§§1.263(a)–2 and 1.263(a)–3 of the pro-posed regulations) and §1.263(a)–2 of theproposed regulations (for example, withregard to the 12-month rule). The unitof property rules in the proposed regula-tions apply only for purposes of section263(a) and §§1.263(a)–1, 1.263(a)–2, and1.263(a)–3 of the proposed regulations,and not any other Code or regulation sec-tion. For example, no inference is intendedthat these unit of property rules have anyapplication for section 263A(f) interestcapitalization purposes.

The current regulations under section263(a) do not provide any guidance on de-termining the appropriate unit of property.Some courts have addressed the unit ofproperty issue under section 263(a), buttheir holdings are based on the particu-lar facts of each case and do not containrules that are generally applicable for pur-poses of section 263(a). See, FedEx Corp.v. United States, 291 F. Supp. 2d 699(W.D. Tenn. 2003), aff’d, 412 F.3d 617(6th Cir. 2005) (concluding that an aircraft,and not the aircraft engine, was the appro-priate unit of property); Smith v. Commis-sioner, 300 F.3d 1023 (9th Cir. 2002) (con-cluding that an aluminum reduction cell,rather than entire cell line, was the ap-propriate unit of property); Ingram Indus-tries, Inc. v. Commissioner, T.C. Memo2000–323 (concluding that a towboat, andnot the towboat engine, was the appropri-ate unit of property); LaSalle Trucking Co.v. Commissioner, T.C. Memo 1963–274(concluding that truck engines, tanks, andcabs were each separate units of property).

In FedEx, the court ruled on whetheran aircraft engine or the entire aircraft wasthe appropriate unit of property for deter-mining whether the costs of engine shop

visits (ESVs) must be treated as capitalexpenditures. Relying on the opinions inIngram and Smith, the court concluded thatthe following four factors were relevant indetermining the appropriate unit of prop-erty: (1) whether the taxpayer and the in-dustry treat the component part as a partof a larger unit of property for regulatory,market, management, or accounting pur-poses; (2) whether the economic useful lifeof the component part is coextensive withthe economic useful life of the larger unitof property; (3) whether the larger unit ofproperty and the smaller unit of propertycan function without each other; and (4)whether the component part can be and ismaintained while affixed to the larger unitof property. Applying these factors to air-craft engines, the court concluded that theengines should not be considered a unit ofproperty separate and apart from the air-plane.

In Notice 2004–6, the IRS and Trea-sury Department requested comments onthe relevance of various unit of propertyfactors derived from FedEx and other casesthat addressed the unit of property issue.The factors listed in Notice 2004–6 in-cluded: (1) whether the property is man-ufactured, marketed, or purchased sepa-rately; (2) whether the property is treatedas a separate unit by a regulatory agency,in industry practice, or by the taxpayerin its books and records; (3) whether theproperty is designed to be easily removedfrom a larger assembly, is regularly or pe-riodically replaced, or is one of a fungi-ble set of interchangeable or rotable assets;(4) whether the property must be removedfrom a larger assembly to be fixed or im-proved; (5) whether the property has a dif-ferent economic life than the larger assem-bly; (6) whether the property is subject toa separate warranty; (7) whether the prop-erty serves a discrete purpose or functionsindependently from a larger assembly; or(8) whether the property serves a dual pur-pose function.

The IRS and Treasury Departmentreceived nine comments on the unit ofproperty issue, four of which specificallyrecommended that the proposed regula-tions adopt the factors used by the courtin FedEx. These factors essentially arecontained in factors 1, 2, 4, 5, and 7 ofNotice 2004–6. Several of the factorslisted in Notice 2004–6 have been in-corporated into the proposed regulations.

However, the IRS and Treasury Depart-ment determined that some factors werenot relevant for certain types of property.For example, the factors listed in Notice2004–6 primarily derive from case lawthat addresses tangible personal property;therefore, the factors were not as help-ful in determining the appropriate unit ofproperty for real property, such as land.Further, some types of property lend them-selves to specific unit of property rules,such as buildings and property owned bytaxpayers in a regulated industry. TheIRS and Treasury Department believethat the administrative burden associatedwith determining the appropriate unit ofproperty can be reduced for both the IRSand taxpayers by identifying specific rulesreflecting an approach appropriate forthe taxpayer’s industry and the type ofproperty at issue. Therefore, the proposedregulations provide different unit of prop-erty rules for four categories of property,rather than prescribing one rule for alltypes of property.

The unit of property rules in the pro-posed regulations apply to all real andpersonal property other than networkassets. For purposes of the unit of prop-erty rules, network assets means railroadtrack, oil and gas pipelines, water andsewage pipelines, power transmissionand distribution lines, and telephone andcable lines that are owned or leased bytaxpayers in each of those respective in-dustries. Network assets include, forexample, trunk and feeder lines, polelines, and buried conduit. They do notinclude property that would be included asa structural component of a building un-der §1.263(a)–3(d)(2)(iv) of the proposedregulations, nor do they include separateproperty that is adjacent to, but not part ofa network asset, such as bridges, culverts,or tunnels. The proposed regulations donot affect current guidance that addressesthe unit of property or capitalization rulesfor network assets, such as Rev. Proc.2001–46, 2001–2 C.B. 263 (track main-tenance allowance method for Class Irailroads); Rev. Proc. 2002–65, 2002–2C.B. 700 (track maintenance allowancemethod for Class II and III railroads); andRev. Proc. 2003–63, 2003–2 C.B. 304(safe harbor unit of property rule for ca-ble television distribution systems). TheIRS and Treasury Department requestcomments on the relevant rules for deter-

2006–39 I.R.B. 537 September 25, 2006

mining the appropriate unit of property fornetwork assets. Additionally, the IRS andTreasury Department request commentson whether to include rules for networkassets in final regulations, or whether todevelop for network assets industry-spe-cific guidance that is similar to the abovereferenced revenue procedures.

With the exception of network assets,the four categories of property in the pro-posed regulations are intended to cover allreal and personal property. In addition tothe four categories of property, the unit ofproperty rules provide for an initial unitof property determination, which, exceptwith regard to buildings and structuralcomponents, is made prior to categorizingthe property. The initial unit of propertydetermination is based on the functionalinterdependence test in §1.263A–10(a)(2),relating to the capitalization of interest.The initial unit of property determina-tion is intended to be a common-senseapproach to defining the largest possibleunit of property as a starting point foranalyzing the rules under one of the fourrelevant unit of property categories. Afterthe initial unit of property is determined,the additional unit of property rules areintended to result in a determination thateither confirms the initial unit of propertyas the unit of property, or that separatesone or more components of the initial unitof property into separate units of property.

Some commentators suggested thatthe functional interdependence test un-der §1.263A–10(a)(2) regarding interestcapitalization should be the sole test fordetermining the appropriate unit of prop-erty. The IRS and Treasury Departmentbelieve that the functional interdepen-dence test is a relevant, but not dispositivefactor. The purpose of that test under§1.263A–10(a)(2) is to calculate the ap-propriate unit of property for determiningthe accumulated production expendituresat the beginning and end of the productionperiod. The preamble that accompaniedthe promulgation of §1.263A–10 discussesthe reasoning for adopting a broad formu-lation of the unit of property definitionand states that “this concept of singleproperty may differ from the concept ofsingle or separate property that taxpayersuse for other purposes (e.g., for comput-ing amounts of depreciation deductions orseparately tracking the bases of assets).”

T.D. 8584, 1995–1 C.B. 20, 25; [59 FR67, 187] Dec. 29, 1994).

In contrast to the unit of property rulesin §1.263A–10(a)(2), the purpose of theunit of property rules under section 263(a)is to provide a starting point for determin-ing whether an amount paid materially in-creases the value of, or restores, the unitof property. Thus, §1.263A–10(a)(2) hasa different purpose than the proposed reg-ulations under section 263(a). Further, indetermining the appropriate unit of prop-erty for purposes of section 263(a), thefunctional interdependence test does notalways produce appropriate results. Forexample, a taxpayer might argue that ap-plication of that test results in an entirecomplex of structures and machinery, suchas an entire power plant, being treated as asingle unit of property. The IRS and Trea-sury Department do not believe that resultis correct for purposes of section 263(a).

After the initial unit of property deter-mination is made, the unit of property anal-ysis continues with determining the ap-propriate category of property and apply-ing the rules in that category. The pro-posed regulations provide specific rulesfor four categories of property: (1) prop-erty owned by taxpayers in a regulated in-dustry; (2) buildings and structural com-ponents; (3) other personal property; and(4) other real property. The unit of prop-erty determination made under the appli-cable category is then subject to an ad-ditional rule in §1.263(a)–3(d)(2)(vii) re-garding treatment for other Federal incometax purposes. The rules for each of the fourcategories are explained below.

2. Category I: Taxpayers in regulatedindustries

The first unit of property category in theproposed regulations is property owned bytaxpayers in a regulated industry. The pro-posed regulations provide that if the tax-payer is in an industry for which a Federalregulator has a uniform system of accounts(USOA) identifying a particular unit ofproperty, the taxpayer must use the sameunit of property for Federal income taxpurposes, regardless of whether the tax-payer is subject to the regulatory account-ing rules of the Federal regulator and re-gardless of whether the property is par-ticular to that industry. This rule derivesfrom one of the factors cited by the court in

FedEx for determining the appropriate unitof property — whether the taxpayer andthe industry treat the component part aspart of the larger unit of property for regu-latory, market, management, or accountingpurposes. Thus, this rule ties into the reg-ulatory accounting element of the FedExfactor, as well as the general concept of in-dustry practice. The IRS and Treasury De-partment are aware of three Federal regula-tors that provide a USOA: (1) the FederalEnergy Regulatory Commission (FERC);(2) the Federal Communications Commis-sion (FCC); and (3) the Surface Trans-portation Board (STB). Accordingly, thisunit of property category applies to taxpay-ers such as power companies, telecommu-nications companies, and railroads.

The IRS and Treasury Department de-termined that the regulatory accountingrule should be applied similarly to all tax-payers in industries for which a Federalregulator provides a USOA, regardlessof whether the taxpayer is subject to theregulatory accounting rules of the Federalregulator. This rule is consistent with thegeneral standard of using industry prac-tice to determine the appropriate unit ofproperty. Further, it results in all taxpayerswithin a specific industry being treatedthe same for Federal income tax purposes,without regard to whether a particular tax-payer is subject to the accounting rules ofthe Federal regulator. The rule is limitedto the regulator’s USOA and does not ap-ply to other Federal regulatory rules, suchas rules concerning safety or health. Theproposed regulations apply only to USOAprovided by Federal regulators and do notapply to USOA issued by any state or localagencies. Rules of state and local agenciesmay be different than Federal regulatoryrules and can vary widely within an indus-try depending on the taxpayer’s location.

Four of the commentators on this aspectof Notice 2004–6 recommended adoptingthe four factors cited in FedEx, from whichthe regulated industry rule was derived.None of the commentators specifically ob-jected to a regulatory accounting rule, al-though one commentator suggested thatwhere cost recovery is determined for non-tax purposes by a Federal or state agency,the regulations should provide a specialelection that may be made on an annual ba-sis under which the taxpayer may use thesame unit of property for tax purposes as itmust use for regulatory purposes. The IRS

September 25, 2006 538 2006–39 I.R.B.

and Treasury Department believe the unitof property inquiry should result in oneclear determination that will be used con-sistently by the taxpayer unless the under-lying facts change and, therefore, do notbelieve an annual election is appropriate.

3. Category II: Buildings and structuralcomponents

In general, a building and its struc-tural components must be treated as oneunit of property. This rule is based onthe definitions of building and structuralcomponent in the regulations under sec-tion 48. The repair allowance regulationsunder the Class Life Asset DepreciationRange (CLADR) system also provide thata building and its structural componentsgenerally are a single unit of property.See §1.167(a)–11(d)(2)(vi). The IRS andTreasury Department believe that thesedefinitions are useful in determining theappropriate unit of property for buildingsand structural components. One com-mentator specifically requested that theproposed regulations use the definition ofbuilding under §1.48–1(e) to determinea unit of property. The proposed regu-lations rely on the definition of buildingunder §1.48–1(e). Property located insidea building that is not a structural com-ponent of the building must be analyzedunder one of the other three unit of prop-erty categories; for example, machineryand equipment inside a factory must beanalyzed under Category III (the otherpersonal property category).

This Category II is the only categoryto which the initial unit of property de-termination does not apply. Applyingthe functional interdependence test to abuilding would raise issues in cases wherecertain floors or portions of a buildingare placed in service independently of an-other. The IRS and Treasury Departmentbelieve that, unless the additional rule in§1.263(a)–3(d)(2)(vii) of the proposedregulations (regarding treatment for otherFederal income tax purposes) applies torequire a component of a building to betreated as a separate unit of property, thebuilding and its structural componentsshould be the unit of property. The IRSand Treasury Department recognize, how-ever, that it is not always appropriate totreat the entire building as the unit of prop-erty. For example, a taxpayer who owns a

unit in a condominium building, whetherthe unit is used for personal or investmentpurposes, should not treat the entire build-ing as the unit of property. Therefore,the IRS and Treasury request commentson how the unit of property rules shouldapply to condominiums, cooperatives, andsimilar types of property.

4. Category III: Other personal property

The unit of property determination forpersonal property not included in CategoryI (taxpayers in a regulated industry) is afacts and circumstances test, based on fourexclusive factors, none of which is dispos-itive or weighs more heavily than the oth-ers.

a. Factor 1: Marketplace treatment factor

The first exclusive factor is whetherthe component is (1) marketed separatelyto or acquired or leased separately bythe taxpayer (from a party other than theseller/lessor of the property of which thecomponent is a part) at the time it is ini-tially acquired or leased; (2) subject to aseparate warranty contract (from a partyother than the seller/lessor of the propertyof which the component is a part); (3) sub-ject to a separate maintenance manual orwritten maintenance policy; (4) appraisedseparately; or (5) sold or leased separatelyby the taxpayer to another party. Thisfactor contains a number of items intendedto determine the treatment in the market-place of the component as a separate unitof property.

Whether the component is acquiredseparately was a factor addressed by thecourts in FedEx and Ingram, and is alsopart of the CLADR repair allowance reg-ulations under section 167 and the unit ofproperty determination for interest capi-talization in §1.263A–10. In FedEx, thecourt discussed this issue in the context ofwhether the taxpayer and the industry treatthe component part as part of the largerunit of property for regulatory, market,management, or accounting purposes. Infinding that the aircraft engines were notpurchased separately, the court relied onthe fact that the engines and aircraft weredesigned to be compatible and were gen-erally acquired by the taxpayer at the sametime. The court disregarded the fact thatthe taxpayer purchased the engines andairframes from different sellers when the

aircraft were initially acquired. The IRSand Treasury Department believe that theacquisition of a component from a differ-ent seller at the time the larger propertyis acquired should be a relevant factor,and that the same rule should apply ifthe taxpayer leases the component from adifferent party than the seller of the largerproperty.

The IRS and Treasury Department rec-ognize that this factor may produce differ-ent results depending on whether the prop-erty is new or used. When a taxpayer ac-quires or leases used property, it is possiblethat items that were separate units of prop-erty when purchased new will be treatedas one unit of property because the ini-tial purchaser has assembled the units intoone functional item that it sells or leases.The IRS and Treasury Department consid-ered whether it was appropriate to have afactor that could treat new and used prop-erty differently, and decided that the differ-ence reasonably reflects the substance ofthe transactions — where the taxpayer ac-quires or leases a component from a differ-ent party from whom it acquires or leasesthe larger property, the taxpayer typicallyis conducting different, but related, trans-actions with separately negotiated terms.

Whether the component is subject to aseparate warranty contract, maintenancemanual, or written maintenance policy wascited as a factor in FedEx and is adoptedas part of the marketplace treatment factorin the proposed regulations. The warrantycontract factor applies only to a warrantythat is provided by a party other than theseller/lessor of the larger property. It is notintended to apply to a warranty providedby the sellor/lessor that may contain sepa-rate warranties (for example, for differenttime periods) on various components ofthe larger property. Whether the propertyis manufactured separately was a possi-ble factor cited in Notice 2004–6. Theproposed regulations do not specificallyadopt this factor because components thatare subject to a separate warranty or main-tenance procedures also are likely to bemanufactured separately. The FedEx caseused as a factor whether the componentwas appraised or valued separately andthe CLADR repair allowance regulationsunder section 167 addressed whether thecomponent was sold separately to anotherparty. The proposed regulations adopt

2006–39 I.R.B. 539 September 25, 2006

these tests as part of the marketplace fac-tor.

The IRS and Treasury Department be-lieve that it is important that all the crite-ria in this factor be taken into account to-gether when weighing this factor with theother three factors. Some criteria may bestronger indicators warranting treatment ofthe component as a separate unit of prop-erty than others. The IRS and TreasuryDepartment acknowledge that several ofthe criteria within this factor do not workwell for property produced by the taxpayer,and request comments regarding how andwhether a marketplace factor should applyto self-constructed property.

b. Factor 2: Industry practice andfinancial accounting factor

The second exclusive factor in thisCategory III is whether the componentis treated as a separate unit of propertyin industry practice or by the taxpayer inits books and records. This factor wascited by the court in FedEx. The IRSand Treasury Department believe that thetaxpayer’s treatment of the componentas separate in its books and records is arelevant factor in determining whether thecomponent should be treated as a separateunit of property in the proposed regula-tions. In particular, if the taxpayer’s booksand records assign different economic use-ful lives to the component and the largerproperty, this factor would weigh heavilytoward treating the component as a sepa-rate unit of property.

The IRS and Treasury Department con-sidered whether to use as a factor whetherthe component has a different economicuseful life than the property of which it isa part. This factor was cited by the courtsin Smith, Ingram, and FedEx. However,for this factor to be useful, the regula-tions would need to define economicuseful life. The proposed regulations at§1.263(a)–3(f) (with regard to restorationof a unit of property) provide a definitionof economic useful life, which has dif-ferent meanings depending on whether ataxpayer has an AFS. If the unit of propertyrules adopted this definition, the economicuseful life test under this factor wouldproduce different results depending onwhether the taxpayer has an AFS. Thesedifferent results are not justified in thiscontext. Further, a taxpayer’s treatment

of the component in its books and recordsunder this Factor 2 includes any usefullife determinations of the component andthe property of which the component is apart in the books and records. Therefore,the economic useful life factor was notspecifically adopted as a separate factor.

c. Factor 3: Rotable part factor

The third exclusive factor in the otherpersonal property category is whether thetaxpayer treats the component as a rotablepart. A rotable part is defined as a partthat is removeable from property, repairedor improved, and either immediately rein-stalled on other property or stored for laterinstallation. This factor was cited by thecourts in Smith and LaSalle. The court inFedEx ignored this factor, but consideredas a separate concept whether the compo-nent can be and is maintained while affixedto the larger unit. The IRS and TreasuryDepartment considered this separate con-cept as well, but believe that the rotablepart factor incorporates this concept fromFedEx. As the examples in the proposedregulations illustrate, this factor focuses onthe particular taxpayer’s treatment of theproperty as a rotable part in determiningwhether the rotable is a separate unit ofproperty. Therefore, for example, if therotable part is a separate unit of propertyto the taxpayer and the taxpayer incorpo-rates the rotable into other property for re-sale, the rotable part will not necessarily bea separate unit of property to the purchaser.

Two commentators stated that the treat-ment of a component as a rotable part is oflimited or no relevance. While treatmentof minor parts as rotable would not weighheavily toward separate unit of propertytreatment, the IRS and Treasury Depart-ment believe that the treatment of majorcomponents as rotable is a relevant factorin determining whether a component is aseparate unit of property, particularly whenthe economic useful life of the larger prop-erty is limited by the expected useful lifeof the rotable part. Many taxpayers do notmaintain an inventory of rotable spares fortheir major components. Although it is un-derstood that the purpose for maintainingan inventory of rotables is to minimize thetime that the larger property is out of ser-vice, treatment of a major component as arotable has consequences that tend to beindicative of a separate unit of property.

For example, in the case of a taxpayer thatdoes not maintain an inventory of rotablespare parts, if a major component of thelarger property breaks down, then the en-tire larger property must be taken out ofservice while the major component is be-ing repaired. This is indicative of the largerproperty and the component collectivelybeing treated as one unit of property. Con-versely, a taxpayer that does maintain aninventory of rotable spare parts for a ma-jor component is able to continue to use thelarger property without regard to the timerequired to repair the broken down compo-nent. In this instance, the IRS and TreasuryDepartment believe that continued use ofthe larger property is indicative of separateunit of property treatment for the rotablepart. In addition, rotables being depre-ciated as rotable spare parts is indicativeof separate treatment because the compo-nents are depreciated separately from thelarger property.

In the request for comments, Notice2004–6 combined several other factorswith the rotables factor, including whethera component is designed to be easily re-moved from a larger assembly, is regularlyor periodically replaced, or is one of afungible set of interchangeable assets.These factors are broader than the rota-bles factor in the proposed regulations andwould sweep in many minor componentsthat rarely, if ever, would be appropriatelyconsidered a separate unit of property.Further, these factors are duplicative ofthe rotables part factor, because a rotablegenerally meets all of these factors. TheIRS and Treasury Department believe thatthese factors are not more helpful in deter-mining whether a component is a separateunit of property than the rotables factordescribed in the proposed regulations.Therefore, the proposed regulations do notinclude these other factors.

d. Factor 4: Function factor

The fourth and final factor in CategoryIII is whether the property of which thecomponent is a part generally functionsfor its intended use without the compo-nent property. This factor was cited by thecourt in FedEx and is similar to the dis-crete purpose test under the CLADR re-pair allowance regulations. It is also simi-lar to the functional interdependence testunder §1.263A–10(a)(2) and the rules in

September 25, 2006 540 2006–39 I.R.B.

these proposed regulations regarding theinitial unit of property determination. Asnoted in the discussion of the initial unit ofproperty determination, the IRS and Trea-sury Department agree with commentatorsthat the functional interdependence test isa relevant, although not dispositive, factorin the unit of property analysis. Althoughthe proposed regulations use the functionalinterdependence test to determine the ini-tial unit of property, the functional inter-dependence test in that context is merelya starting point in determining the appro-priate unit of property, rather than a spe-cific factor to be considered. Providingthis version of the functional interdepen-dence test as a specific factor gives appro-priate weight to that test in the unit of prop-erty analysis for other personal property.

5. Category IV: Other real property

The unit of property determination forreal property not included in Category I orII is based on a facts and circumstancestest. The property subject to this categoryis primarily land and land improvementsowned or leased by taxpayers not in a reg-ulated industry. This category does notlist specific factors because land and landimprovements are such unique assets thatspecific factors cannot uniformly provideappropriate results. Thus, the unit of prop-erty determination for property in this cat-egory may be based on some, all, or noneof the factors listed in Category III for per-sonal property, or may be based on otherfactors. The IRS and Treasury Depart-ment request comments on whether addi-tional guidance is needed for this categoryof property and, if so, what unit of propertyguidance would be appropriate.

6. Additional rule for unit of property

After determining the initial unit ofproperty and applying the unit of propertyrules under the appropriate category, theadditional rule in §1.263(a)–3(d)(2)(vii)must be applied. Under this rule, if ataxpayer properly treats a component as aseparate unit of property for any Federalincome tax purpose, the taxpayer musttreat the component as a separate unit ofproperty for purposes of §1.263(a)–3. Thepurpose of this rule is to prevent taxpay-ers from taking inconsistent positions byarguing that a component of property is aunit of property for one tax purpose and

that it is not a separate unit of property forcapitalization purposes. For example, if ataxpayer does a cost segregation study ona building and properly identifies separatesection 1245 property, the taxpayer musttreat that separate property as the unit ofproperty for capitalization purposes.

As a further example, if a taxpayerproperly recognizes a loss under section165, or under another applicable provi-sion, from a retirement of a componentof property or from the worthlessness orabandonment of a component of property,the taxpayer must treat the component asa separate unit of property. A loss arisingunder another applicable provision in thiscontext includes a loss arising under (1)§1.167(a)–8 or 1.167(a)–11, as applica-ble, from a retirement of a componentof property if the component is not sub-ject to section 168 (MACRS property)or former section 168 (ACRS property);(2) §1.167(a)–8(a) from a retirement of acomponent of property if the componentis MACRS or ACRS property (applying§1.167(a)–8(a) as though the retirementis a normal retirement from a single as-set account) unless the component is astructural component or the componentis in a mass asset account (ACRS prop-erty) or a general asset account (MACRSproperty); or (3) §1.168(i)–1(e) from thedisposition of a component of property ifthe component is MACRS property and ina general asset account. No inference isintended that this rule in the proposed reg-ulations requires or allows taxpayers thatare using a unit of property for purposes ofthe proposed regulations to use the sameunit of property for purposes of any Codeor regulation section other than section263(a) and §§1.263(a)–1, 1.263(a)–2, and1.263(a)–3 of the proposed regulations.

This rule is intended to prevent tax-payers from taking a loss deduction on acomponent of a unit of property, and thendeducting the cost of the replaced com-ponent as a repair. The application ofthis rule results in the replacement com-ponent being treated as a separate unit ofproperty, thus requiring capitalization un-der §1.263(a)–2 of amounts paid to acquireor produce the replacement component.The IRS and Treasury Department believethat taxpayers must be consistent in thetreatment of a unit of property for capital-ization (other than interest capitalization),depreciation, and loss deduction purposes.

The IRS and Treasury Department recog-nize that the language of this consistencyrule is very broad, and request commentsregarding circumstances in which this ruleshould not apply.

V. Improvements in General

Section 1.263(a)–1(b) of the currentregulations provides that an amount mustbe capitalized if it (1) adds to the value,or substantially prolongs the useful life,of property owned by the taxpayer, or (2)adapts the property to a new or differentuse. Notice 2004–6 requested commentson what general principles of capitaliza-tion should apply to amounts paid to repairor improve tangible property. Commenta-tors were almost unanimous in their sug-gestion that the current principles of value,useful life, and new or different use be re-tained. The IRS and Treasury Departmentagree with the commentators that the cur-rent guidelines generally are appropriate.However, the current regulations require asubjective inquiry into the application ofthe particular facts at issue, which oftenresults in disagreements between taxpay-ers and the IRS. Accordingly, the proposedregulations attempt to clarify and expandthe standards in the current regulations bysetting forth rules to determine whetherthere has been a material increase in value(including adapting property to a new ordifferent use) and to determine whetherthere has been a restoration of property(the useful life rules). In addition, the pro-posed regulations provide objective rulesfor improvements in an optional repairallowance method.

The proposed regulations generallyprovide that a taxpayer must capitalizethe aggregate of related amounts paid thatimprove a unit of property, whether theimprovements are made by the taxpayeror a third party. The aggregate of relatedamounts does not encompass otherwisedeductible repair costs unless those costsdirectly benefit or are incurred by reasonof a capital improvement. Instead, theaggregation language is intended to in-clude amounts paid for an entire project,including removal costs and other projectcosts, regardless of whether amounts arepaid to more than one party or whether thework spans more than one taxable year.The proposed regulations do not affect thetreatment of amounts paid to retire and

2006–39 I.R.B. 541 September 25, 2006

remove a unit of property in connectionwith the installation or production of areplacement asset. See Rev. Rul. 2000–7,2000–1 C.B. 712.

Several commentators suggested thatthe proposed regulations provide thatthe relevant distinction between capitalimprovements and deductible repairs iswhether the amounts were paid to put theproperty in ordinarily efficient operatingcondition or to keep the property in ordi-narily efficient operating condition. SeeEstate of Walling v. Commissioner, 373F.2d 190 (3d Cir. 1967); Illinois Mer-chants Trust Co. v. Commissioner, 4B.T.A. 103 (1926), acq. (V–2 C.B. 2);Rev. Rul. 2001–4, 2001–1 C.B. 295. Theimprovement rules in the proposed regu-lations are consistent with the put versuskeep standard, to the extent that standardis relevant. An amount paid may be acapital expenditure even if it does not putthe property in ordinarily efficient oper-ating condition because not all repair orimprovement costs affect the functional-ity of the property. Thus, amounts paidthat keep property in ordinarily efficientoperating condition are not necessarilydeductible repair costs, particularly if theuseful life is extended. On the other hand,amounts that put property in ordinarilyefficient operating condition are likely tobe amounts paid prior to the property’sbeing placed in service or to ameliorate apre-existing condition or defect. Amountspaid in these later situations would becapital expenditures under either the valuerule or the restoration rule in the proposedregulations.

Some commentators suggested that thefrequency of the expenditure should beconsidered, noting that an expenditure be-ing regularly incurred on a cyclical basisshould be a strong indication of deductiblemaintenance. The IRS and Treasury De-partment considered this comment butconcluded that the frequency of the ex-penditure was too vague a standard to beadministrable. Further, the IRS and Trea-sury Department believe that the proposedregulations provide appropriate guidanceon cyclical maintenance by clarifyingother rules, such as the appropriate com-parison rule for adding value and the rulesrelating to prolonging economic usefullife.

In accordance with several commentsreceived in response to Notice 2004–6, the

proposed regulations provide that a Fed-eral, state, or local regulator’s requirementthat a taxpayer perform certain repairs ormaintenance is not relevant in determin-ing whether the amount paid improvesthe unit of property. Several courts haveheld that amounts paid to bring propertyinto compliance with government regu-lations were capital expenditures, in partbecause they made the taxpayer’s prop-erty more valuable for use in its trade orbusiness. See, Swig Investment Co. v.United States, 98 F.3d 1359 (Fed. Cir.1996) (replacing cornices and parapetson hotel to comply with city earthquakeordinance); Teitelbaum v. Commissioner,294 F.2d 541 (7th Cir. 1961) (convertingelectrical system from direct current toalternating current to comply with cityordinance); RKO Theatres, Inc. v. UnitedStates, 163 F. Supp. 598 (Ct. Cl. 1958)(installing fire-proof doors and fire es-capes to comply with city code); HotelSulgrave, Inc. v. Commissioner, 21 T.C.619 (1954) (installing sprinkler systemto comply with city code). In each case,however, the court did not rely entirelyon regulatory compliance as a basis forrequiring capitalization. For example, inHotel Sulgrave and RKO Theatres, bothinvolving the installation of certain equip-ment to comply with city fire codes, thecourts emphasized that the work involvedthe addition of property with a usefullife extending beyond the taxable year.Moreover, both Swig and Teitelbaum in-volved expenditures for the replacementof major structural components of a build-ing (parapets and cornices in Swig andan electrical system in Teitelbaum) withupgraded components. Thus, in all thesecases, even without the legal compulsionto make these changes, the taxpayers’amounts paid would have constituted cap-ital expenditures.

In contrast to the cases discussed above,both the courts and the IRS have permitteda current deduction for some governmentmandated expenditures. For example, inMidland Empire Packing Co. v. Commis-sioner, 14 T.C. 635 (1950), acq. (1950–2C.B. 3), the court allowed the taxpayerto deduct the costs of applying a concreteliner to its basement walls to satisfy Fed-eral meat inspectors. Similarly, the IRShas permitted taxpayers to treat as other-wise deductible repairs amounts paid to re-mediate certain environmental contamina-

tion and to replace certain waste storagetanks to comply with applicable state andFederal regulations. See Rev. Rul. 94–38,1994–1 C.B. 35; Rev. Rul. 98–25, 1998–1C.B. 998. The IRS specifically recognizedin Rev. Rul. 2001–4, 2001–1 C.B. 295 thatthe requirement of a regulatory authority tomake certain repairs or to perform certainmaintenance on an asset to continue oper-ating the asset does not mean that the workperformed must be capitalized. Thus, theproposed regulations reiterate that state-ment in Rev. Rul. 2001–4 and providethat a legal compulsion to repair or main-tain tangible property is not a relevant fac-tor in the repair versus improvement anal-ysis. The IRS and Treasury Departmentfurther believe that a new government re-quirement for existing property that man-dates certain expenditures with respect tothe property does not create an inherent de-fect in the property.

In response to several comments, theproposed regulations provide that if ataxpayer needs to replace part of a unitof property that cannot practicably bereplaced with the same type of part, thereplacement of the part with an improvedbut comparable part does not, by itself,result in an improvement to the unit ofproperty. This rule is intended to applyin cases where the same replacement partis no longer available, generally becauseof technological advancements or productenhancements. This rule, however, is notintended to apply if, instead of replacingan obsolete part with the most similarcomparable part available, the taxpayerreplaces the part with one of a better qual-ity than what would have sufficed.

The proposed regulations do not pre-scribe a plan of rehabilitation doctrine astraditionally described in the case law.That judicially-created doctrine providesthat a taxpayer must capitalize otherwisedeductible repair costs if they are incurredas part of a general plan of rehabilitationto the property. See, Norwest Corp. v.Commissioner, 108 T.C. 265 (1997); Mossv. Commissioner, 831 F.2d 833 (9th Cir.1987); United States v. Wehrli, 400 F.2d686 (10th Cir. 1968). Specifically, if anexpenditure is made as part of a generalplan of rehabilitation, modernization, andimprovement of the property, the expen-diture must be capitalized, even though,standing alone, the item may be classifiedas one of repair or maintenance. Wehrli,

September 25, 2006 542 2006–39 I.R.B.

400 F.2d at 689. Whether a general planof rehabilitation exists, and whether a par-ticular repair or maintenance item is partof it, are questions of fact to be determinedbased upon all the surrounding facts andcircumstances, including, but not limitedto, the purpose, nature, extent, and valueof the work done. Id. at 690.

The issue of whether an amount paidmust be capitalized under the plan of re-habilitation doctrine has been the subjectof much litigation, with varying results.For example, some cases have limited ap-plication of the plan of rehabilitation doc-trine to buildings that are not suitable fortheir intended use in the taxpayer’s trade orbusiness. See Schroeder v. Commissioner,T.C. Memo 1996–336; Koanis v. Commis-sioner, T.C. Memo 1978–184, aff’d mem.,639 F.2d 788 (9th Cir. 1981); Keller StreetDev. Co. v. Commissioner, 37 T.C. 559(1961); acq., 1962–2 C.B. 5, aff’d in part,rev’d in part on other grounds, 323 F.2d166 (9th Cir. 1963). Other courts, as wellas the IRS, have viewed the plan of rehabil-itation doctrine more broadly, emphasiz-ing the planned aspect of the work done bythe taxpayer, rather than the condition ofthe property. See Mountain Fuel SupplyCo. v. United States, 449 F.2d 816 (10th

Cir. 1971); Wolfsen Land & Cattle Co. v.Commissioner, 72 T.C. 1 (1979); Rev. Rul.88–57, 1988–2 C.B. 36.

In Rev. Rul. 2001–4, 2001–1 C.B. 295,the IRS clarified its view of the plan of re-habilitation doctrine. In applying the planof rehabilitation doctrine to the facts in Sit-uation 3 of that ruling, the IRS noted that(1) the taxpayer planned to perform sub-stantial capital improvements to upgradethe unit of property; (2) the repairs were in-cidental to the taxpayer’s plan to upgradethe unit of property; and (3) the effect ofall the work performed on the unit of prop-erty, including the repairs and maintenancework, was to materially increase the valueor prolong the useful life of the unit ofproperty. The ruling also notes that the ex-istence of a written plan, by itself, is notsufficient to trigger the plan of rehabilita-tion doctrine. The ruling’s interpretationof the plan of rehabilitation doctrine is con-sistent with the majority of cases apply-ing that doctrine. See California CasketCo. v. Commissioner, 19 T.C. 32 (1952),acq., 1953–1 C.B. 3; Stoeltzing v. Com-missioner, 266 F.2d 374 (3d Cir. 1959);

Bank of Houston v. Commissioner, T.C.M.1960–110.

The IRS and Treasury Department donot believe it is appropriate to capitalize asan improvement otherwise deductible re-pair costs solely because the taxpayer hasa plan (written or otherwise) to performperiodic repairs or maintenance or solelybecause the taxpayer performs several re-pairs to the same property at one time. TheIRS and Treasury Department believe thatit is appropriate to capitalize otherwise de-ductible repair costs as part of an improve-ment only if the taxpayer improves a unitof property and the otherwise deductiblerepair costs directly benefit or are incurredby reason of the improvement to the prop-erty. Section 263A applies to these expen-ditures. Section 263A requires that all di-rect costs of an improvement and all in-direct costs that directly benefit or are in-curred by reason of the improvement mustbe capitalized. This application of section263A to otherwise deductible repair costsin this context is consistent with the appli-cation of the plan of rehabilitation doctrinedescribed in Rev. Rul. 2001–4. The pro-posed regulations provide that repairs thatare made at the same time as an improve-ment, but that do not directly benefit orare not incurred by reason of the improve-ment, are not required to be capitalized un-der section 263(a).

VI. Value

A. In general

The proposed regulations provide thata taxpayer must capitalize amounts paidthat materially increase the value of a unitof property and provide an exclusive listof five tests for determining whether anamount paid materially increases value.An amount paid must be capitalized if itmeets any of the five tests. The first testis whether the amount paid ameliorates acondition or defect that either existed priorto the taxpayer’s acquisition of the unitof property or arose during the productionof the unit of property. See United DairyFarmers, Inc. v. United States, 267 F.3d510 (6th Cir. 2001); Dominion Resources,Inc. v. United States, 219 F.3d 359 (4th

Cir. 2000); Jones v. Commissioner, 242F.2d 616 (5th Cir. 1957). This rule is con-sistent with the concept that amounts paidto put property into ordinarily efficient op-

erating condition must be capitalized. Thispre-existing defect rule applies regardlessof whether the taxpayer was aware of thecondition or defect at the time of acqui-sition or production. The IRS and Trea-sury Department considered but rejectedas too subjective the idea of providing dif-ferent treatment based on the taxpayer’sprior knowledge of the condition or defect.The IRS and Treasury Department requestcomments on whether, and in what circum-stances, the pre-existing defect rule shouldtake into account the condition of the prop-erty in the hands of a transferor. For ex-ample, if an individual transfers propertyto a corporation in exchange for stock ina transaction under section 351, shouldthe pre-existing defect rule take into ac-count the condition of the property whenacquired by the individual, rather than thecondition of the property when received bythe corporation?

The second test for materially increas-ing value is whether the work was per-formed prior to the date the property isplaced in service by the taxpayer. Thistest essentially restates the concept thatamounts paid to put property into ordinar-ily efficient operating condition must becapitalized. The IRS and Treasury Depart-ment believe that if the property cannot beplaced in service prior to work being per-formed, that work necessarily increases thevalue of the property.

The third value test is whether theamounts paid adapt the property to a newor different use. The commentators agreedthat this factor should remain a standardfor capitalization. The new or differentuse standard is unchanged from the currentregulations, but it is included in the valuesection of the proposed regulations, ratherthan as its own standard. The new or dif-ferent use test is not intended to apply toamounts paid to prepare a unit of propertyfor sale (for example, painting a house).

The fourth value test is whether theamount paid results in a betterment ormaterial addition to the unit of property.The betterment language is consistentwith the statutory language of section263(a)(1) as well as the current regulationsat §1.263(a)–1(a)(1). A betterment is animprovement that does more than restoreto a former good condition. The better-ment test is intended to capture amountspaid that are qualitative improvements tothe property that make the property bet-

2006–39 I.R.B. 543 September 25, 2006

ter and more valuable than mere repairswould do, such as using upgraded mate-rials when materials comparable to theoriginal were available and would havesufficed. However, the betterment test isnot intended to be a fair market value test.

The fifth test in the value section ofthe proposed regulations is whether theamount paid results in a material increasein capacity, productivity, efficiency, orquality of output of the unit of property.These standards are consistent with caselaw under the current regulations.

The proposed regulations provide anexception to the value tests if the originaleconomic useful life of the unit of propertyis 12 months or less and the taxpayer doesnot elect to capitalize amounts paid for theproperty. The purpose of this rule is to notrequire capitalization under the value rulesfor improvements made to 12-month prop-erty. This exception, however, does not ap-ply to the restoration rule for determiningwhether an amount paid improves prop-erty. Thus, for example, if a taxpayer per-forms work on 12-month property that pro-longs the economic useful life of the prop-erty, the amount paid must be capitalized.

The proposed regulations do not adoptan increase in fair market value as a stan-dard for capitalization. In response toNotice 2004–6, most commentators statedthat value means fair market value. How-ever, in practice, taxpayers generally donot measure, and would have no reason tomeasure, the fair market value of a unit ofproperty prior to some condition necessi-tating the expenditure. Further, taxpayersgenerally have no reason to measure thefair market value of a unit of propertyafter the work is performed. The IRSand Treasury Department did not wantto propose regulations with a standardthat required taxpayers to have propertyappraised solely for the purpose of apply-ing a capitalization standard. In fact, thecourts rarely have applied a strict increasein fair market value standard. Usually,the courts rely on some surrogate for fairmarket value to determine whether valueis increased. For example, courts havelooked to the amount of the expenditureversus (1) the cost of the property (seeStoeltzing v. Commissioner, 266 F.2d 374(3d Cir. 1959)); (2) the cost of comparablenew property (see LaSalle Trucking Co.v. Commissioner, T.C. Memo 1963–274);and (3) the cost of comparable used prop-

erty (see Ingram Industries, Inc. v. Com-missioner, T.C. Memo 2000–323). Courtshave considered fair market value onlyin a few cases when property has beenappraised for some other purpose (seeJones v. United States, 279 F. Supp. 772,774 (D. Del. 1968)), or when propertyhas been appraised in the course of thelitigation (see FedEx, 291 F. Supp. 2d at706–707).

Additionally, the fair market value ofproperty may change over time without re-gard to the use, upkeep, or improvementsmade by the taxpayer, due to other factorssuch as supply and demand or changes instyle, trends, technologies, etc. For ex-ample, land may increase in fair marketvalue over time without the taxpayer per-forming any activities to improve it. Con-versely, amounts paid to make substantialimprovements to a unit of property maynot always increase fair market value, ormay not increase the fair market value bythe full amount paid for the improvements.See, Harrah’s Club v. United States, 661F.2d 203 (Ct. Cl. 1981) (amount paid torestore antique automobiles must be capi-talized even though restoration did not in-crease fair market value by the amountpaid for the restoration). Attempting to ad-just fair market value for factors like thesefurther complicates any possible compar-ison. The IRS and Treasury Departmentbelieve that the fair market value standardis too subjective and impractical, particu-larly because most repairs also increase thefair market value of property if the value iscompared immediately before and after thework is performed. Therefore, the IRS andTreasury Department do not believe thatfair market value is an appropriate stan-dard. The value factors in the proposedregulations are intended to be objective in-dications of work performed that generallywould increase the fair market value of theunit of property. Whether amounts paidmaterially increase the value of a unit ofproperty requires an analysis of the pur-pose, the physical nature, and the effect ofthe work for which the amounts were paid,and not an analysis of the fair market valueof the property or the level of monetary ex-penditures.

Some commentators requested that theregulations provide a bright line rule defin-ing a material increase in value with re-spect to a specified percentage increase,for example a twenty-five percent increase

in capacity. The IRS and Treasury De-partment do not believe that providing afixed percentage as a presumption of whatis a material increase would be an ap-propriate safe harbor. Although perhapsmeasurable, the same fixed percentage in-crease in capacity would not work well asa rule applicable to all types of property.A twenty-five percent increase in capacitymay be a reasonable litmus test for deter-mining whether there has been a materialincrease in value for certain types of prop-erty. However, for many types of property,a much smaller increase in capacity maybe an extraordinary, or in some cases im-possible, improvement. For example, anincrease in the square footage of a 50,000square foot building by 5 percent would bea rather large improvement that should becapitalized. Therefore, the determinationof whether an increase in capacity, produc-tivity, efficiency, or quality is a material in-crease in value should be based on all thefacts and circumstances.

B. Appropriate comparison

Notice 2004–6 requested commentson the proper starting point for compar-ing whether an expenditure materiallyincreases the value of property. Almost allthe commentators suggested that the pro-posed regulations adopt the test set forthin Plainfield-Union Water Co. v. Commis-sioner, 39 T.C. 333 (1962), nonacq. onother grounds (1964–2 C.B. 8) (the Plain-field-Union test). In that case, the courtnoted that almost any properly performedrepair adds value as compared with thesituation existing immediately prior tothat repair. The proper test, the courtsaid, is whether the expenditure materiallyenhances the value of the property as com-pared with the status of the property priorto the condition necessitating the expen-diture. The court also noted that the testis appropriate even when the expendituredoes not arise from a sudden, unexpected,or unusual external circumstance.

The IRS and Treasury Departmentagree with this application of the Plain-field-Union test and believe that the test isappropriately applied to cases of normalwear and tear as well as cases when theexpenditure arises from a sudden, unex-pected, or unusual external circumstance.The proposed regulations adopt the Plain-field-Union test for cases in which a partic-

September 25, 2006 544 2006–39 I.R.B.

ular event necessitates the expenditure andclarify that when the event necessitatingthe expenditure is normal wear and tear,the condition of the property immediatelyprior to the event necessitating the ex-penditure is the condition of the propertyafter the last time the taxpayer correctedthe effects of normal wear and tear or, ifthe taxpayer has not previously correctedthe effects of normal wear and tear, thecondition of the property when placed inservice by the taxpayer. This comparisonrule for wear and tear is intended to applywhen a taxpayer engages in regular, cycli-cal maintenance of a unit of property tocorrect the effects of normal wear and tear.Although wear and tear begins affectingthe condition of property as soon as it isplaced in service, the proposed regulationsdo not adopt the placed-in-service dateas the appropriate comparison point. Al-though the placed-in-service date wouldbe the appropriate comparison point whenthe taxpayer first corrects the effects ofnormal wear and tear, the IRS and Trea-sury Department believe that the conditionof the property after the previous mainte-nance cycle is the appropriate comparisonpoint for each subsequent maintenancecycle.

The Plainfield-Union test works wellwhen the amount paid is necessitated by aspecific event (like amounts paid to repairdamage or amounts paid to maintain prop-erty by correcting the effects of wear andtear). However, the test does not work ina pure improvement setting; that is, whena taxpayer decides to improve propertywithout any event causing the taxpayerto perform the work to restore the prop-erty to a former good condition. There-fore, the proposed regulations do not ap-ply the Plainfield-Union test to the firstthree value factors (pre-existing defects,work performed prior to the property beingplaced in service, and adapting the prop-erty to a new or different use). These fac-tors are more appropriately analyzed on anabsolute, rather than relative basis. Sim-ilarly, the test does not work well for bet-terments, which by definition are improve-ments that do more than restore property toa former good condition.

VII. Restoration

The proposed regulations provide thata taxpayer must capitalize amounts paid to

restore property. The restoration lan-guage is from section 263(a)(2) and§1.263(a)–1(a)(2) of the current regu-lations and generally has been viewedas a rule requiring the capitalizationof amounts paid that substantially pro-long the useful life of the property. See§1.263(a)–1(b). This section of the pro-posed regulations defines economic usefullife and what it means to substantiallyprolong economic useful life.

The comments received in responseto Notice 2004–6 varied greatly with re-gard to useful life, with two commentatorsspecifically suggesting that the concept ofuseful life be eliminated from the regula-tions. The other commentators suggestedthat economic useful life be defined as theperiod of time over which the propertyis expected to be useful to the taxpayer,taking into account the various factorslisted in §1.167(a)–1(b). The proposedregulations adopt this definition of eco-nomic useful life for taxpayers that do nothave an AFS. Economic useful life is notdetermined by reference to the recoveryperiod under section 168 for the property.

For a taxpayer that has an AFS, the eco-nomic useful life of the property is pre-sumed to be the same as the useful lifeused by the taxpayer for purposes of deter-mining depreciation in its AFS. The IRSand Treasury Department believe that theeconomic useful life definition is subjec-tive and difficult to apply; therefore, thisrule provides certainty for taxpayers withan AFS. The regulations provide an excep-tion to this rule for situations in which ataxpayer does not assign a useful life tocertain property in its AFS, even thoughthe property has a useful life of more thanone year. For example, a taxpayer maytreat amounts paid for a unit of propertyas an expense in its AFS if the property isused in a specific research project and hasno alternative future uses. Additionally,many taxpayers have a policy of treatingas an expense in their AFS an amount paidfor tangible property below a certain dol-lar threshold, despite the fact that the prop-erty has a useful life of more than one year.This type of property does not have a use-ful life for purposes of determining depre-ciation in the taxpayer’s AFS, even thoughit may have a useful life of more than oneyear. Therefore, the IRS and Treasury De-partment believe that in these situations itis appropriate for taxpayers to use the eco-

nomic useful life definition that applies totaxpayers without an AFS.

One commentator stated that the usefullife used for book depreciation purposes isnot appropriate for tax purposes becausethe book useful life takes into account fac-tors that do not measure the inherent usefullife, but rather the period over which theproperty is expected to be useful (on av-erage) to the taxpayer. The IRS and Trea-sury Department believe it is appropriateto take into account the period over whichthe property may reasonably be expectedto be useful to the taxpayer, as required bytaxpayers without an AFS, rather than theinherent useful life of the property.

The proposed regulations also providefour rules for determining when an amountpaid substantially prolongs economic use-ful life. The first rule requires capitaliza-tion when the amount paid extends the pe-riod over which the property may reason-ably be expected to be useful to the tax-payer beyond the end of the taxable yearimmediately succeeding the taxable yearin which the economic useful life of theproperty was originally expected to cease.One commentator suggested that the reg-ulations provide a safe harbor bright linerule to define whether an amount substan-tially prolongs the useful life. The IRSand Treasury Department believe that aone year rule is an appropriate bright line.Therefore, the regulations require capital-ization when the amount paid extends theoriginal useful life of the property by morethan one taxable year. The IRS and Trea-sury Department believe that a one yearrule is a more appropriate bright line thana rule based on a percentage of the usefullife, because the one-year rule correspondswith the 12-month safe harbor rule for theacquisition or production of property.

The second rule requires capitalizationif a major component or a substantial struc-tural part of the unit of property is replacedand notes that the replacement of a rela-tively minor portion of the physical struc-ture of the unit of property or a relativelyminor portion of any of its major parts doesnot constitute the replacement of a majorcomponent or substantial structural part ofthe unit of property. It is possible, how-ever, for amounts paid to replace a rela-tively minor portion of the physical struc-ture of the unit of property or a relativelyminor portion of any of its major partsto substantially prolong the economic use-

2006–39 I.R.B. 545 September 25, 2006

ful life of the property if the property isnear the end of its economic useful life,in which case the amounts paid neverthe-less must be capitalized. The rule is not in-tended to require capitalization if a majorcomponent is replaced with a similar, usedcomponent that has not been rebuilt, forexample, if the engine in a car is replacedwith a used engine with similar mileageobtained from a junkyard, or a componentof property subject to a warranty or main-tenance agreement is replaced with a usedpart that has been repaired.

Although the replacement of minorparts does not usually prolong the eco-nomic useful life of most property, thereplacement of most or all minor parts forsome types of property may be the equiva-lent of rebuilding the property, particularlyin cases in which the property consists al-most entirely of minor parts. Therefore,the third rule provides that amounts paidthat restore a unit of property (or a majorcomponent or substantial structural part ofthe unit of property) to a like-new condi-tion substantially prolong the useful life.The IRS and Treasury Department intendthat this test be applied to situations inwhich the property undergoes the equiva-lent of being rebuilt. Merely recondition-ing a property by dismantling the property,and cleaning and inspecting components,is not the equivalent of rebuilding. All oralmost all major and minor parts of theunit of property (or the major componentor substantial structural part of the unit ofproperty) must be returned to the originalmanufacturers’ specifications.

The fourth rule relates to the restorationof a unit of property after the taxpayer hasproperly deducted a casualty loss undersection 165 with respect to the property.Section 165(a) allows a taxpayer to deductany loss sustained during the taxable yearand not compensated for by insuranceor otherwise. Generally, any loss arisingfrom a fire, storm, shipwreck, or othercasualty is allowable as a deduction undersection 165(a). Section 1.165–7(a)(1).The amount of the deduction is the dif-ference between the fair market value ofthe property before and after the casualty,to the extent the amount does not exceedthe property’s adjusted basis. Section1.165–7(b)(1). A casualty loss deductionunder section 165(a) results in a decreasein the taxpayer’s basis in the property.

The courts have distinguished betweenlosses that are deductible as casualtiesunder section 165(a) and incidental repaircosts that are deductible under section162(a) as ordinary and necessary businessexpenses. In general, if property is lost,destroyed, or abandoned as a result of acasualty, a loss deduction under section165(a) is appropriate; however, if propertyis simply damaged in a casualty and ex-penditures are made to repair the propertyin a manner that does not permanently im-prove or better it or prolong its useful life,those expenditures are business expensesdeductible under section 162(a). Henslerv. Commissioner, 73 T.C. 168, 179 (1979);see also Hubinger v. Commissioner, 36F.2d 724, 726 (2d Cir. 1929) (expensesresulting from “trifling accidental causes”are deductible only under section 162(a)and not under section 165(a)); AtlanticGreyhound Corp. v. United States, 111F. Supp. 953 (1953) (“the provisions fordeductions of ‘ordinary and necessary ex-penses’ and ‘casualty losses’ would seemto be mutually exclusive, for the normalconnotation of one negates, at least byimplication, the idea of the other”). Thus,the mere fact that the damage results froma casualty is not controlling; instead, thenature of the damage resulting from the ca-sualty is relevant in determining whetherthe expenditure should be treated as a lossor deduction.

The IRS and Treasury Departmentbelieve that when a taxpayer properlydeducts a casualty loss, the nature of thedamage resulting from the casualty issuch that any repairs done to restore theproperty after the casualty should not betreated as ordinary and necessary repaircosts. Thus, the proposed regulationsprovide that any amounts paid to repairproperty after a casualty loss must be cap-italized.

Commentators stated that amounts paidat any point during the property’s eco-nomic useful life that do not change thefunction, design, etc., but enable prop-erty to be used for its expected useful lifeshould not be determined to extend theuseful life. The IRS and Treasury Depart-ment believe that there are circumstancesin which amounts paid that merely restoreproperty to a former good condition mayproperly be capitalized as substantiallyprolonging useful life, for example, whenrepairs are made to property after a ca-

sualty loss. As another example, workperformed at the end of the economic use-ful life of the unit of property may extendthe property’s useful life. Additionally,replacement of a major component or asubstantial structural part of a unit of prop-erty extends the useful life, particularlywhen the expected life of the component iscoterminous with the economic useful lifeof the unit of property, and the economicuseful life of the unit of property is infact limited by the period over which thecomponent is expected to be useful. Thus,the proposed regulations do not adopt thecommentators’ suggestion.

VIII. Repair Allowance Method

A. In general

The primary focus of the proposedregulations is to provide guidance that dis-tinguishes deductible repair expenses fromcapital expenditures. However, becausethis remains inherently a facts-and-cir-cumstances based determination, the IRSand Treasury Department requested com-ments in Notice 2004–6 on whether theregulations should provide a repair al-lowance. Six commentators suggestedthe regulations should provide a repairallowance or other de minimis rules forrepair expenditures. Two commentatorsspecifically proposed a repair allowancesystem modeled on the former CLADR re-pair allowance system. The proposed reg-ulations adopt these suggestions and pro-vide an optional repair allowance method,similar to the CLADR repair allowance,to create objective rules in this area. Al-though some commentators additionallyrequested other de minimis rules for re-pair expenditures as well, the IRS andTreasury Department believe that a repairallowance is an appropriate safe harborfor repair expenditures. Therefore, theproposed regulations do not provide a safeharbor other than the repair allowance.

Under the repair allowance in the pro-posed regulations, the taxpayer comparesthe amounts paid for materials and laborduring the taxable year to repair, maintain,or improve repair allowance property tothe repair allowance amount. The amountspaid are deductible under section 162 tothe extent of the repair allowance amount,and any excess amounts paid are capital-ized. Under the proposed repair allowance

September 25, 2006 546 2006–39 I.R.B.

method, a repair allowance amount isdetermined separately for each MACRSclass. The repair allowance amount fora particular class is determined by multi-plying the repair allowance percentage ineffect for that class by the average unad-justed basis of repair allowance propertyin that class. For buildings that are repairallowance property, the repair allowancemethod is applied separately to each build-ing. This rule is consistent with the rulefor buildings under the CLADR repairallowance system.

B. Capitalized amount

The excess of amounts paid to re-pair, maintain, or improve all the repairallowance property in a MACRS classover the repair allowance amount for theclass must be capitalized (the capital-ized amount). The capitalized amountincludes the taxpayer’s direct costs of re-pairing, maintaining, or improving repairallowance property in a particular MACRSclass. In addition, the taxpayer must addto the capitalized amount any allocableindirect costs of producing the repair al-lowance property in the MACRS class,which must be capitalized in accordancewith the taxpayer’s method of accountingfor section 263A costs. Except with re-gard to repair allowance property that isdepreciated under section 168(g) or repairallowance property that is public utilityproperty (for which separate rules are pro-vided), the proposed regulations permittaxpayers to choose one of two methods oftreating the capitalized amount. The firstmethod is to treat the capitalized amountas a separate single asset and to depreciatethe asset in accordance with that MACRSclass. The second method is to allocatethe capitalized amount for a particularMACRS class to all repair allowanceproperty in the particular MACRS classin proportion to the unadjusted basis ofthe property in that MACRS class as ofthe beginning of the taxable year. Undereither the single asset method or the allo-cation method, the capitalized amount istreated as a section 168(i)(6) improvementand is treated as placed in service by thetaxpayer on the last day of the first halfof the taxable year in which the amount ispaid, before application of the conventionunder section 168(d). For example, thecapitalized amount for a calendar year tax-

payer would be treated as placed in serviceon June 30 of the taxable year.

Because the single asset treatment doesnot permit taxpayers to recognize a gain orloss on the disposition of repair allowanceproperty, the IRS and Treasury Depart-ment request comments on whether, in thefinal regulations, taxpayers should be per-mitted to change to the allocation treat-ment for the taxable year of disposition andif so, what record keeping rules or otherrules should be required for taxpayers tomake that change. With regard to the allo-cation treatment, the IRS and Treasury De-partment request comments on whether theallocation should be based on an amountother than the unadjusted basis as of thebeginning of the taxable year, such as theunadjusted basis at the end of the taxableyear or the average unadjusted basis.

C. Repair allowance property

Repair allowance property is definedin the proposed regulations as real or per-sonal property subject to MACRS thatis used in the taxpayer’s trade or busi-ness or for the production of income. Italso includes certain tangible propertynot otherwise subject to MACRS if thetaxpayer, solely for purposes of the repairallowance method, classifies the propertyin the appropriate MACRS class in whichthe property would be included if the prop-erty were subject to MACRS. Taxpayersare not required to classify non-MACRSproperty (property placed in service be-fore the effective date of section 168 andproperty for which the taxpayer properlyelected out of section 168). Non-classi-fied property will not be repair allowanceproperty eligible for the repair allowancemethod. Certain types of property arenot included in repair allowance prop-erty, including any property for which thetaxpayer has elected to use the CLADRrepair allowance method and property forwhich the taxpayer uses the method of ac-counting provided in Rev. Proc. 2001–46,2001–2 C.B. 263, or Rev. Proc. 2002–65,2002–2 C.B. 700 (both with regard to rail-road track). Thus, the repair allowance inthe proposed regulations does not repealthe CLADR repair allowance, nor does itprohibit taxpayers from using the repairallowance method in these regulations forrepair allowance property, while contin-

uing to use the CLADR repair allowancefor other property.

D. Excluded additions

Repair allowance property also doesnot include excluded additions, the cost ofwhich must be capitalized. The CLADRrepair allowance system has a similar rule.Under the CLADR repair allowance sys-tem, excluded additions are defined asany expenditures (1) that increase by 25%or more the productivity or capacity ofan existing identifiable unit of propertyover its productivity or capacity when firstacquired; (2) that modify an existing iden-tifiable unit of property for a substantiallydifferent use; (3) for an additional iden-tifiable unit of property or a replacementof an identifiable unit of property that wasretired; (4) for a replacement of a part inor a component or portion of an existingidentifiable unit of property if such part,component, or portion is for replacementof a part, component or portion which wasretired in a retirement upon which gain orloss was recognized; (5) in the case of abuilding or other structure, for additionalcubic or linear space; and (6) in the case ofthose units of property of pipelines, elec-tric utilities, telephone companies, andtelegraph companies consisting of lines,cables, and poles, for replacement of 5%or more of the unit of property with respectto which the replacement is made.

One commentator suggested that theproposed regulations should not haveexcluded additions similar to those in theCLADR repair allowance because they aretoo qualitative and difficult to administer.The IRS and Treasury Department agreethat some of the items listed as excludedadditions under the CLADR system aretoo subjective and do not provide the kindof objective determination the proposedrepair allowance is intended to provide.For this reason, the proposed regulationslimit the excluded additions to amountspaid (1) for the acquisition or produc-tion of a specific unit of property; (2)for work that ameliorates a condition ordefect that either existed prior to the tax-payer’s acquisition of the unit of propertyor arose during the production of the unitof property, whether or not the taxpayerwas aware of the condition or defect atthe time of acquisition or production; (3)for work performed prior to the date the

2006–39 I.R.B. 547 September 25, 2006

unit of property is placed in service by thetaxpayer (without regard to any applicableconvention under section 168(d)); (4) thatadapts the unit of property to a new or dif-ferent use; or (5) that increases the cubicor square space of a building.

Thus, the proposed regulations adoptexcluded additions 2, 3, and 5 in theCLADR repair allowance. These ex-cluded additions are also listed in§1.263(a)–3(e)(1) of the proposed reg-ulations as factors that indicate a materialincrease in value. The regulations do notadopt excluded addition 1 in the CLADRrepair allowance because an increase inproductivity or capacity of 25% or moremay be too difficult to measure. The reg-ulations do not specifically cite excludedaddition 4 from the CLADR repair al-lowance; however, if a part, component,or portion of a unit of property is retiredin a retirement upon which gain or lossproperly was recognized, the replacementof that component is a separate unit ofproperty under §1.263(a)–3(d)(2) of theproposed regulations and thus is addressedby excluded addition 1 of the proposedregulations. Excluded addition 6 in theCLADR repair allowance addresses net-work assets and was not adopted in theproposed regulations pending commentson how the final regulations should ad-dress the unit of property rules relating tonetwork assets.

In addition to the three excluded addi-tions that the proposed regulations carryover from the CLADR repair allowance,the excluded additions in the proposed reg-ulations include amounts paid for workthat ameliorates a pre-existing conditionor defect and for work performed prior tothe date the unit of property is placed inservice by the taxpayer. These two ex-cluded additions also are listed as factorsin §1.263(a)–3(e)(1) of the proposed reg-ulations that indicate a material increasevalue. The IRS and Treasury Departmentbelieve that the excluded additions pro-vided in the repair allowance in the pro-posed regulations are more objective thanthose in the CLADR regulations and areeasier to verify.

E. Leased property

Like the repair allowance underCLADR, repair allowance property doesnot include property leased by the tax-

payer from another party. One commen-tator suggested that the repair allowanceapply to leased property. The IRS andTreasury Department recognize that tax-payers that lease property confront thesame issues as owners in distinguishingdeductible repairs from capital improve-ments. However, the application of the re-pair allowance method to leased propertyraises several difficult issues. The IRS andTreasury Department request commentson whether the repair allowance methodshould be extended to leased property and,if so, how the following issues should beresolved: (1) How should the unadjustedbasis of leased property be determined?Should fair market value be used insteadof unadjusted basis and, if so, how andwhen should fair market value be deter-mined? (2) How should the regulations bedrafted to prevent abuse between relatedlessors and lessees? (3) How should theregulations be drafted to prevent both thelessor and lessee from using the repairallowance method for the same property?(4) How should the regulations addressqualified lessee construction allowancesfor short-term leases under section 110?(5) What is the proper treatment of thecapitalized amount for leased propertyunder the repair allowance? (6) Shouldlessees be permitted to classify the leasedproperty to a MACRS class and use one ofthe treatments of the capitalized amountin the proposed regulations? (7) Shouldthe capitalized amount be allocated toindividual leases and amortized over theremaining term of each lease and, if so,how should that allocation be made? (8) Ifthe taxpayer has a number of leases withvarying lease terms, should the capitalizedamount be allocated to certain groups ofleases and amortized over the average re-maining term of the leases and if so, howshould the leases be grouped? (9) Arethere any other issues with regard to theapplication of a repair allowance to leasedproperty that need to be addressed?

F. Network assets

The definition of repair allowance prop-erty in the proposed regulations does notspecifically exclude network assets. How-ever, application of the repair allowancerequires a determination of the appropriateunit of property, in particular with regardto identifying excluded additions. The unit

of property determination with regard tonetwork assets is not addressed in the pro-posed regulations and is an issue on whichthe IRS and Treasury Department have re-quested comments. Therefore, the IRS andTreasury Department anticipate that finalregulations specifically will include net-work assets as repair allowance propertyif appropriate unit of property rules can bedetermined. If appropriate unit of propertyrules cannot be determined for network as-sets, the IRS and Treasury Department re-quest comments on whether to develop in-dustry-specific guidance on how the repairallowance method should apply (in partic-ular, how excluded additions should be de-termined) with regard to network assets ina particular industry.

G. Repair allowance percentages

The repair allowance percentages un-der the CLADR repair allowance weredetermined by the Treasury Department’sOffice of Industrial Economics, whichis no longer in existence. The percent-ages were published in various revenueprocedures (most recently in Rev. Proc.83–35, 1983–1 C.B. 745), made obsoleteby Rev. Proc. 87–56, 1987–2 C.B. 674,with regard to property subject to section168, and were revised and supplementedperiodically. The proposed regulationscreate a new repair allowance percent-age for each MACRS class. These ratesare based on the principle that a taxpayerwill spend 50% of the property’s unad-justed basis on repairs over the property’sMACRS recovery period. Thus, the re-pair allowance percentages for a particularMACRS class in the proposed regulationswere computed by: (1) dividing 100% bythe number of years in the recovery periodfor the MACRS class, which representsthe portion of the property’s unadjustedbasis that is allocable to each year of therecovery period, and; (2) multiplying theresult by 50%. For example, if a tax-payer has repair allowance property ina MACRS class with a 5 year recoveryperiod, 100% divided by 5 is 20%, whichrepresents the portion of the property’sunadjusted basis that is allocable to eachyear of the recovery period. Multiplyingthe 20% amount by 50% results in a re-pair allowance percentage of 10% for thatMACRS class.

September 25, 2006 548 2006–39 I.R.B.

The IRS and Treasury Department re-quest comments on whether the repairallowance percentages should be differentthan those provided in the proposed reg-ulations, whether the rates in Rev. Proc.83–35 should be used, and whether thefinal regulations should permit taxpay-ers to choose between repair allowancepercentages in Rev. Proc. 83–35 andthe final regulations. The IRS and Trea-sury Department also request commentson whether a separate repair allowancepercentage should be provided for certaintypes of property, such as repair allowanceproperty subject to section 168(g) (forexample, a percentage that reflects therecovery period under the alternative de-preciation system in section 168(g) ratherthan the MACRS recovery period undersection 168). Finally, the IRS and Trea-sury Department request comments onwhether industries should be permittedto request guidance through the IndustryIssue Resolution program to establish dif-ferent repair allowance percentages fortheir particular industry.

H. Manner of electing and manner ofrevoking election

The proposed regulations reserve the is-sue of how a taxpayer will elect the re-pair allowance method. Two commenta-tors suggested that taxpayers be permittedto elect the repair allowance on a year byyear basis. The IRS and Treasury Depart-ment disagree with this suggestion. Therepair allowance method is a method of ac-counting under section 446(e) and shouldbe used consistently by taxpayers. Allow-ing a year by year election would com-plicate a taxpayer’s record keeping andwould create a burden on IRS examiningagents when auditing a taxpayer’s com-pliance with the repair allowance method.Therefore, the IRS and Treasury Depart-ment do not expect to permit a year byyear election. However, even though therepair allowance method is a method ofaccounting under section 446(e), the IRSand Treasury Department expect to pro-vide that taxpayers may elect the repairallowance method prospectively withouthaving to file an application for change inaccounting method and that the electionbe done on a cutoff basis. Procedures forelecting the repair allowance method willbe provided either in the final regulations

or in published guidance in the InternalRevenue Bulletin.

The proposed regulations provide thatthe repair allowance method, if elected,must be elected for all repair allowanceproperty. A taxpayer may revoke an elec-tion made under the repair allowancemethod only by obtaining the Commis-sioner’s consent. Procedures for obtainingthe Commissioner’s consent to revoke anelection will be provided either in the finalregulations or in published guidance in theInternal Revenue Bulletin. The IRS andTreasury Department expect to providethat a taxpayer that revokes an electionmay not re-elect the repair allowancemethod for a period of at least five tax-able years, beginning with the year of therevocation unless, based on a showing ofunusual and compelling circumstances,consent is specifically granted by theCommissioner to re-elect the repair al-lowance at an earlier time. The IRS andTreasury Department request commentson the appropriateness of the five yearwaiting period, as well as on the circum-stances that should be considered unusualand compelling so that the Commissionerwould grant consent to re-elect the repairallowance prior to expiration of the fiveyear waiting period.

I. Record keeping

The proposed regulations do not imposeany specific record keeping requirements.However, under section 6001, taxpayersare required to keep books and records suf-ficient to establish the amounts used tocompute a deduction under the repair al-lowance method. For example, taxpayersmust maintain books and records reason-ably sufficient to determine (1) the totalamounts paid (other than amounts paid forexcluded additions) during the taxpayeryear for the repair, maintenance, or im-provement of repair allowance property inthe specific MACRS class; (2) the unad-justed basis of all repair allowance prop-erty in the specific MACRS class at thebeginning and the end of the taxable year;(3) the repair allowance percentages usedfor the specific MACRS class for the tax-able year; and (4) the treatment of the cap-italized amounts (whether capitalized as asingle asset or allocated to all repair al-lowance property in the specific MACRSclass).

Proposed Effective Date

These regulations are proposed to ap-ply to taxable years beginning on or af-ter the date the final regulations are pub-lished in the Federal Register. The finalregulations will provide rules applicable totaxpayers that seek to change a method ofaccounting to comply with the rules con-tained in the final regulations. Taxpay-ers may not change a method of account-ing in reliance upon the rules contained inthe proposed regulations until the rules arepublished as final regulations in the Fed-eral Register.

The IRS and Treasury Department an-ticipate that, except as otherwise provided(for example, in the repair allowance sec-tion), the final regulations will providethat a taxpayer seeking to change to amethod of accounting provided in the fi-nal regulations must follow the applicableprocedures for obtaining the Commis-sioner’s automatic consent to a change inaccounting method. Generally, a change inmethod of accounting is made using an ad-justment under section 481(a). However,the IRS and Treasury Department are con-cerned about the potential administrativeburden on taxpayers and the IRS that mayresult from section 481(a) adjustments thatoriginate many years prior to the effectivedate of the final regulations. The IRS andTreasury Department request commentson whether there are circumstances inwhich it is appropriate to permit a changein method of accounting to be made usinga cut-off basis instead of a section 481(a)adjustment. Finally, the IRS and TreasuryDepartment request comments on any ad-ditional terms and conditions for changesin methods of accounting that would behelpful to taxpayers in adopting the rulescontained in these proposed regulations.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a signifi-cant regulatory action as defined in Exec-utive Order 12866. Therefore, a regula-tory assessment is not required. It also hasbeen determined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to these regu-lations, and, because the regulation doesnot impose a collection of information onsmall entities, the Regulatory Flexibility

2006–39 I.R.B. 549 September 25, 2006

Act (5 U.S.C. chapter 6) does not apply.Pursuant to section 7805(f) of the Code,this notice of proposed rulemaking will besubmitted to the Chief Counsel for Advo-cacy of the Small Business Administrationfor comment on its impact on small busi-ness.

Comments and Public Hearing

Before the proposed regulations areadopted as final regulations, considerationwill be given to any written comments(a signed original and eight (8) copies)or electronic comments that are submittedtimely to the IRS. Comments are requestedon all aspects of the proposed regulations.In addition, the IRS and Treasury Depart-ment specifically request comments onthe clarity of the proposed rules and howthey may be made easier to understand.All comments will be available for publicinspection and copying.

A public hearing has been scheduledfor Tuesday, December 19, 2006, at 10:00a.m., in the auditorium of the New Car-rollton Federal Building, 5000 Ellin Road,Lanham, MD 20706. Due to building se-curity procedures, visitors must enter atthe main front entrance. In addition, allvisitors must present photo identificationto enter the building. Because of accessrestrictions, visitors will not be admittedbeyond the immediate entrance area morethan 30 minutes before the hearing starts.For information about having your nameplaced on the building access list to attendthe hearing, see the “FOR FURTHER IN-FORMATION CONTACT” section of thispreamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit electronic or written comments andan outline of the topics to be discussed andthe time to be devoted to each topic (signedoriginal and eight (8) copies) by Novem-ber 28, 2006. A period of 10 minutes willbe allotted to each person for making com-ments. An agenda showing the schedulingof the speakers will be prepared after thedeadline for receiving outlines has passed.Copies of the agenda will be available freeof charge at the hearing.

Drafting Information

The principal author of these regula-tions is Kimberly L. Koch, Office of the

Associate Chief Counsel (Income Tax andAccounting), IRS. However, other person-nel from the IRS and Treasury Departmentparticipated in their development.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.162–4 is revised to

read as follows:

§1.162–4 Repairs.

Amounts paid for repairs and mainte-nance to tangible property are deductibleif the amounts paid are not required to becapitalized under §1.263(a)–3.

Par. 3. Section 1.263(a)–0 is amendedby revising the entries for §1.263(a)–1through §1.263(a)–3 to read as follows:

§1.263(a)–0 Table of contents. * * *

§1.263(a)–1 Capital expenditures; ingeneral.

(a) General rule for capital expendi-tures.

(b) Examples of capital expenditures.(c) Amounts paid to sell property.(1) In general.(2) Treatment of capitalized amount.(3) Examples.(d) Amount paid.(e) Effective date.(f) Accounting method changes.

§1.263(a)–2 Amounts paid to acquire orproduce tangible property.

(a) Overview.(b) Definitions.(1) Amount paid.(2) Personal property.(3) Real property.(4) Produce.(c) Coordination with other provisions

of the Internal Revenue Code.(1) In general.(2) Materials and supplies.

(d) Acquired or produced tangible prop-erty.

(1) In general.(i) Requirement of capitalization.(ii) Examples.(2) Defense or perfection of title to tan-

gible property.(i) In general.(ii) Examples.(3) Transaction costs.(i) In general.(ii) Examples.(4) 12-month rule.(i) In general.(ii) Coordination with section 461.(iii) Exceptions to 12-month rule.(iv) Character of property subject to

12-month rule.(v) Election to capitalize.(vi) Examples.(e) Treatment of capital expenditures.(f) Recovery of capitalized amounts.(1) In general.(2) Examples.(g) Effective date.(h) Accounting method changes.

§1.263(a)–3 Amounts paid to improvetangible property.

(a) Overview.(b) Definitions.(1) Amount paid.(2) Personal property.(3) Real property.(c) Coordination with other provisions

of the Internal Revenue Code.(1) In general.(2) Example.(d) Improved property.(1) Capitalization rule.(2) Determining the appropriate unit of

property.(i) In general.(ii) Initial unit of property determina-

tion.(iii) Category I: Taxpayers in regulated

industries.(iv) Category II: Buildings and struc-

tural components.(v) Category III: Other personal prop-

erty.(vi) Category IV: Other real property.(vii) Additional rule.(viii) Examples.(3) Compliance with regulatory re-

quirements.(4) Unavailability of replacement parts.

September 25, 2006 550 2006–39 I.R.B.

(5) Repairs performed during an im-provement.

(i) In general.(ii) Exception for individuals.(e) Value.(1) In general.(2) Exception.(3) Appropriate comparison.(4) Examples.(f) Restoration.(1) In general.(2) Economic useful life.(i) Taxpayers with an applicable finan-

cial statement.(ii) Taxpayers without an applicable fi-

nancial statement.(iii) Definition of “applicable financial

statement.”(3) Substantially prolonging economic

useful life.(i) In general.(ii) Replacements.(iii) Restoration to like-new condition.(iv) Restoration after a casualty loss.(4) Examples.(g) Repair allowance method.(1) In general.(2) Election of repair allowance

method.(3) Application of repair allowance

method.(4) Repair allowance amount.(i) In general.(ii) Average unadjusted basis.(iii) Unadjusted basis.(iv) Buildings.(5) Capitalized amount.(i) In general.(ii) Single asset treatment of capitalized

amount.(iii) Allocation treatment of capitalized

amount.(iv) Section 168(g) repair allowance

property.(v) Section 168(g) election.(vi) Public utility property.(6) Repair allowance property.(i) In general.(ii) Certain property not subject to sec-

tion 168.(iii) Exclusions from repair allowance

property.(7) Excluded additions.(i) In general.(ii) Treatment of excluded additions.(8) Repair allowance percentage.(9) Manner of election.(10) Manner of revoking election.

(11) Examples.(h) Treatment of capital expenditures.(i) Recovery of capitalized amounts.(j) Effective date.(k) Accounting method changes.

* * * * *Par. 4. Sections 1.263(a)–1 through

1.263(a)–3 are revised to read as follows:

§1.263(a)–1 Capital expenditures; ingeneral.

(a) General rule for capital expendi-tures. Except as provided in chapter 1 ofthe Internal Revenue Code, no deductionis allowed for—

(1) Any amount paid for new buildingsor for permanent improvements or better-ments made to increase the value of anyproperty or estate, or

(2) Any amount paid in restoring prop-erty or in making good the exhaustionthereof for which an allowance is or hasbeen made in the form of a deduction fordepreciation, amortization, or depletion.

(b) Examples of capital expenditures.The following amounts paid are examplesof capital expenditures:

(1) An amount paid to acquire orproduce real or personal property. See§1.263(a)–2.

(2) An amount paid to improve real orpersonal property. See §1.263(a)–3.

(3) An amount paid to acquire or createintangibles. See §1.263(a)–4.

(4) An amount paid or incurred to facil-itate an acquisition of a trade or business,a change in capital structure of a businessentity, and certain other transactions. See§1.263(a)–5.

(5) An amount assessed and paid un-der an agreement between bondholders orshareholders of a corporation to be used ina reorganization of the corporation or vol-untary contributions by shareholders to thecapital of the corporation for any corporatepurpose. See section 118 and §1.118–1.

(6) An amount paid by a holding com-pany to carry out a guaranty of dividendsat a specified rate on the stock of a sub-sidiary corporation for the purpose of se-curing new capital for the subsidiary andincreasing the value of its stockholdings inthe subsidiary. This amount must be addedto the cost of the stock in the subsidiary.

(c) Amounts paid to sell property—(1)In general. Commissions and other trans-action costs paid to facilitate the sale

of property generally must be capitalized.However, in the case of dealers in property,amounts paid to facilitate the sale of prop-erty are treated as ordinary and necessarybusiness expenses. See §1.263(a)–5(g) forthe treatment of amounts paid to facilitatethe disposition of assets that constitute atrade or business.

(2) Treatment of capitalized amount.Amounts capitalized under paragraph(c)(1) of this section are treated as a reduc-tion in the amount realized and generallyare taken into account either in the taxableyear in which the sale occurs or in thetaxable year in which the sale is aban-doned if a loss deduction is permissible.The capitalized amount is not added to thebasis of the property and is not treated asan intangible under §1.263(a)–4.

(3) Examples. The following examples,which assume the sale is not an installmentsale under section 453, illustrate the rulesof this paragraph (c):

Example 1. Sales costs of real property. X ownsa parcel of real estate. X sells the real estate and payslegal fees, recording fees, and sales commissions tofacilitate the sale. X must capitalize the fees and com-missions and, in the taxable year of the sale, offsetthe fees and commissions against the amount realizedfrom the sale of the real estate.

Example 2. Sales costs of dealers. Assume thesame facts as in Example 1, except that X is a dealerin real estate. The commissions and fees paid to facil-itate the sale of the real estate are treated as ordinaryand necessary business expenses under section 162.

Example 3. Sales costs of personal property usedin the trade or business. X is a farmer and owns atruck for use in X’s trade or business. X decides tosell the truck and on November 15, 2008, X paysto advertise the sale of the truck in the local newsmedia. On February 15, 2009, X sells the truck to Y.X is required to capitalize in 2008 the amount paid toadvertise the sale of the truck and, in 2009, is requiredto offset the amount paid against the amount realizedfrom the sale of the truck.

Example 4. Costs of abandoned sale of personalproperty used in a trade or business. Assume thesame facts as in Example 3, except that, instead ofselling the truck on February 15, 2009, X decides onthat date not to sell the truck and takes the truck off themarket. X is required to capitalize in 2008 the amountpaid to advertise the sale of the truck. However, Xmay treat the amount paid as a loss under section 165in 2009 when the sale is abandoned.

Example 5. Sales costs of personal property notused in a trade or business. Assume the same facts asin Example 3, except that X does not use the truck inX’s trade or business, but instead uses it for personalpurposes. X decides to sell the truck and on Novem-ber 15, 2008, X pays to advertise the sale of the truckin the local news media. On February 15, 2009, Xsells the truck to Y. X is required to capitalize in 2008the amount paid to advertise the sale of the truck and,in 2009, is required to offset the amount paid againstthe amount realized from the sale of the truck.

2006–39 I.R.B. 551 September 25, 2006

Example 6. Costs of abandoned sale of personalproperty not used in a trade or business. Assume thesame facts as in Example 5, except that, instead ofselling the truck on February 15, 2009, X decides onthat date not to sell the truck and takes the truck off themarket. X is required to capitalize in 2008 the amountpaid to advertise the sale of the truck. Although thesale is abandoned in 2009, X may not treat the amountpaid as a loss under section 165 because the truck wasnot used in X’s trade or business or in a transactionentered into for profit.

(d) Amount paid. For purposes of thissection, the terms amounts paid and pay-ment mean, in the case of a taxpayer us-ing an accrual method of accounting, aliability incurred (within the meaning of§1.446–1(c)(1)(ii)). A liability may not betaken into account under this section priorto the taxable year during which the liabil-ity is incurred.

(e) Effective date. The rules in this sec-tion apply to taxable years beginning on orafter the date of publication of the Treasurydecision adopting these rules as final reg-ulations in the Federal Register.

(f) Accounting method changes. [Re-served]

§1.263(a)–2 Amounts paid to acquire orproduce tangible property.

(a) Overview. This section providesrules for applying section 263(a) toamounts paid to acquire or produce realor personal property. See §1.263(a)–3for the treatment of amounts paid to im-prove tangible property, §1.263(a)–4 forthe treatment of amounts paid to acquireor create intangibles, and §1.263(a)–5 forthe treatment of amounts paid to facilitatean acquisition of a trade or business, achange in capital structure of a businessentity, and certain other transactions.

(b) Definitions. For purposes of thissection, the following definitions apply:

(1) Amount paid. In the case of a tax-payer using an accrual method of account-ing, the terms amounts paid and paymentmean a liability incurred (within the mean-ing of §1.446–1(c)(1)(ii)). A liability maynot be taken into account under this sectionprior to the taxable year during which theliability is incurred.

(2) Personal property. Personal prop-erty means tangible personal property asdefined in §1.48–1(c).

(3) Real property. Real property meansland and improvements thereto, such asbuildings or other inherently permanentstructures (including items that are struc-

tural components of such buildings orstructures) that are not personal prop-erty as defined in paragraph (b)(2) of thissection. Local law is not controlling indetermining whether property is real prop-erty for purposes of this section.

(4) Produce. Produce means construct,build, install, manufacture, develop, cre-ate, raise, or grow. See §1.263(a)–3 forcapitalization rules applicable to amountspaid to improve property.

(c) Coordination with other provisionsof the Internal Revenue Code—(1) In gen-eral. Nothing in this section changes thetreatment of any amount that is specificallyprovided for under any provision of the In-ternal Revenue Code or regulations otherthan section 162(a) or section 212 and theregulations under those sections.

(2) Materials and supplies. Nothingin this section changes the treatment ofamounts paid for materials and suppliesthat are properly treated as deductions ordeferred expenses, as appropriate, under§1.162–3.

(d) Acquired or produced tangibleproperty—(1) In general—(i) Require-ment of capitalization. A taxpayer mustcapitalize amounts paid to acquire orproduce real or personal property hav-ing a useful life substantially beyond thetaxable year, including land and land im-provements, buildings, machinery andequipment, and furniture and fixtures, anda unit of property (as determined under§1.263(a)–3(d)(2)), having a useful lifesubstantially beyond the taxable year. Ataxpayer also must capitalize amountspaid to acquire real or personal propertyfor resale and to produce real or personalproperty for sale. See section 263A for thescope of costs required to be capitalizedto property produced by the taxpayer or toproperty acquired for resale.

(ii) Examples. The following examplesillustrate the rule of this paragraph (d)(1):

Example 1. Acquisition of personal property —coordination with §1.162–3. X, an airline, operates afleet of aircraft. X purchases and maintains in stockfor repairs to its aircraft a great number of differ-ent expendable flight equipment spare parts (includ-ing cartridges, canisters, cylinders, and disks), basedin part on the manufacturer’s recommendations andin part on the airline’s experience. The expendableflight equipment spare parts are carried on hand by Xuntil they are installed in the particular type of aircraftfor which purchased. The expendable flight equip-ment spare parts are of a type normally not repairedand reused. As these parts are taken from stock andused to repair aircraft, the stock supply is replenished

by X purchasing new parts. In 2008, X purchasesexpendable flight equipment spare parts. X prop-erly treats the amount paid for the expendable flightequipment spare parts as a deferred expense under§1.162–3. Nothing in this section changes the treat-ment of the original acquisition cost as a deferred ex-pense.

Example 2. Acquisition of personal property —coordination with §1.162–3. X, an industrial laundrybusiness, leases many products, including garments,linens, shop towels, continuous roll towels, and mops(rental items). X maintains a supply of rental items onhand to replace worn or damaged items. The rentalitems have useful lives of 12 months or less. In 2008,X purchases a large quantity of rental items. Theamount paid for the rental items is properly treatedby X as a deferred expense under §1.162–3. Nothingin this section changes the treatment of the originalacquisition cost as a deferred expense.

Example 3. Acquisition of personal property. In2008, X purchases new cash registers, which have auseful life substantially beyond the taxable year, foruse in its retail store located in a leased space in ashopping mall. X must capitalize under this para-graph (d)(1) the amount paid to purchase each cashregister.

Example 4. Relocation and installation of per-sonal property. Assume the same facts as in Example3, except that X’s lease expires in 2009 and X decidesto relocate its retail store to a different building. In ad-dition to various other costs, X pays $5,000 to movethe cash registers and $1,000 to reinstall them in theother store. X is not required to capitalize under thisparagraph (d)(1) the $5,000 amount paid for movingthe cash registers; however, X must capitalize underthis paragraph (d)(1) the $1,000 amount paid to rein-stall the cash registers in its other store because, underparagraph (b)(4) of this section, installation costs areproduction costs.

Example 5. Acquisition of land. X purchases aparcel of undeveloped real estate. X must capitalizeunder this paragraph (d)(1) the amount paid to acquirethe real estate. See §1.263(a)–2(d)(3) for the treat-ment of amounts paid to facilitate the acquisition ofreal property.

Example 6. Acquisition of building. X purchasesa building. X must capitalize under this paragraph(d)(1) the amount paid to acquire the building. See§1.263(a)–2(d)(3) for the treatment of amounts paidto facilitate the acquisition of real property.

Example 7. Acquisition of property for resale. Xpurchases goods for resale. X must capitalize underthis paragraph (d)(1) the amounts paid to acquire thegoods. See section 263A for the treatment of amountspaid to acquire property for resale.

Example 8. Production of property for sale. Xproduces goods for sale. X must capitalize underthis paragraph (d)(1) the amount paid to produce thegoods. See section 263A for the treatment of amountspaid to produce property.

Example 9. Production of building. X constructsa building. X must capitalize under this paragraph(d)(1) the amount paid to construct the building. Seesection 263A for the treatment of amounts paid toproduce real property.

Example 10. Acquisition of assets constituting atrade or business. Y owns tangible and intangible as-sets that constitute a trade or business. X purchasesall the assets of Y in a taxable transaction. X must

September 25, 2006 552 2006–39 I.R.B.

capitalize under this paragraph (d)(1) the amount paidfor the tangible assets of Y. See §1.263(a)–4 for thetreatment of amounts paid to acquire intangibles and§1.263(a)–5 for the treatment of amounts paid to fa-cilitate the acquisition of assets that constitute a tradeor business. See section 1060 for special allocationrules for certain asset acquisitions.

(2) Defense or perfection of title toproperty—(i) In general. Amounts paidto defend or perfect title to real or per-sonal property constitute amounts paid toacquire or produce property within themeaning of this section and must be capi-talized. See section 263A for the scope ofcosts required to be capitalized to propertyproduced by the taxpayer or to propertyacquired for resale.

(ii) Examples. The following examplesillustrate the rule of this paragraph (d)(2):

Example 1. Amounts paid to contest condemna-tion. X owns real property located in County. Countyfiled an eminent domain complaint condemning aportion of X’s property to use as a roadway. X hiredan attorney to contest the condemnation. Amountspaid by X to the attorney must be capitalized becausethey were to defend X’s title to the property.

Example 2. Amounts paid to invalidate or-dinance. X is in the business of quarrying andsupplying sand and stone in a certain municipality.Several years after X established its business, themunicipality in which it was located passed an ordi-nance that prohibited the operation of X’s business.X incurred attorney’s fees in a successful prosecutionof a suit to invalidate the municipal ordinance. Xprosecuted the suit to preserve its business activitiesand not to defend X’s title in the property. Therefore,attorney’s fees paid by X are not required to be capi-talized under this paragraph (d)(2). However, undersection 263A, all indirect costs, including otherwisedeductible costs, that directly benefit or are incurredby reason of the taxpayer’s production activitiesmust be capitalized to the property produced for sale.Therefore, because the amounts paid to invalidate theordinance are incurred by reason of X’s productionactivities, the amounts paid must be capitalized undersection 263A to the property produced for sale by X.

Example 3. Amounts paid to challenge buildingline. The board of public works of a municipalityestablished a building line across X’s business prop-erty, adversely affecting the value of the property. Xincurred legal fees in unsuccessfully litigating the es-tablishment of the building line. Amounts paid by Xto the attorney must be capitalized because they wereto defend X’s title to the property.

(3) Transaction costs—(i) In general.A taxpayer must capitalize amounts paid tofacilitate the acquisition of real or personalproperty, including shipping costs, biddingcosts, sales and transfer taxes, legal and ac-counting fees, title fees, engineering fees,survey costs, inspection costs, appraisalfees, recording fees, application fees, com-missions, and compensation for the ser-vices of a qualified intermediary or otherfacilitator of an exchange under section

1031. See §1.263(a)–5 for the treatmentof amounts paid to facilitate the acquisi-tion of assets that constitute a trade or busi-ness. See section 263A for the scope ofcosts required to be capitalized to propertyproduced by the taxpayer or to property ac-quired for resale.

(ii) Examples. The following examplesillustrate the rule of this paragraph (d)(3):

Example 1. Legal fees, taxes, and commissionsto facilitate an acquisition. X purchases a buildingand pays legal fees, sales taxes, and sales commis-sions to facilitate the acquisition. X must capitalizethe amounts paid for legal fees, sales taxes, and salescommissions.

Example 2. Moving costs to facilitate an acqui-sition. X purchases all the assets of Y and, in con-nection with the purchase, hires a transportation com-pany to move storage tanks from Y’s plant to X’splant. X must capitalize the amount paid to move thetanks from Y’s plant to X’s plant because the amountpaid facilitates the acquisition of the storage tanks.

(4) 12-month rule—(i) In general.Except as otherwise provided in this para-graph (d)(4), an amount paid for theacquisition or production (including anyamount paid to facilitate the acquisitionor production) of a unit of property (asdetermined under §1.263(a)–3(d)(2)) withan economic useful life (as defined in§1.263(a)–3(f)(2)) of 12 months or less isnot a capital expenditure under paragraph(d) of this section.

(ii) Coordination with section 461. Inthe case of a taxpayer using an accrualmethod of accounting, the rules of thisparagraph (d)(4) do not affect the deter-mination of whether a liability is incurredduring the taxable year, including the de-termination of whether economic perfor-mance has occurred with respect to the li-ability. See §1.461–4 for rules relating toeconomic performance.

(iii) Exceptions to 12-month rule. The12-month rule in paragraph (d)(4)(i) of thissection does not apply to the following:

(A) Amounts paid for property that is orwill be included in property produced forsale or property acquired for resale;

(B) Amounts paid to improve propertyunder §1.263(a)–3;

(C) Amounts paid for land; and(D) Amounts paid for any component

of a unit of property.(iv) Character of property subject to

12-month rule. Property to which a tax-payer applies the 12-month rule containedin paragraph (d)(4)(i) of this section is nottreated upon sale or disposition as a capi-tal asset under section 1221 or as property

used in the trade or business under section1231.

(v) Election to capitalize. A taxpayermay elect not to apply the 12-month rulecontained in paragraph (d)(4)(i) of thissection with regard to a unit of property.An election made under this paragraph(d)(4)(v) applies to any unit of propertyduring the taxable year to which para-graph (d)(4)(i) of this section would apply(but for the election under this paragraph(d)(4)(v)). A taxpayer makes the electionby treating the amount paid as a capitalexpenditure in its timely filed originalFederal income tax return (including ex-tensions) for the taxable year in whichthe amount is paid. In the case of apass-through entity, the election is madeby the pass-through entity, and not by theshareholders, partners, etc. An electionmay not be made through the filing ofan application for change in accountingmethod or by an amended Federal incometax return and an election may not be re-voked.

(vi) Examples. The rules of this para-graph (d)(4) are illustrated by the follow-ing examples, in which it is assumed (un-less otherwise stated) that the taxpayer isa calendar year, accrual method taxpayerthat has not elected out of the 12-monthrule under paragraph (d)(4)(v) of this sec-tion with regard to the unit of property, andthat none of the property is materials andsupplies under §1.162–3:

Example 1. Production cost. X corporationmanufactures and sells aluminum storm windowsand doors. To conduct its business, X purchasesstrips of aluminum called extrusions and appliespaint electrostatically to the extrusions through acomplex process. In 2008, X installs a leaching pitto provide a draining area for liquid waste producedin the process of painting the extrusions. X previ-ously had dumped this waste into a creek bed, butthe local water department ordered it to cease thispractice. The economic useful life of the leachingpit is 12 months, after which time the factory will beconnected to the local sewer system. Assume that theleaching pit is the unit of property, as determined un-der §1.263(a)–3(d)(2). X is not required to capitalizeunder paragraph (d) of this section the amount paidto produce the leaching pit because the useful life ofthe leaching pit is 12 months or less. However, undersection 263A, all indirect costs, including otherwisedeductible costs, that directly benefit or are incurredby reason of the taxpayer’s manufacturing activitiesmust be capitalized to the property produced for sale.Therefore, because the amounts paid for the leachingpit are incurred by reason of X’s manufacturing op-erations, the amounts paid must be capitalized undersection 263A to the property produced for sale by X.

2006–39 I.R.B. 553 September 25, 2006

Example 2. Acquisition or production cost. Xpurchases or produces jigs, dies, molds, and patternsfor use in the manufacture of motor vehicles and mo-tor vehicle parts. The economic useful life of thejigs, dies, molds, and patterns is 12 months. Assumeeach jig, die, mold, and pattern is a separate unit ofproperty, as determined under §1.263(a)–3(d)(2). Xis not required to capitalize under paragraph (d) ofthis section the amounts paid to produce or purchasethe jigs, dies, molds, and patterns because the eco-nomic useful life is 12 months or less. However, un-der section 263A, all indirect costs, including other-wise deductible costs, that directly benefit or are in-curred by reason of the taxpayer’s manufacturing ac-tivities must be capitalized to the property producedfor sale. Therefore, because the amounts paid for thejigs, dies, molds, and patterns are incurred by reasonof X’s manufacturing operations, the amounts paidmust be capitalized under section 263A to the prop-erty produced for sale by X.

Example 3. Acquisition or production cost. As-sume the same facts as in Example 2, but the eco-nomic useful life of the jigs, dies, molds, and patternsis 3 years. X is required to capitalize under paragraph(d) of this section the amounts paid to produce or pur-chase the jigs, dies, molds, and patterns because theeconomic useful life is more than 12 months.

Example 4. Acquisition cost. X corporation isan interstate motor carrier. On December 1, 2008, Xpurchases, pays for, and takes delivery of truck tireswith an economic useful life of 12 months. AssumeX does not use the original tire capitalization methoddescribed in Rev. Proc. 2002–27, 2002–1 C.B. 802(see §601.601(d)(2) of this chapter). Also assumethat each tire is a separate unit of property, as de-termined under §1.263(a)–3(d)(2). X is not requiredunder paragraph (d) of this section to capitalize theamount paid for the tires because the economic use-ful life of the tires is 12 months or less.

Example 5. Transaction costs. Assume the samefacts as in Example 4, but in addition to the amountpaid for the tires, X also pays sales tax and deliverycharges for the tires. X is not required to capitalizeunder paragraph (d) of this section the sales tax anddelivery charges because they were paid to facilitatethe acquisition of property with an economic usefullife of 12 months or less.

Example 6. Coordination with section 461 fixedliability rule. Assume the same facts as in Example 4,except that instead of purchasing the tires on Decem-ber 1, 2008, X enters into a contract with the tire man-ufacturer on that date to purchase tires from the man-ufacturer in 2009. X purchases, pays for, and takesdelivery of the tires on March 31, 2009. X does notincur a liability under section 461 for the tires in 2008because X does not have a fixed liability with respectto the tires until 2009. When X incurs the amount in2009, X is not required under paragraph (d) of thissection to capitalize that amount.

Example 7. Coordination with section 461 eco-nomic performance rule. Assume the same facts asin Example 4, except that the tires are not deliveredto X until March 31, 2009. X does not incur a liabilityunder section 461 for the tires in 2008 because eco-nomic performance does not occur with respect to theliability until the property is provided to X in 2009.See §1.461–4(d)(2). When X incurs the amount in2009, X is not required under paragraph (d) of thissection to capitalize that amount.

Example 8. Election not to capitalize. Assumethe same facts as in Example 4, except that X electsunder paragraph (d)(4)(v) of this section not to applythe 12-month rule contained in paragraph (d)(4)(i) ofthis section to the tires purchased on December 1,2008. X must capitalize under paragraph (d) of thissection the amount paid for the tires.

Example 9. Exception to 12-month rule — prop-erty acquired for resale. Assume the same facts as inExample 4, except that X purchases the tires for re-sale. The 12-month rule in paragraph (d)(4)(i) of thissection does not apply because the tires are propertyacquired for resale. Thus, X is required under para-graph (d) of this section to capitalize the amount paidfor the tires.

Example 10. Exception to 12-month rule — com-ponent of property. Assume the same facts as inExample 4, except that the tires are the first set oftires to be installed on a truck tractor acquired by Xand X uses the original tire capitalization method de-scribed in Rev. Proc. 2002–27 (see §601.601(d)(2)of this chapter) so that the truck tractor (includingthe tires) is the unit of property, as determined under§1.263(a)–3(d)(2). Also assume that the truck tractorhas an economic useful life of more than 12 monthsand that the invoice for the acquisition of the trucktractor separately states the cost of tires and variousother components of the truck tractor. X is requiredunder paragraph (d) of this section to capitalize theamount paid for the truck tractor because the eco-nomic useful life of the truck tractor is more than 12months. Further, X may not use the 12-month rule tocurrently deduct the amount paid for the tires or anyother component of the truck tractor, regardless thatsome components may have an economic useful lifeof 12 months or less and regardless that the cost ofindividual components is separately stated in the in-voice.

(e) Treatment of capital expenditures.Amounts required to be capitalized un-der this section are capital expendituresand must be taken into account througha charge to capital account or basis, or inthe case of property that is inventory inthe hands of a taxpayer, through inclusionin inventory costs. See section 263A forthe treatment of amounts referred to inthis section as well as other amounts paidin connection with the production of realproperty and personal property, includ-ing films, sound recordings, video tapes,books, or similar properties.

(f) Recovery of capitalizedamounts—(1) In general. Amountsthat are capitalized under this sectionare recovered through depreciation, costof goods sold, or by an adjustment tobasis at the time the property is placed inservice, sold, used, or otherwise disposedof by the taxpayer. Cost recovery isdetermined by the applicable InternalRevenue Code and regulation provisionsrelating to the use, sale, or disposition ofproperty. For example, §§1.162–4 and

1.263(a)–3 determine whether amountscapitalized under this section §1.263(a)–2for property that is used to replace acomponent of a unit of property are repairor maintenance expenses or capitalized asan improvement to the unit of property.

(2) Examples. The following examplesillustrate the rule of this paragraph (f)(1)and assume that the taxpayer does not treatthe acquired property as materials and sup-plies under §1.162–3:

Example 1. Recovery when property placed inservice. X owns a 10-unit apartment building. Therefrigerator in one of the apartments stops function-ing and X purchases a new refrigerator to replace theold one. X pays for the acquisition, delivery, andinstallation of the new refrigerator. Assume the re-frigerator is the unit of property, as determined under§1.263(a)–3(d)(2). Section 1.263(a)–2(d) requirescapitalization of amounts paid for the acquisition, de-livery, and installation of the refrigerator. Under thisparagraph (f), the capitalized amounts are recoveredthrough depreciation when the refrigerator is placedin service by X.

Example 2. Recovery when property used in a re-pair. Assume the same facts as in Example 1, exceptthat a window in one of the apartments needs to bereplaced. X pays for the acquisition, delivery, andinstallation of a new window. Assume the windowis a structural component of the apartment buildingand that the apartment building is the unit of prop-erty, as determined under §1.263(a)–3(d)(2). Section1.263(a)–2(d) requires capitalization of amounts paidfor the acquisition and delivery of the window be-cause the window is property with a useful life sub-stantially beyond the end of the taxable year. As-sume the replacement of the old window with the newone does not improve the apartment building under§1.263(a)–3. Under this paragraph (f), the capital-ized amounts paid to acquire the window are recov-ered as ordinary and necessary repair expenses under§1.162–4 when the window is used in the repair byits installation in the apartment building.

Example 3. Recovery when property used in arepair; coordination with section 263A. Assume thesame facts as in Example 2, except that the windowthat is replaced is in an office in a plant where X man-ufactures widgets for sale. Section 1.263(a)–2(d) re-quires capitalization of amounts paid to produce in-ventory. Under section 263A, all indirect costs, in-cluding otherwise deductible repair costs that directlybenefit or are incurred by reason of the production ofinventory must be capitalized to the inventory pro-duced. Although the repair cost otherwise would bedeductible as an expense under §1.162–4, X must de-termine whether the cost of the repair, or an allocableportion thereof, is required to be capitalized to the in-ventory produced as an indirect expense that directlybenefits or is incurred by reason of the production ac-tivities. Any portion of the repair capitalized to in-ventory is recovered through cost of goods at the timethe property is sold or otherwise disposed of in accor-dance with the taxpayer’s method of accounting forinventories.

(g) Effective date. The rules in this sec-tion apply to taxable years beginning on or

September 25, 2006 554 2006–39 I.R.B.

after the date of publication of the Treasurydecision adopting these rules as final reg-ulations in the Federal Register.

(h) Accounting method changes. [Re-served]

§1.263(a)–3 Amounts paid to improvetangible property.

(a) Overview. This section providesrules for applying section 263(a) toamounts paid to improve tangible prop-erty. Paragraph (b) of this section containsdefinitions. Paragraph (c) of this sectioncontains rules for coordinating this sectionwith other provisions of the Internal Rev-enue Code. Paragraph (d) of this sectionprovides rules for determining the treat-ment of amounts paid to improve tangibleproperty, including rules for determiningthe appropriate unit of property. Paragraph(e) of this section contains rules for deter-mining whether amounts paid materiallyincrease the value of the unit of property.Paragraph (f) of this section contains rulesfor determining whether amounts paidrestore the unit of property. Paragraph (g)of this section describes an optional repairallowance method.

(b) Definitions. For purposes this sec-tion, the following definitions apply:

(1) Amount paid. In the case of a tax-payer using an accrual method of account-ing, the terms amounts paid and paymentmean a liability incurred (within the mean-ing of §1.446–1(c)(1)(ii)). A liability maynot be taken into account under this sectionprior to the taxable year during which theliability is incurred.

(2) Personal property. Personal prop-erty means tangible personal property asdefined in §1.48–1(c).

(3) Real property. Real property meansland and improvements thereto, such asbuildings or other inherently permanentstructures (including items that are struc-tural components of such buildings orstructures) that are not personal prop-erty as defined in paragraph (b)(2) of thissection. Local law is not controlling indetermining whether property is real prop-erty for purposes of this section.

(c) Coordination with other provisionsof the Internal Revenue Code—(1) In gen-eral. Nothing in this section changes thetreatment of any amount that is specificallyprovided for under any provision of the In-ternal Revenue Code or regulations (other

than section 162(a) or section 212 and theregulations under those sections).

(2) Example. The following exampleillustrates the rules of this paragraph (c):

Example. Railroad rolling stock. X is a railroadthat properly treats amounts paid for the rehabilitationof railroad rolling stock as deductible expenses un-der section 263(d). X is not required to capitalize theamounts paid because nothing in this section changesthe treatment of amounts specifically provided for un-der section 263(d).

(d) Improved property—(1) Capitaliza-tion rule. Except as provided in the re-pair allowance method in paragraph (g)of this section, a taxpayer must capital-ize the aggregate of related amounts paidto improve a unit of property (including aunit of property for which the acquisitionor production costs were deducted underthe 12-month rule in §1.263(a)–2(d)(4)),whether the improvements are made bythe taxpayer or by a third party. See sec-tion 263A for the scope of costs requiredto be capitalized to property produced bythe taxpayer or to property acquired for re-sale; section 1016 for adding capitalizedamounts to the basis of the unit of prop-erty; and section 168(i)(6) for the treat-ment of additions or improvements to aunit of property. For purposes of this para-graph (d), a unit of property is improved ifthe amounts paid—

(i) Materially increase the value of theunit of property (see paragraph (e) of thissection); or

(ii) Restore the unit of property (seeparagraph (f) of this section).

(2) Determining the appropriate unit ofproperty—(i) In general. The unit of prop-erty rules in this paragraph (d)(2) applyonly for purposes of section 263(a) and§§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3,and not any other Internal Revenue Codeor regulation section. Under this para-graph (d)(2), the appropriate unit of prop-erty is initially determined by applying therules in paragraph (d)(2)(ii) of this section,except as provided in paragraph (d)(2)(iv)of this section (relating to buildings andstructural components). The initial unitof property determination is further ana-lyzed in accordance with the appropriatehierarchical category described in one ofparagraphs (d)(2)(iii) through (d)(2)(vi) ofthis section and by applying the additionalrule in paragraph (d)(2)(vii) of this section.The specific rules contained in paragraphs(d)(2)(iii) through (d)(2)(vii) of this sec-tion dictate whether one or more compo-

nents of the initial unit of property deter-mination must be treated as separate unitsof property.

This paragraph (d)(2) applies to all realand personal property, other than networkassets. For purposes of this paragraph(d)(2), network assets means railroadtrack, oil and gas pipelines, water andsewage pipelines, power transmission anddistribution lines, and telephone and cablelines that are owned or leased by taxpay-ers in each of those respective industries.The term includes, for example, trunk andfeeder lines, pole lines, and buried conduit.It does not include property that would beincluded as a structural component of abuilding under paragraph (d)(2)(iv), nordoes it include separate property that isadjacent to, but not part of a network asset,such as bridges, culverts, or tunnels.

(ii) Initial unit of property determina-tion. Except for property described inparagraph (d)(2)(iv) of this section (re-garding buildings and structural compo-nents), the unit of property determinationunder this paragraph (d)(2) begins byidentifying property that consists entirelyof components that are functionally inter-dependent. Components of property arefunctionally interdependent if the plac-ing in service of one component by thetaxpayer is dependent on the placing inservice of the other component by thetaxpayer. For purposes of this section,property that is aggregated and subject toa general asset account election may notbe treated as a single unit of property.

(iii) Category I: Taxpayers in regulatedindustries. In the case of a taxpayer en-gaged in a trade or business in a regulatedindustry, the unit of property is the USOA(uniform system of accounts) unit of prop-erty. For purposes of this section, a reg-ulated industry is an industry for which aFederal regulator (including any Federaldepartment, agency, commission, board,or similar entity) has a USOA identifyinga particular unit of property (USOA unitof property). This rule applies to any tax-payer engaged in a trade or business in theregulated industry, regardless of whetherthe taxpayer is subject to the regulatoryaccounting rules of the Federal regulator.The unit of property determination madeunder this paragraph (d)(2)(iii) is subject toparagraph (d)(2)(vii) of this section, whichmay require one or more components to betreated as separate units of property.

2006–39 I.R.B. 555 September 25, 2006

(iv) Category II: Buildings and struc-tural components. In the case of a building(as defined in §1.48–1(e)(1)) other thanthat described in paragraph (d)(2)(iii) ofthis section, the building and its structuralcomponents (as defined in §1.48–1(e)(2))are a single unit of property. The unit ofproperty determination made under thisparagraph (d)(2)(iv) is subject to para-graph (d)(2)(vii) of this section, whichmay require one or more components tobe treated as separate units of property.

(v) Category III: Other personal prop-erty. In the case of personal property otherthan that described in paragraph (d)(2)(iii)of this section, the unit of property deter-mination must be made on the basis ofthe four factors listed in this paragraph(d)(2)(v). These four factors are the exclu-sive factors under this paragraph (d)(2)(v).No one factor is determinative and it is notintended that a determination be made onthe basis of the number of factors indicat-ing that a component is, or is not, a sepa-rate unit of property. The unit of propertydetermination made under this paragraph(d)(2)(v) is subject to paragraph (d)(2)(vii)of this section, which may require one ormore components to be treated as separateunits of property. The following factorsmust be taken into account:

(A) Whether the component is—(1) Marketed separately to the taxpayer

by a party other than the seller/lessor of theproperty of which the component is a partat the time the property is initially acquiredor leased;

(2) Acquired or leased separately bythe taxpayer from a party other than theseller/lessor of the property of which thecomponent is a part at the time the prop-erty is initially acquired or leased;

(3) Subject to a separate warrantycontract (from a party other than theseller/lessor of the property of which thecomponent is a part);

(4) Subject to a separate maintenancemanual or written maintenance policy;

(5) Appraised separately; or(6) Sold or leased separately by the tax-

payer to another party;(B) Whether the component is treated

as a separate unit of property in industrypractice or by the taxpayer in its books andrecords;

(C) Whether the taxpayer treats thecomponent as a rotable part (a part thatis removable from property, repaired or

improved, and either immediately rein-stalled on other property or stored for laterinstallation); and

(D) Whether the property of which thecomponent is a part generally functionsfor its intended use without the componentproperty.

(vi) Category IV: Other real property.In the case of real property other thanthat described in paragraphs (d)(2)(iii) and(d)(2)(iv) of this section, the unit of prop-erty determination must be made on thebasis of all the facts and circumstances.The unit of property determination madeunder this paragraph (d)(2)(vi) is subject toparagraph (d)(2)(vii) of this section, whichmay require one or more components tobe treated as separate units of property.

(vii) Additional rule. If the taxpayerproperly treats a component as a sepa-rate unit of property for any Federal in-come tax purpose, the taxpayer must treatthe component as a separate unit of prop-erty for purposes of this paragraph (d)(2).For purposes of paragraph (d)(2), the termany Federal income tax purpose includes,but is not limited to, the use of differentplaced-in-service dates (other than the useof a new placed-in-service date for an im-provement (as determined under this sec-tion) to the unit of property or a differentplaced-in-service date for a particular floorof a building) or different classes of prop-erty as set forth in section 168(e) (MACRSclasses), for the component and the prop-erty of which the component is a part. Ifthe taxpayer properly recognizes a loss un-der section 165, or under another applica-ble provision, from a retirement of a com-ponent of property or from the worthless-ness or abandonment of a component ofproperty, the taxpayer must treat the com-ponent as a separate unit of property forpurposes of this paragraph (d)(2). There-fore, any property that replaces the compo-nent also will be treated as a separate unitof property. See §1.263(a)–2(d)(1). Forpurposes of this paragraph (d)(2), merelyclaiming a tax credit related to tangibleproperty does not constitute treatment ofthat property as a separate unit of propertyfor a Federal income tax purpose.

(viii) Examples. The rules of this para-graph (d)(2) are illustrated by the follow-ing examples, in which it is assumed (un-less otherwise stated) that the taxpayer hasnot made a general asset account electionwith regard to the property and that para-

graph (d)(2)(vii) of this section does not re-quire the use of a different unit of property:

Example 1. Category I. X is an electric utilitycompany that operates a power plant to generate elec-tricity. X’s operation previously was regulated by theFederal Energy Regulatory Commission (FERC) but,for various reasons, is no longer subject to regulationby FERC. Under FERC’s USOA, each turbine, econ-omizer, generator, and pulverizer is treated as a sepa-rate unit of property for regulatory accounting pur-poses. The initial unit of property determined un-der paragraph (d)(2)(ii) of this section is the entirepower plant, which consists entirely of componentsthat are functionally interdependent. The power plantmust next be analyzed under paragraph (d)(2)(iii) ofthis section because X is engaged in a trade or busi-ness in an industry for which a Federal regulator hasa USOA. Under the rules in that paragraph, X musttreat each turbine, economizer, generator, and pul-verizer as a separate unit of property for determiningwhether an amount paid improves the unit of propertyfor Federal income tax purposes.

Example 2. Category I. X is a Class I railroad. AllClass I railroads are regulated by the Surface Trans-portation Board (STB). Under STB’s USOA, eachlocomotive and each freight car is treated as a sep-arate unit of property for regulatory accounting pur-poses. Although each locomotive consists of variouscomponents, such as an engine, generators, batteries,trucks, etc., those components are functionally inter-dependent. Thus, the locomotive is an initial unit ofproperty as determined under paragraph (d)(2)(ii) ofthis section. Similarly, each freight car consists en-tirely of functionally interdependent components and,thus, each freight car is an initial unit of property un-der paragraph (d)(2)(ii) of this section. Each loco-motive and freight car must next be analyzed underparagraph (d)(2)(iii) of this section because X is en-gaged in a trade or business in an industry for which aFederal regulator has a USOA. Under the rules in thatparagraph, X must treat each locomotive and eachfreight car as a separate unit of property for deter-mining whether an amount paid improves the unit ofproperty for Federal income tax purposes.

Example 3. Category I. Assume the same facts asin Example 2, except that X is a Class II railroad. TheSTB does not regulate Class II railroads. However,because X is engaged in a trade or business in an in-dustry (the railroad industry) for which a Federal reg-ulator has a USOA, the rules in paragraph (d)(2)(iii)of this section apply, regardless of whether X is sub-ject to those rules. Based on these facts, X must treateach locomotive and each freight car as a separateunit of property for determining whether an amountpaid improves the unit of property for Federal incometax purposes.

Example 4. Category I. X is a telecommunica-tions company regulated by the Federal Communi-cations Commission (FCC) and subject to a USOAfor telephone companies. The assets of X include atelephone central office switching center, which con-tains numerous switches and various other switchingequipment that all work together to provide telephoneservice to customers. The initial unit of property de-termined under paragraph (d)(2)(ii) of this section isthe central office switching center, which consists en-tirely of components that are functionally interdepen-dent. The telecommunications system must next beanalyzed under paragraph (d)(2)(iii) of this section

September 25, 2006 556 2006–39 I.R.B.

because X is engaged in a trade or business in anindustry for which a Federal regulator has a USOA.Under the rules in that paragraph, X must treat eachswitch and/or piece of equipment as defined in theUSOA of the FCC and used in the central office op-eration as a separate unit of property for determiningwhether an amount paid improves the unit of propertyfor Federal income tax purposes.

Example 5. Category II. X owns a manufactur-ing building containing various types of manufactur-ing equipment that are not structural components ofthe manufacturing building. Because the propertyis a building, as defined in §1.48–1(e)(1), paragraph(d)(2)(ii) of this section does not apply and the prop-erty must be analyzed under paragraph (d)(2)(iv) ofthis section. Under the rules in that paragraph, Xmust treat the manufacturing building and its struc-tural components as a single unit of property for de-termining whether an amount paid improves the unitof property for Federal income tax purposes. The ap-propriate unit of property determination for the man-ufacturing equipment must be made separately underparagraph (d)(2)(v) of this section.

Example 6. Category III; additional rule. As-sume the same facts as in Example 5, except thatX does a cost segregation study of the manufactur-ing building and properly determines that refriger-ation equipment used to create a walk-in freezer inthe manufacturing building is section 1245 propertyas defined in section 1245(a)(3). The refrigerationequipment is not part of the HVAC system that re-lates to the general operation or maintenance of thebuilding. For Federal income tax purposes, X prop-erly treats the refrigeration equipment as a separateunit of property for depreciation purposes. The rulesof paragraph (d)(2)(v) of this section apply to deter-mine whether the refrigeration equipment, or somesmaller component, is the appropriate unit of prop-erty. In this example, assume that no componentsof the refrigeration equipment meet any of the factsand circumstances listed in paragraph (d)(2)(v) of thissection. Based on these facts, X must treat the refrig-eration equipment as the unit of property for deter-mining whether an amount paid improves the unit ofproperty for Federal income tax purposes.

Example 7. Category III; additional rule. As-sume the same facts as in Example 6, except thatthe refrigeration equipment for the walk-in freezerceases to function. X decides not to repair the re-frigeration equipment, but to replace it altogether. Xabandons the refrigeration equipment for the walk-infreezer and properly recognizes a loss under section165 from the abandonment of the refrigeration equip-ment. Therefore, X must treat the refrigeration equip-ment for the walk-in freezer as a separate unit of prop-erty for determining whether amounts paid to replacethe equipment must be capitalized for Federal incometax purposes. See §1.263(a)–2(d)(1).

Example 8. Category III. (i) X is a commercialairline engaged in the business of transporting pas-sengers and freight throughout the United States andabroad. To conduct its business, X owns or leases var-ious types of aircraft. X purchases the aircraft engineseparately at the time the aircraft is acquired. Theengine is subject to a separate warranty and writtenmaintenance policy provided by the engine manufac-turer. For financial accounting purposes, X accountsfor each type of aircraft by maintaining separate ac-counts on its books for each type of airframe and en-

gine in its fleet. To perform maintenance on an en-gine, X removes the engine from the aircraft and re-places it with another used engine that has returnedfrom a maintenance visit.

(ii) The initial unit of property determined underparagraph (d)(2)(ii) of this section is the aircraft (andnot the entire fleet of aircraft), which consists entirelyof components that are functionally interdependent.The aircraft must next be analyzed under one of para-graphs (d)(2)(iii) through (d)(2)(vi) of this section.Although X is engaged in a trade or business in an in-dustry regulated by the Federal Aviation Administra-tion (FAA), the FAA does not have a USOA. There-fore, the rules of paragraph (d)(2)(iii) of this sectiondo not apply to X; instead, the rules of paragraph(d)(2)(v) of this section apply to determine whetherthe entire aircraft, or the engine, is the appropriateunit of property. In this Example 8, the aircraft engineis acquired separately, is subject to a separate war-ranty and maintenance policy, is treated separately forfinancial accounting purposes, and is rotable. Basedon these facts, X must treat the engine as the unit ofproperty for determining whether an amount paid im-proves the engine for Federal income tax purposes. Xmust treat the aircraft without the engine as a unit ofproperty for determining whether an amount paid im-proves the aircraft for Federal income tax purposes.

Example 9. Category III. X is a corporation thatowns a small aircraft for use in its trade or business.X performs required maintenance on its aircraft en-gines. The aircraft engine is not marketed, purchased,leased, appraised, or sold separately, but it is subjectto a separate warranty and written maintenance policyprovided by the engine manufacturer. For financialaccounting purposes, X does not maintain separateaccounts on its books for individual engines. X doesnot treat the engine as a rotable part. The initial unit ofproperty determined under paragraph (d)(2)(ii) of thissection is the aircraft, which consists entirely of com-ponents that are functionally interdependent. The air-craft must next be analyzed under paragraph (d)(2)(v)of this section to determine whether the entire air-craft, or the engine, is the appropriate unit of prop-erty. Based on these facts, the engine is not a separateunit of property. Therefore, X must treat the aircraft,including the aircraft engine, as the unit of propertyfor determining whether an amount paid improves theunit of property for Federal income tax purposes.

Example 10. Category III. X is a towboat op-erator that owns and leases a fleet of towboats. Xperforms maintenance on its towboat engines every3 to 4 years, in accordance with the engine manufac-turer’s maintenance manuals. Towboat engines arenot marketed, purchased, leased, appraised, or soldseparately; however, the engines are subject to a sep-arate warranty and written maintenance policy pro-vided by the engine manufacturer. For financial ac-counting purposes, X does not maintain separate ac-counts on its books for individual engines. X does nottreat the engine as a rotable part. The initial unit ofproperty determined under paragraph (d)(2)(ii) of thissection is the towboat (and not the entire fleet of tow-boats), which consists entirely of components that arefunctionally interdependent. The towboat must nextbe analyzed under paragraph (d)(2)(v) of this section.Based on these facts, the engine is not a separate unitof property. Therefore, X must treat the towboat, in-cluding the towboat engine, as the unit of property

for determining whether an amount paid improves theunit of property for Federal income tax purposes.

Example 11. Category III. X purchases a car touse in X’s taxi service. The invoice received by Xfor the purchase of the car separately lists several op-tions, including air conditioning, automatic transmis-sion, antilock braking system, side impact air bags,power group, and special alloy wheels. Under para-graph (d)(2)(ii) of this section, the initial unit of prop-erty is the car because the options are functionally in-terdependent with the car. The options are not subjectto separate warranties. X is an individual and does notkeep books and records other than for tax purposes.For depreciation purposes, X properly treats the carand options as one unit of property. X does not treatany of the options as rotable parts. Based on thesefacts, the options are not separate units of property.X must treat the car, including the options, as the unitof property for determining whether an amount paidimproves the unit of property for Federal income taxpurposes.

Example 12. Category III. X is a common car-rier that owns a fleet of fuel hauling trucks and peri-odically performs maintenance on its truck engines.The entire fleet of trucks is subject to a general as-set account election, one for the truck trailers and onefor the truck tractors. Under paragraph (d)(2)(ii) ofthis section, X may not treat the entire fleet as theunit of property. Instead, the initial units of propertydetermined under paragraph (d)(2)(ii) of this sectionare each truck tractor and each truck trailer. Eachtractor consists entirely of functionally interdepen-dent components and each trailer consists entirely offunctionally interdependent components. To deter-mine whether the engine is a separate unit of propertyfrom the tractor, the factors in paragraph (d)(2)(v) ofthis section apply. The engines are marketed sepa-rately from the tractor and are subject to a separatewarranty and written maintenance policy provided bythe engine manufacturer. The engines are not treatedas a separate unit of property in industry practice orby X in its books and records. The engine is removedfrom the tractor, repaired or improved, and stored forlater installation on another tractor. Based on thesefacts, the engine is a separate unit of property. There-fore, X must treat the engine as the unit of propertyfor determining whether an amount paid improves theunit of property for Federal income tax purposes.

Example 13. Category III. Assume the same factsas in Example 12, except that the inquiry is whetherthe oil filter in the tractor engine is a separate unitof property. The oil filter is not marketed, acquired,leased, appraised, or sold separately, nor is it subjectto a separate warranty or maintenance manual. Thefilter is not treated as a separate unit of property inindustry practice or by X in its books and records, noris it treated as a rotable part. Based on these facts, theoil filter is not a separate unit of property. Therefore,X must treat the engine, including the oil filter, as theunit of property for determining whether an amountpaid improves the unit of property for Federal incometax purposes.

Example 14. Category III. (i) X manufacturesand sells computers and computer equipment. It alsooperates a separate computer maintenance business,for which X maintains pools of rotable spare partsthat are primarily used to repair computer equipmentpurchased or leased by its customers. Most of X’scomputer maintenance business is conducted pur-

2006–39 I.R.B. 557 September 25, 2006

suant to standardized maintenance agreements thatobligate X to provide all parts and labor, productupgrades, preventive maintenance, and telephoneassistance necessary to keep a customer’s computeroperational for the duration of the contract (usuallyone year) in exchange for a predetermined fee. In itscomputer maintenance business, X sends techniciansto its customer’s location, who use the supply ofrotable spare parts to diagnose problems in the cus-tomer’s equipment, and then exchange the workingparts for any malfunctioning parts. A customer’spart that is identified as the cause of the malfunctionis replaced with the identical functioning part fromX’s rotable spare parts pool. The malfunctioningpart removed from the customer’s equipment is thenrepaired and placed in X’s rotable spare parts pool forcontinued use in the computer maintenance business.

(ii) Under paragraph (d)(2)(ii) of this section, Xmay not treat the entire pool of rotable spare partsas the unit of property. Instead, the initial unit ofproperty determined under paragraph (d)(2)(ii) of thissection is each rotable spare part because each partconsists entirely of functionally interdependent com-ponents. Assume for purposes of this Example 14that paragraph (d)(2)(v) of this section does not re-quire any components of the rotable spare parts to betreated as separate units of property. Based on thesefacts, the entire pool of spare parts is not the unit ofproperty. Therefore, X must treat each rotable sparepart as a unit of property for determining whether anamount paid improves the unit of property for Federalincome tax purposes.

Example 15. Category III. (i) X is a dentist andoperates a small dental clinic. On March 1, 2008, Xpurchases a new laptop computer, with a one-yearwarranty, for use in the dental business. On May 1,2009, after the warranty has expired, the computermalfunctions and X contacts the manufacturer’scomputer maintenance shop for assistance. Themaintenance shop sends a technician to X’s dentalclinic, who uses a supply of rotable spare parts todiagnose problems in X’s computer. The techniciandetermines that the circuit board must be replacedand exchanges X’s malfunctioning circuit board withthe identical functioning circuit board from the com-puter maintenance operation’s rotable spare partspool. The malfunctioning circuit board removedfrom X’s computer is then repaired and placed in themanufacturer’s rotable spare parts pool for continueduse in the computer maintenance business.

(ii) The initial unit of property determined underparagraph (d)(2)(ii) of this section is the computer,which consists entirely of components (circuit boardor motherboard, central processing unit or CPU, harddrive, RAM, keyboard, monitor, case, etc.) that arefunctionally interdependent. To determine whetherthe circuit board is a separate unit of property fromthe computer, the factors in paragraph (d)(2)(v) of thissection apply. The circuit board was not marketedseparately to X or acquired separately by X, nor is itsubject to a separate warranty. The CPU, however,was marketed separately to the taxpayer, but not ac-quired separately. No component, including the cir-cuit board and CPU of the laptop computer, is treatedas a separate unit of property by X in its books andrecords, nor does X treat any component as a rotablepart. The computer does not function for its intendeduse without the circuit board and the CPU. Based onthese facts, neither the circuit board nor the CPU is a

separate unit of property. X must treat the entire lap-top computer, including the circuit board and CPU,as the unit of property for determining whether anamount paid improves the unit of property for Fed-eral income tax purposes.

(3) Compliance with regulatory re-quirements. For purposes of this section,a Federal, state, or local regulator’s re-quirement that a taxpayer perform certainrepairs or maintenance on a unit of prop-erty to continue operating the property isnot relevant in determining whether theamount paid improves the unit of property.

(4) Unavailability of replacement parts.For purposes of this section, if a taxpayerneeds to replace part of a unit of propertythat cannot practicably be replaced withthe same type of part (for example, becauseof technological advancements or prod-uct enhancements), the replacement of thepart with an improved but comparable partdoes not, by itself, result in an improve-ment to the unit of property.

(5) Repairs performed during an im-provement—(i) In general. Repairs that donot directly benefit or are not incurred byreason of an improvement are not requiredto be capitalized under section 263(a), re-gardless of whether they are made at thesame time as an improvement. See section263A for rules requiring capitalization ofall direct costs of an improvement and allindirect costs that directly benefit or are in-curred by reason of the improvement.

(ii) Exception for individuals. A tax-payer who is an individual may capital-ize amounts paid for repairs that are madeat the same time as substantial capital im-provements to property not used in the tax-payer’s trade or business or for the produc-tion of income if the repairs are done aspart of a remodeling or restoration of thetaxpayer’s residence.

(e) Value—(1) In general. A taxpayermust capitalize amounts paid that materi-ally increase the value of a unit of prop-erty. An amount paid materially increasesthe value of a unit of property only if it—

(i) Ameliorates a condition or defectthat either existed prior to the taxpayer’sacquisition of the unit of property or aroseduring the production of the unit of prop-erty, whether or not the taxpayer was awareof the condition or defect at the time of ac-quisition or production;

(ii) Is for work performed prior to thedate the property is placed in service by the

taxpayer (without regard to any applicableconvention under section 168(d));

(iii) Adapts the unit of property to a newor different use (including a permanentstructural alteration to the unit of prop-erty);

(iv) Results in a betterment (including amaterial increase in quality or strength) ora material addition (including an enlarge-ment, expansion, or extension) to the unitof property; or

(v) Results in a material increase incapacity (including additional cubic orsquare space), productivity, efficiency, orquality of output of the unit of property.

(2) Exception. Notwithstanding therules in paragraph (e)(1)(i) through(e)(1)(v) of this section, an amountpaid does not result in a material in-crease in value to a unit of property ifthe economic useful life (as defined in§1.263(a)–3(f)(2)) of the unit of propertyis 12 months or less and the taxpayer didnot elect to capitalize the amounts paidoriginally for the unit of property.

(3) Appropriate comparison. Forpurposes of paragraphs (e)(1)(iv) and(e)(1)(v) of this section, in cases in whicha particular event necessitates an ex-penditure, the determination of whetherthe amount paid materially increases thevalue of the unit of property is made bycomparing the condition of the propertyimmediately after the expenditure withthe condition of the property immediatelyprior to the event necessitating the expen-diture. When the event necessitating theexpenditure is normal wear and tear tothe unit of property, the condition of theproperty immediately prior to the eventnecessitating the expenditure is the condi-tion of the property after the last time thetaxpayer corrected the effects of normalwear and tear (whether the amounts paidwere for maintenance or improvements)or, if the taxpayer has not previously cor-rected the effects of normal wear and tear,the condition of the property when placedin service by the taxpayer.

(4) Examples. The following examplesillustrate the rules of this paragraph (e) andassume that the amounts paid are not re-quired to be capitalized under any otherprovision of this section (paragraph (f), forexample):

Example 1. Pre-existing condition. In 2008, Xpurchased a store located on 10 acres of land thatcontained underground gasoline storage tanks left by

September 25, 2006 558 2006–39 I.R.B.

prior occupants. The tanks had leaked, causing soilcontamination. X was not aware of the contaminationat the time of purchase. When X discovered the con-tamination, it incurred costs to remediate the soil. Forpurposes of this Example 1, assume the 10 acres ofland is the appropriate unit of property. The amountspaid for soil remediation must be capitalized as animprovement to the land because they ameliorated acondition or defect that existed prior to the taxpayer’sacquisition of the land. The comparison rule in para-graph (e)(3) of this section does not apply to theseamounts paid.

Example 2. Not a pre-existing condition; repairperformed during an improvement. (i) X ownedland on which it constructed a building in 1969 foruse as a bank. The building was constructed withasbestos-containing materials. The health dangers ofasbestos were not widely known when the buildingwas constructed. The presence of asbestos did notnecessarily endanger the health of building occu-pants. The danger arises when asbestos-containingmaterials are damaged or disturbed, thereby releas-ing asbestos fibers into the air (where they can beinhaled). In 1971, Federal regulatory agencies des-ignated asbestos a hazardous substance. In 2008, Xdetermined it needed additional space in its buildingto accommodate additional operations at its branchand decided to remodel the building. However, anyremodeling work could not be undertaken withoutdisturbing the asbestos-containing materials. Thegovernmental regulations required that asbestos beremoved if any remodeling was undertaking thatwould disturb asbestos-containing materials. There-fore, X decided to remove the asbestos-containingmaterials from the building in coordination with theoverall remodeling project.

(ii) For purposes of this Example 2, assume thatthe building is the appropriate unit of property andthat the amounts paid to remodel are required to becapitalized under §1.263(a)–3. The amounts paid toremove the asbestos are not required to be capitalizedas a separate improvement under paragraph (e)(1)(i)of this section because the asbestos, although later de-termined to be unsafe under certain circumstances,was not an inherent defect to the property. The re-moval of the asbestos, by itself, also did not result in amaterial increase in value under paragraphs (e)(1)(ii)through (e)(1)(v) of this section. Under paragraph(d)(5)(i) of this section, repairs that do not directlybenefit or are not incurred by reason of an improve-ment are not required to be capitalized under sec-tion 263(a). Under section 263A, all indirect costs,including otherwise deductible repair costs, that di-rectly benefit or are incurred by reason of the im-provement must be capitalized as part of the improve-ment. The amounts paid to remove the asbestos wereincurred by reason of the remodeling project, whichwas an improvement. Therefore, X must capitalizeunder section 263A to the remodeling improvementamounts paid to remove the asbestos.

Example 3. Work performed prior to placing theproperty in service. In 2008, X purchased a build-ing for use as a business office. The building wasin a state of disrepair. In 2009, X incurred costs torepair cement steps; shore up parts of the first andsecond floors; replace electrical wiring; remove andreplace old plumbing; and paint the outside and in-side of the building. Assume all the work was per-formed on the building or its structural components.

In 2010, X placed the building in service and beganusing the building as its business office. For purposesof this Example 3, assume the building and its struc-tural components are the appropriate unit of property.The amounts paid must be capitalized as an improve-ment to the building because they were for work per-formed prior to X’s placing the building in service.The comparison rule in paragraph (e)(3) of this sec-tion does not apply to these amounts paid.

Example 4. Work performed prior to placing theproperty in service. In January 2008, X purchasednew machinery for use in an existing production lineof its manufacturing business. After the machinerywas installed, X performed critical testing on the ma-chinery to ensure that it was operational. On Novem-ber 1, 2008, the new machinery became operationaland, thus, the machinery was placed in service onNovember 1, 2008 (although X continued to performtesting for quality control). The amounts paid mustbe capitalized as an improvement to the machinerybecause they were for work performed prior to X’splacing the machinery in service. The comparisonrule in paragraph (e)(3) of this section does not ap-ply to these amounts paid.

Example 5. New or different use. X is an inte-rior decorating company and manufactures its owndesigns. In 2008, X decides to stop manufacturingand converts the manufacturing facility into a show-room for X’s business. To convert the facility, Xremoves certain load-bearing walls and builds newload-bearing walls to provide a better layout for theshowroom and its offices. As part of building the newwalls, X moves or replaces electrical, cable, and tele-phone wiring and paints the walls. X also repairs thefloors, builds a fire escape, and performs small car-pentry jobs related to making the showroom acces-sible, including installing ramps and widening door-ways. For purposes of this Example 5, assume thebuilding and its structural components are the unit ofproperty and that the work is performed on the struc-tural components. The amounts paid by X to con-vert the manufacturing facility into a showroom mustbe capitalized as an improvement to the building be-cause they adapted the building to a new or differentuse. The comparison rule in paragraph (e)(3) of thissection does not apply to these amounts paid.

Example 6. New or different use. X owned abuilding consisting of five separate retail stores, eachof which it rented to different tenants. In 2008, twoof the stores rented became vacant and remained va-cant for several months. One of the remaining ten-ants agreed to expand its occupancy to the two va-cant stores, which adjoined its own retail store. X in-curred costs to break down walls between the exist-ing stores and construct an additional rear entrance.For purposes of this Example 6, assume the buildingand its structural components are the appropriate unitof property. The amounts paid by X to convert threeretail stores into one larger store must be capitalizedbecause they resulted in a permanent structural alter-ation, and thus a new or different use, to the building.The comparison rule in paragraph (e)(3) of this sec-tion does not apply to these amounts paid.

Example 7. Not a new or different use. X ownsa building for rental purposes and decides to sell it.In preparation of selling, X paints the interior walls,cleans the gutters, repairs cracks in the porch, and re-finishes the hardwood floors. For purposes of this Ex-ample 7, assume the building and its structural com-

ponents are the unit of property. Amounts paid forwork done in anticipation of selling the building arenot required to be capitalized unless the amounts paidmaterially increase the value as defined in paragraph(e)(3) of this section or prolong the economic usefullife as defined in paragraph (f)(3). The amounts paidby X are not transaction costs paid to facilitate the saleof property under §1.263(a)–1(c), nor do they mate-rially increase the value of the building. Althoughthe amounts were paid for the purpose of selling thebuilding, the sale does not constitute a new or differ-ent use. Therefore, X is not required to capitalize asan improvement under paragraph (e) of this sectionthe amounts paid for work performed on the build-ing. The comparison rule in paragraph (e)(3) of thissection does not apply to these amounts paid.

Example 8. Not a material increase in value. (i)X is a commercial airline engaged in the businessof transporting passengers and freight throughout theUnited States and abroad. To conduct its business, Xowns or leases various types of aircraft. As a con-dition of maintaining its airworthiness certificationfor these aircraft, X is required by the Federal Avia-tion Administration (FAA) to establish and adhere toa continuous maintenance program for each aircraftwithin its fleet. These programs, which are designedby X and the aircraft’s manufacturer and approved bythe FAA are incorporated into each aircraft’s main-tenance manual. The maintenance manuals requirea variety of periodic maintenance visits at variousintervals during the operating lives of each aircraft.One type of maintenance visit is an engine shop visit(ESV), which is performed on X’s aircraft engines ap-proximately every 4 years.

(ii) In 2004, X purchased a new aircraft and en-gine. In 2008, X performs its first ESV on the air-craft engine. The ESV includes some or all of the fol-lowing activities: disassembly, cleaning, inspection,repair, replacement, reassembly, and testing. Dur-ing the ESV, the engine is removed from the aircraftand shipped to an outside vendor who performs theESV. When the engine arrives at the vendor, the en-gine is cleaned and externally inspected. Regard-less of condition, it is thoroughly inspected visuallyand, as appropriate, further inspected using a numberof non-destructive testing procedures. The engine isthen disassembled into major parts and, if necessary,into smaller parts. If inspection or testing disclosesa discrepancy in a part’s conformity to the specifi-cations in X’s maintenance program, the part is re-paired, or if necessary, replaced with a new or usedserviceable part conforming to the specifications. Ifa part can be repaired, but not in time to be returned tothe engine with which the part had arrived, the ven-dor first attempts to replace the part with a similar partfrom customer stock (used parts from X’s aircraft thatwere replaced or exchanged and repaired during anearlier ESV and then stored for future use on X’s air-craft). If a part is not available from customer stock,the part is exchanged with a used, serviceable part inthe vendor’s inventory. A part is replaced (generallywith a used serviceable part) only if the part removedfrom X’s engine cannot be repaired timely.

(iii) For purposes of this Example 8, assumethe aircraft engine is the appropriate unit of prop-erty. To determine whether the ESV results in amaterial increase in value under paragraph (e)(1)(iv)or (e)(1)(v) of this section, the comparison rule inparagraph (e)(3) of this section applies. Because the

2006–39 I.R.B. 559 September 25, 2006

event necessitating the ESV was normal wear andtear, and X had not previously performed an ESV onthe engine, the relevant comparison is the conditionof the property immediately after the ESV with thecondition of the property when placed in service byX. Using this comparison, the ESV did not result in amaterial addition, betterment, or material increase incapacity, productivity, efficiency, or quality of outputof the engine compared to the condition of the enginewhen placed in service, nor did it adapt the engineto a new or different use. Therefore, the amountspaid by X for the ESV did not result in a materialincrease in value to the engine. X is not required tocapitalize as an improvement under paragraph (e) ofthis section amounts paid for the ESV.

Example 9. Betterment; regulatory requirement.X owned a hotel in City that included five foot highunreinforced terra cotta and concrete parapets withoverhanging cornices around the entire roof perime-ter. The parapets and cornices were in good condi-tion. In 2008, City passed an ordinance setting highersafety standards for parapets and cornices becauseof the hazardous conditions caused by earthquakes.To comply with the ordinance, X replaced the oldparapets and cornices with new ones made of glassfiber reinforced concrete, which made them lighterand stronger than the original ones. They were at-tached to the hotel using welded connections insteadof wire supports, making them more resistant to dam-age from lateral movement. For purposes of this Ex-ample 9, assume the hotel building and its structuralcomponents are the appropriate unit of property. Theevent necessitating the expenditure was the 2008 Cityordinance. Prior to the ordinance, the old parapetsand cornices were in good condition, but were deter-mined by City to create a potential hazard. After theexpenditure, the new parapets and cornices signifi-cantly improved the structural soundness of the hotel.Therefore, the amounts paid by X to replace the para-pets and cornices must be capitalized because they re-sulted in a betterment to the hotel. City’s requirementthat X correct the potential hazard to continue oper-ating the hotel is not relevant in determining whetherthe amount paid improved the hotel. See paragraph(d)(3) of this section.

Example 10. Not a material increase in value;regulatory requirement. X owned a meat process-ing plant. In 2008, X discovered that oil was seep-ing through the concrete walls of the plant, creatinga fire hazard. Federal meat inspectors advised X thatit must correct the seepage problem or shut down itsplant. To correct the problem, X incurred costs to adda concrete lining to the walls from the floor to a heightof about four feet and also to add concrete to the floorof the plant. For purposes of this Example 10, assumethe plant building and its structural components arethe appropriate unit of property. The event necessitat-ing the expenditure was the seepage of the oil. Priorto the seepage, the plant did not leak and was func-tioning for its intended use. The expenditure did notresult in a material addition, betterment, or materialincrease in capacity, productivity, efficiency, or qual-ity of output of the plant compared to the conditionof the plant prior to the seepage of the oil, nor did itadapt the plant to a new or different use. Therefore,the amounts paid by X to correct the seepage do notmaterially increase the value of the plant. X is notrequired to capitalize as an improvement under para-graph (e) of this section amounts paid to correct the

seepage problem. The Federal meat inspectors’ re-quirement that X correct the seepage to continue oper-ating the plant is not relevant in determining whetherthe amount paid improved the plant. See paragraph(d)(3) of this section.

Example 11. Not a material increase in value; re-placement with same part. X owns a small retail shop.In 2008, a storm damaged the roof of X’s shop by dis-placing numerous wooden shingles. X decides to re-place all the wooden shingles on the roof and hireda contractor to replace all the shingles on the roofwith new wooden shingles. No part of the sheath-ing, rafters, or joists was replaced. For purposes ofthis Example 11, assume the shop and its structuralcomponents are the appropriate unit of property. Theevent necessitating the expenditure was the storm.Prior to the storm, the retail shop was functioning forits intended use. The expenditure did not result in amaterial addition, betterment, or material increase incapacity, productivity, efficiency, or quality of out-put of the shop compared to the condition of the shopprior to the storm, nor did it adapt the shop to a newor different use. Therefore, the amounts paid by X toreshingle the roof with wooden shingles do not mate-rially increase the value of the shop. X is not requiredto capitalize as an improvement under paragraph (e)of this section amounts paid to replace the shingles.

Example 12. Not a material increase in value; re-placement with comparable part. Assume the samefacts as in Example 11, except that wooden shinglesare not available on the market. X decides to re-place all the wooden shingles with comparable as-phalt shingles. The amounts paid by X to reshinglethe roof with asphalt shingles do not materially in-crease the value of the shop, even though the asphaltshingles may be an improvement over the woodenshingles. Because the wooden shingles could notpracticably be replaced with new wooden shingles,the replacement of the old shingles with comparableasphalt shingles does not, by itself, result in an im-provement to the shop. X is not required to capitalizeas an improvement under paragraph (e) of this sectionamounts paid to replace the shingles.

Example 13. Betterment; replacement with im-proved parts. Assume the same facts as in Example11, except that, instead of replacing the wooden shin-gles with asphalt shingles, X decides to replace all thewooden shingles with shingles made of lightweightcomposite materials that are maintenance-free and donot absorb moisture. The new shingles have a 50-yearwarranty and a Class A fire rating. X must capitalizeas an improvement amounts paid to reshingle the roofbecause they result in a betterment to the shop.

Example 14. Material increase in capacity. Xowns a factory building with a storage area on thesecond floor. In 2008, X replaces the columns andgirders supporting the second floor to permit storageof supplies with a gross weight 50 percent greaterthan the previous load-carrying capacity of the stor-age area. For purposes of this Example 14, assumethe factory building and its structural components arethe appropriate unit of property. X must capitalize asan improvement amounts paid for the columns andgirders because they result in a material increase inthe load-carrying capacity of the building. The com-parison rule in paragraph (e)(3) of this section doesnot apply to these amounts paid because the expendi-ture was not necessitated by a particular event.

Example 15. Material increase in capacity. In2008, X purchased harbor facilities consisting of aslip for the loading and unloading of barges and achannel leading from the slip to the river. At the timeof purchase, the channel was 150 feet wide, 1,000feet long, and 10 feet deep. To allow for ingress andegress and for the unloading of its barges, X neededto deepen the channel to a depth of 20 feet. X hired acontractor to dredge the channel to the required depth.For purposes of this Example 15, assume the channelis the appropriate unit of property. X must capital-ize as an improvement amounts paid for the dredgingbecause it resulted in a material increase in the capac-ity of the channel. The comparison rule in paragraph(e)(3) of this section does not apply to these amountspaid because the expenditure was not necessitated bya particular event.

Example 16. Not a material increase in capac-ity. Assume the same facts as in Example 15, exceptthat the channel was susceptible to siltation and, by2009, the channel depth had been reduced to 18 feet.X hired a contractor to redredge the channel to a depthof 20 feet. The event necessitating the expenditurewas the siltation of the channel. Both prior to the sil-tation and after the redredging, the depth of the chan-nel was 20 feet. Therefore, the amounts paid by X forredredging the channel did not materially increase thecapacity of the unit of property. X is not required tocapitalize as an improvement under paragraph (e) ofthis section amounts paid to redredge.

Example 17. Not a material increase in capacity.X owns a building used in its trade or business. Thefirst floor has a drop-ceiling. X decides to removethe drop-ceiling and repaint the original ceiling. Forpurposes of this Example 17, assume the building andits structural components are the appropriate unit ofproperty. The removal of the drop-ceiling does notcreate additional capacity in the building that was notthere prior to the removal. Therefore, the amountspaid by X to remove the drop-ceiling and repaint theoriginal ceiling did not materially increase the capac-ity of the unit of property. X is not required to capital-ize as an improvement under paragraph (e) of this sec-tion amounts paid related to removing the drop-ceil-ing. The comparison rule in paragraph (e)(3) of thissection does not apply to these amounts paid becausethe expenditure was not necessitated by a particularevent.

(f) Restoration—(1) In general. A tax-payer must capitalize amounts paid that re-store a unit of property. Amounts paid re-store property if the amounts paid substan-tially (as defined in paragraph (f)(3) of thissection) prolong the economic useful lifeof the unit of property.

(2) Economic useful life—(i) Taxpayerswith an applicable financial statement.For taxpayers with an applicable finan-cial statement (as defined in paragraph(f)(2)(iii) of this section), the economicuseful life of a unit of property generallyis presumed to be the same as the usefullife used by the taxpayer for purposes ofdetermining (at the time the property isoriginally acquired or produced by the

September 25, 2006 560 2006–39 I.R.B.

taxpayer) depreciation in its applicablefinancial statement, regardless of anysalvage value of the property. A tax-payer may rebut this presumption onlyif there is a clear and convincing basisthat the economic useful life (as definedin paragraph (f)(2)(ii) of this section fortaxpayers without an applicable financialstatement) of the unit of property is signif-icantly different than the useful life usedby the taxpayer for purposes of determin-ing depreciation in its applicable financialstatement. If a taxpayer does not havean applicable financial statement at thetime the property was originally acquiredor produced, but does have an applicablefinancial statement at some later date, theeconomic useful life of the unit of prop-erty must be determined under paragraph(f)(2)(ii) of this section. Further, if a tax-payer treats amounts paid for a unit ofproperty as an expense in its applicablefinancial statement on a basis other thanthe property having a useful life of oneyear or less, the economic useful life ofthe unit of property must be determinedunder paragraph (f)(2)(ii) of this section.For example, if a taxpayer has a policyof treating as an expense on its applica-ble financial statement amounts paid forproperty costing less than a certain dollaramount, notwithstanding that the propertyhas a useful life of more than one year, theeconomic useful life of the property mustbe determined under paragraph (f)(2)(ii)of this section.

(ii) Taxpayers without an applicable fi-nancial statement. For taxpayers that donot have an applicable financial statement(as defined in paragraph (f)(2)(iii) of thissection), the economic useful life of a unitof property is not necessarily the usefullife inherent in the property but is the pe-riod over which the property may reason-ably be expected to be useful to the tax-payer or, if the taxpayer is engaged in atrade or business or an activity for the pro-duction of income, the period over whichthe property may reasonably be expectedto be useful to the taxpayer in its trade orbusiness or for the production of income,as applicable. This period is determinedby reference to the taxpayer’s experiencewith similar property, taking into accountpresent conditions and probable future de-velopments. Factors to be considered indetermining this period include, but are notlimited to—

(A) Wear and tear and decay or declinefrom natural causes;

(B) The normal progress of the art, eco-nomic changes, inventions, and current de-velopments within the industry and thetaxpayer’s trade or business;

(C) The climatic and other local con-ditions peculiar to the taxpayer’s trade orbusiness; and

(D) The taxpayer’s policy as to repairs,renewals, and replacements.

(iii) Definition of “applicable financialstatement”. The taxpayer’s applicablefinancial statement is the taxpayer’s fi-nancial statement listed in paragraphs(f)(2)(ii)(A) through (C) of this sectionthat has the highest priority (includingwithin paragraph (f)(2)(ii)(B) of this sec-tion). The financial statements are, indescending priority —

(A) A financial statement required tobe filed with the Securities and ExchangeCommission (SEC) (the 10-K or the An-nual Statement to Shareholders);

(B) A certified audited financial state-ment that is accompanied by the report ofan independent CPA (or in the case of aforeign entity, by the report of a similarlyqualified independent professional), that isused for—

(1) Credit purposes,(2) Reporting to shareholders, partners,

or similar persons; or(3) Any other substantial non-tax pur-

pose; or(C) A financial statement (other than

a tax return) required to be provided tothe Federal or a state government or anyFederal or state agencies (other than theSEC or the Internal Revenue Service).

(3) Substantially prolonging economicuseful life—(i) In general. An amount paidsubstantially prolongs the economic usefullife of the unit of property if it extends theperiod over which the property may rea-sonably be expected to be useful to the tax-payer in its trade or business or for the pro-duction of income, as applicable (or, if thetaxpayer is not engaged in a trade or busi-ness or an activity for the production ofincome, the period over which the prop-erty may reasonably be expected to be use-ful to the taxpayer) beyond the end of thetaxable year immediately succeeding thetaxable year in which the economic use-ful life of the unit of property was orig-inally expected to cease, or if the prop-erty’s economic useful life was previously

prolonged (as determined under this para-graph (e)(3)(i)), the end of the taxable yearimmediately succeeding the taxable yearin which the prolonged economic usefullife was expected to cease.

(ii) Replacements. Amounts paid willbe deemed to substantially prolong theeconomic useful life of the unit of prop-erty if a major component or a substantialstructural part of the unit of property is re-placed with either a new part or a part thathas been restored to like-new condition asdescribed in paragraph (f)(3)(iii) of thissection. Thus, the replacement of a partwith another part that is not new or is notin like-new condition (for example, a usedor reconditioned part) does not constitutethe replacement of a major component orsubstantial structural part of the unit ofproperty under this paragraph (f)(3)(ii).Further, replacement of a relatively minorportion of the physical structure of the unitof property or a relatively minor portion ofany of its major parts, even if those partsare new, does not constitute the replace-ment of a major component or substantialstructural part of the unit of property.

(iii) Restoration to like-new condition.Amounts paid will be deemed to substan-tially prolong the economic useful life ofthe unit of property if they result in the unitof property or a major component or sub-stantial structural part of the unit of prop-erty being restored to a like-new condi-tion (including bringing the unit of prop-erty or a major component or substantialstructural part of the property to the statusof new, rebuilt, remanufactured, or simi-lar status under the terms of any Federalregulatory guideline or the manufacturer’soriginal specifications).

(iv) Restoration after a casualty loss.Amounts paid will be deemed to substan-tially prolong the useful life of the unit ofproperty if the taxpayer properly deductsa casualty loss under section 165 withrespect to the unit of property and theamounts paid restore the unit of propertyto a condition that is the same or betterthan before the casualty.

(4) Examples. The following examplesillustrate the rules of this paragraph (f) and,except as otherwise provided, assume thatthe amounts paid would not be required tobe capitalized under any other provision ofthis section (paragraph (e), for example):

Example 1. Prolonged economic useful life. Xis a Class I railroad that owns a fleet of locomotives.

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In 1989, X purchased a new locomotive with an eco-nomic useful life (as defined in paragraph (f)(2) ofthis section) of 22 years (from 1989 - 2011). X per-forms substantially the same cyclical maintenance onits locomotives approximately every 6 years. X per-formed cyclical maintenance on the locomotive in1995, in 2001, and in 2007. Assume that the loco-motive (which includes the engine) is the appropriateunit of property and that none of the cyclical main-tenance projects resulted in a restoration under para-graph (f)(3)(ii) or (f)(3)(iii) of this section. Amountspaid for cyclical maintenance in 1995 and 2001 donot substantially prolong the economic useful life ofthe locomotive. However, the cyclical maintenanceperformed in 2007 will prolong the economic use-ful life of the locomotive to 2013, which is beyondthe end of the next succeeding taxable year after theeconomic useful life of the locomotive ceases (2011).Therefore, under paragraphs (f)(1) and (f)(3)(i) ofthis section, X must capitalize as an improvement tothe locomotive amounts paid for the cyclical main-tenance performed in 2007, regardless of whether Xwas required to capitalize the amounts paid in previ-ous years for cyclical maintenance.

Example 2. Economic useful life not prolonged.Assume the same facts as in Example 1, except thatin 2009, X replaces a filter in the locomotive engine.X generally replaces this type of filter every 4 years.Although the filter itself would last beyond the endof the locomotive’s economic useful life in 2011, theamount paid for the filter does not substantially pro-long the economic useful life of the locomotive be-cause the filter will not extend beyond 2009 the pe-riod over which the locomotive may reasonably beexpected to be useful to X in its trade or business.Additionally, although the filter is a necessary com-ponent of the locomotive, the filter is not a substantialstructural part or major component of the locomotive.Therefore, the amount paid to replace the filter doesnot substantially prolong the economic useful life ofthe locomotive.

Example 3. Minor part replacement. X owns asmall retail shop. In 2008, a storm damaged the roofof X’s shop by displacing numerous wooden shin-gles. X decides to replace all the wooden shingleson the roof and hires a contractor to replace all theshingles on the roof with new wooden shingles. Nopart of the sheathing, rafters, or joists was replaced.For purposes of this Example 3, assume the shop andits structural components are the appropriate unit ofproperty. The replacement of the shingles did notextend the useful life of the shop under paragraph(f)(3)(i) of this section. The portion of the roof re-placed is not a substantial structural part of the shop,nor does the replacement of the shingles restore to alike-new condition a major component or substantialstructural part of the shop. Therefore, the amountspaid by X to reshingle the roof with wooden shinglesdo not substantially prolong the economic useful lifeof the shop.

Example 4. Major component or substantialstructural part. Assume the same facts as in Exam-ple 3, except that when the contractor began work onthe shingles, the contractor discovered that a majorportion of the sheathing had rotted, and the rafterswere weakened as well. The contractor replaced allthe sheathing and a significant portion of the rafters.The roof (including the shingles, sheathing, rafters,and joists) is a substantial structural part of a build-

ing. The replacement of the shingles, sheathing, andrafters restored to a like-new condition a substantialstructural part of the shop. Therefore, under para-graphs (f)(1) and (f)(3)(iii) of this section, X mustcapitalize as an improvement to the shop amountspaid to replace the roof of the shop.

Example 5. Not a major component or structuralpart. X uses a car in providing a taxi service. X pur-chased the car in 2008. Assume that the unit of prop-erty is the car. The car has an economic useful lifeof 5 years. In 2011, the battery dies and X takes thecar to a repair shop, which replaces the battery. Al-though the battery itself may last beyond the end ofthe car’s economic useful life, the amount paid for thebattery does not substantially prolong the economicuseful life of the car because the battery will not ex-tend beyond 2013 the period over which the car mayreasonably be expected to be useful to X in its tradeor business. Although the battery is a necessary com-ponent of the car, the battery is not a substantial struc-tural part or major component of the car. Therefore,the amount paid to replace the battery does not sub-stantially prolong the economic useful life of the car.

Example 6. Major component or structural part.Assume the same facts as Example 5, except ratherthan the battery dying, the car overheats and causesso much damage that the engine has to be rebuilt. Theengine is a major component of the car. Therefore, Xis required to capitalize as an improvement to the carunder paragraphs (f)(1) and (f)(3)(iii) of this sectionthe amounts paid to rebuild the engine.

Example 7. Repair performed during an improve-ment; coordination with section 263A. Assume thesame facts as Example 6, except that X has a bro-ken taillight fixed at the same time that the enginewas rebuilt. The repair to the taillight was not in-curred because the engine was rebuilt, nor did it ben-efit the rebuild of the engine. The repair of the bro-ken taillight is a deductible expense under §1.162–4.Under section 263A, all indirect costs, including oth-erwise deductible repair and maintenance costs thatdirectly benefit or are incurred by reason of the im-provement must be capitalized as part of the improve-ment. Therefore, all amounts paid that are incurredby reason of the engine being rebuilt must be capital-ized, including, for example, amounts paid for activi-ties that would usually be deductible maintenance ex-penses, such as refilling the engine with oil and radia-tor fluid. Amounts paid to repair the broken taillight,however, are not incurred by reason of the engine be-ing rebuilt, nor do the amounts paid directly benefitthe engine rebuild, despite being repaired at the sametime. Thus, X is not required to capitalize to the im-provement of the car (the rebuild of the engine) theamounts paid to repair the broken taillight.

Example 8. Related amounts to replace majorcomponent or structural part. (i) X owns a retailgasoline station, consisting of a paved area used forautomobile access to the pumps and parking areas, abuilding used to market gasoline, and a canopy cov-ering the gasoline pumps. The premises also consistsof underground storage tanks (USTs) that are con-nected by piping to the pumps and are part of themachinery used in the immediate retail sale of gas.The pumps also are connected to a monitoring unitin the building that allows the sales clerk to monitorthe gasoline sales. To comply with regulations issuedby the Environmental Protection Agency, X is re-quired to remove and replace leaking USTs. In 2008,

X hires a contractor to perform the removal and re-placement, which consists of removing the old tanksand installing new tanks with leak detection systems.The removal of the old tanks includes removing thepaving material covering the tanks, excavating a holelarge enough to gain access to the old tanks, discon-necting any strapping and pipe connections to the oldtanks, and lifting the old tanks out of the hole. Instal-lation of the new tanks includes placement of a linerin the excavated hole, placement of the new tanks,installation of a leak detection system, installation ofan overfill system, connection of the tank to the pipesleading to the pumps, backfilling of the hole, and re-placement of the paving. X is also required to pay apermit fee to the county to undertake the installationof the new tanks.

(ii) X pays the permit fee to the county on October15, 2008. The contractor performs all of the requiredwork and, on November 1, 2008, bills X for the costsof removing the old USTs. On November 15, 2008,the contractor bills X for the remainder of the work.Assume the fuel distribution system is the appropriateunit of property. The USTs are major components ofthe fuel distribution system. Therefore, under para-graphs (f)(1) and (f)(3)(ii) of this section, X must cap-italize as an improvement to the fuel distribution sys-tem the aggregate of related amounts paid to replacethe USTs, which related amounts include the amountpaid to the county, the amount paid to remove the oldUSTs, and the amount paid to install the new USTs(regardless that the amounts were separately invoicedand paid to two different parties).

Example 9. Major component or substantialstructural part. X is a common carrier that ownsa fleet of petroleum hauling trucks. In 2008, Xreplaces the existing engine, cab, and petroleum tankof a truck with a new engine, cab, and tank. Assumethe tractor of the truck (which includes the cab andthe engine) is a separate unit of property from therest of the truck. Also assume that the trailer (whichcontains the petroleum tank) is a separate unit ofproperty from the truck. The engine and the cabare major components of the truck tractor, and thepetroleum tank is a major component of the trailer.Therefore, under paragraphs (f)(1) and (f)(3)(ii) ofthis section, X must capitalize as an improvement tothe tractor amounts paid to replace the engine andcab, and must capitalize as an improvement to thetrailer amounts paid to replace the petroleum tank.

Example 10. Restoration of major component tolike-new condition. (i) X is a towboat operator thatowns and leases a fleet of towboats. In 2008, X re-places an existing towboat engine with a rebuilt en-gine. A towboat engine is rebuilt through a series ofsteps designed to put the engine in like-new operat-ing condition to the maximum extent possible. En-gines in a towboat nearing the end of its useful life orengines that have been removed from towboats dueto a catastrophic malfunction are likely candidatesfor the rebuilding process. The goal of the rebuild-ing process is to bring each of an engine’s compo-nent parts to the manufacturer’s original dimensionalspecifications for new parts.

(ii) Replacement of the existing towboat enginewith a rebuilt engine involves dry-docking the tow-boat. The rebuilding and replacement process takesapproximately 3 to 5 months. The process requiresthe removal of the engine from the towboat andthe removal of all of the moving and nonmoving

September 25, 2006 562 2006–39 I.R.B.

components from the engine as well. The engine’scrankcase and oil pan are separated, and every part ofthe engine is cleaned, inspected using intense illumi-nation, machined, and treated with special materialsto restore the engine to like-new operating condition.The engine crankcase and oil pan are extensively ma-chined and welded, and numerous dimensional testsand checks are performed to ensure that the engine isreturned to a like-new condition through the rebuild-ing process. In addition, a reconditioned crankshaftand camshaft normally are installed in the engineduring the rebuilding process. The power packs arecompletely rebuilt with a large number of new partsduring the rebuilding process. The oil pumps, waterpumps, engine turbochargers, and governors arenormally removed and exchanged for rebuilt partsduring the rebuilding process. The accessory drivegears, all of the piping on the front and aft ends of theengine, the governor drive gear, and the turbochargerdrive gears are removed and normally exchanged forrebuilt parts during the rebuilding process. The goalof the rebuilding process is to bring each of an en-gine’s component parts to the engine manufacturer’soriginal dimensional specifications for new parts.Assume the towboat (which includes the engine) isthe appropriate unit of property. The work done onthe towboat engine constitutes a remanufacture orrebuild of the engine, which is a major componentof the towboat. Therefore, under paragraphs (f)(1)and (f)(3)(iii) of this section, X must capitalize as animprovement to the towboat amounts paid to rebuildthe towboat engine.

Example 11. Repairs performed during an im-provement; coordination with section 263A. Assumethe same facts as in Example 10, except that whilethe towboat is in dry-dock to have the engine rebuilt,X also makes repairs to the hull and rudders that arenot by themselves an improvement under this sec-tion. The amounts paid to repair the hull and rud-ders do not directly benefit nor are incurred by rea-son of the engine rebuild. Under section 263A, allindirect costs, including otherwise deductible repaircosts that directly benefit or are incurred by reasonof the improvement must be capitalized as part of theimprovement. Therefore, all amounts paid that areincurred by reason of the engine being rebuilt mustbe capitalized to the improvement, including, for ex-ample, amounts paid for activities such as cleaningand inspecting the engine, which usually would bedeductible maintenance costs. Amounts paid to re-pair the hull and rudders, however, are not incurred byreason of the engine being rebuilt, nor do the amountspaid directly benefit the engine rebuild, despite beingincurred at the same time. Thus, in accordance withparagraph (d)(5)(i) of this section, X is not requiredto capitalize to the towboat amounts paid to repair thehull and rudders to the improvement.

Example 12. Restoration to like-new condition;coordination with section 263A. Assume the samefacts as Example 10, except that while the towboatis in dry-dock, X also makes substantial improve-ments to the propulsion systems and the mechani-cal systems, including rebuilding large sections ofthe hull, and rebuilding, replacing, or upgrading thesteering systems, shafting systems, and electrical sys-tems, such that almost the entire towboat is restoredto like-new condition. This process constitutes a re-manufacture or rebuild of the towboat. Under sec-tion 263A, all indirect costs, including otherwise de-

ductible repair costs that directly benefit or are in-curred by reason of the improvement must be capi-talized as part of the improvement. Therefore, underparagraph (d)(5)(i) of this section, X must capital-ize to the improvement of the towboat (the rebuild)amounts paid that otherwise would be deductible re-pair costs that directly benefit or are incurred by rea-son of the improvement.

Example 13. Restoration to like-new condition.X is a Class I railroad that owns a fleet of freightcars. Approximately every 10 years, X rebuilds itsfreight cars. The rebuild includes a complete dis-assembly, inspection, and reconditioning and/or re-placement of components of the suspension and draftsystems, trailer hitches, and other special equipment.Modifications are made to the car to upgrade variouscomponents to the latest engineering standards. Thefreight car essentially is stripped to the frame, withall of its substantial components either reconditionedor replaced. The frame itself is the longest-lastingpart of the car and is reconditioned. The walls ofthe freight-train car are replaced or are sandblastedand repainted. New wheels typically are installedon the car. All the remaining components of the carare restored before they are reassembled. At the endof the rebuild, the freight cars have been restored tolike-new condition. Assume the freight car is theappropriate unit of property. The work done to thefreight car constitutes a remanufacture or rebuild ofthe freight car. Therefore, under paragraphs (f)(1) and(f)(3)(iii) of this section, X must capitalize as an im-provement to the freight car amounts paid to rebuildthe freight car.

Example 14. Restoration of major component tolike-new condition. X owned a factory that it ac-quired in 1997. In 2008, the factory roof began toleak. These leaks on occasion resulted in damage toX’s products and prevented the use of certain portionsof the factory. X decided to reroof the entire factoryand hired a contractor to perform the reroofing. Thestructure of the roof, including substantial portionsof the rafters and joists, was restored to a like-newcondition. Assume the factory building and its struc-tural components are the appropriate unit of property.The roofing process constitutes a remanufacture orrebuild of the roof, which is a substantial structuralpart of the factory. Therefore, under paragraphs (f)(1)and (f)(3)(iii) of this section, X must capitalize as animprovement to the factory amounts paid to reroof thefactory.

Example 15. Minor part replacement; coordina-tion with section 263A. X is in the business of smelt-ing aluminum. X’s aluminum smelting facility in-cludes a plant where molten aluminum is poured intomolds and allowed to solidify. Because of the poten-tial of fire from a molten metal explosion, the plant’sroof must be made of fire-resistant material. The roofmust also be without leaks because rain water hittingthe molten aluminum could cause an explosion. Theroof of the plant was made of roofing material andcorrugated sheet metal decking, which supports theroofing material. During 2008, X removed and re-placed a minor portion of the plant’s roof deckingand roofing material. At the time of the replacement,the pattern of the original metal support decking wasnot available. Therefore, X used comparable fire re-sistant wood decking to replace the corrugated metaldecking. For purposes of this Example 15, assumethe plant building and its structural components are

the appropriate unit of property and that the amountpaid does not prolong the economic useful life of theplant under paragraph (f)(3)(i) of this section. Theportion of the roof structure being replaced is not asubstantial structural part of the plant, nor does thework performed return to like-new condition a majorcomponent or substantial structural part of the plant.Further, because X could not practicably replace theroof material with the same type of material, the re-placement of the original roof material with an im-proved, but comparable, material does not, by itself,result in an improvement. Therefore, the amount paidto remove and replace a minor part of the plant’s roofdecking and roofing materially does not substantiallyprolong the economic useful life of the plant. How-ever, under section 263A, all indirect costs, includ-ing otherwise deductible costs, that directly benefit orare incurred by reason of the taxpayer’s manufactur-ing activities must be capitalized to the property pro-duced for sale. Therefore, because the amounts paidfor the roof decking and materials are incurred byreason of X’s manufacturing operations, the amountspaid must be capitalized under section 263A to theproperty produced for sale by X.

Example 16. Minor part replacement. (i) X is acommercial airline engaged in the business of trans-porting passengers and freight throughout the UnitedStates and abroad. To conduct its business, X ownsor leases various types of aircraft. As a condition ofmaintaining its airworthiness certification for theseaircraft, X is required by the Federal Aviation Ad-ministration (FAA) to establish and adhere to a con-tinuous maintenance program for each aircraft withinits fleet. These programs, which are designed byX and the aircraft’s manufacturer and approved bythe FAA are incorporated into each aircraft’s main-tenance manual. The maintenance manuals requirea variety of periodic maintenance visits at variousintervals during the operating lives of each aircraft.One type of maintenance visit is an engine shop visit(ESV), which is performed on X’s aircraft engines ap-proximately every 4 years.

(ii) In 2004, X purchased a new aircraft and en-gine. In 2008, X performs its first ESV on the air-craft engine. The ESV includes some or all of the fol-lowing activities: disassembly, cleaning, inspection,repair, replacement, reassembly, and testing. Dur-ing the ESV, the engine is removed from the aircraftand shipped to an outside vendor who performs theESV. When the engine arrives at the vendor, the en-gine is cleaned and externally inspected. Regard-less of condition, it is thoroughly inspected visuallyand, as appropriate, further inspected using a numberof non-destructive testing procedures. The engine isthen disassembled into major parts and, if necessary,into smaller parts. If inspection or testing disclosesa discrepancy in a part’s conformity to the specifi-cations in X’s maintenance program, the part is re-paired, or if necessary, replaced with a new or usedserviceable part conforming to the specifications. Ifa part can be repaired, but not in time to be returned tothe engine with which the part had arrived, the ven-dor first attempts to replace the part with a similar partfrom customer stock (used parts from X’s aircraft thatwere replaced or exchanged and repaired during anearlier ESV and then stored for future use on X’s air-craft). If a part is not available from customer stock,the part is exchanged with a used, serviceable part inthe vendor’s inventory. A part is replaced (generally

2006–39 I.R.B. 563 September 25, 2006

with a used serviceable part) only if the part removedfrom X’s engine cannot be repaired timely. Althoughmany minor parts may be replaced during the ESV,the ESV does not return the engine to a like-new con-dition.

(iii) For purposes of this Example 16, assume theaircraft engine is the appropriate unit of property. TheESV does not result in the replacement of the enginenor does it restore the engine to a like-new condition.Therefore, the amount paid for the ESV does not sub-stantially prolong the economic useful life of the en-gine.

Example 17. Repairs performed during animprovement; coordination with section 263A. (i)Assume the same facts as in Example 16, except thatX purchased the aircraft in 1986 and, in addition tothe continuous maintenance program for engines,X adheres to a continuous maintenance programfor its aircraft airframes. One type of maintenancevisit is a heavy maintenance visit (HMV), which isperformed on X’s aircraft airframes approximatelyevery 8 years. In 2008, X decided to make substan-tial modifications to the airframe, which resulted inthe restoration of the airframe to like-new condition.The modifications included removing all the bellyskin panels on the aircraft’s fuselage and replacingthem with new skin panels; replacing the metalsupports under the lavatories and galleys; removingthe wiring in the leading edges of both wings andreplacing it with new wiring; removing the fuel tankbladders, harnesses, wiring systems, and connectorsand replacing them with new components; openingevery lap joint on the airframe and replacing theepoxy and rivets used to seal the lap joints with anon-corrosive sealant and larger rivets; reconfiguringand upgrading the avionics and the equipment in thecockpit; replacing all the seats, overhead bins, side-wall panels, partitions, carpeting, windows, galleys,lavatories, and ceiling panels with new items; in-stalling a cabin smoke and fire detection system, anda ground proximity warning system; and paintingthe exterior of the aircraft. In addition, X performedmuch of the same work that would be performedduring an HMV.

(ii) For purposes of this Example 17, assume theaircraft airframe is the appropriate unit of property.The amounts paid to modify the airframe are requiredto be capitalized as an improvement to the airframeunder paragraph (f) of this section because the mod-ifications restored the airframe to a like-new condi-tion. Assume the amounts paid for the HMV arenot required to be capitalized as a separate improve-ment to the airframe. Under section 263A, all indi-rect costs, including otherwise deductible repair coststhat directly benefit or are incurred by reason of theimprovement must be capitalized as part of the im-provement. Therefore, X must capitalize to the im-provement of the airframe (the restoration) amountspaid that usually would be ordinary and necessary re-pair costs, including any amounts paid for the HMVthat directly benefit or are incurred by reason of theimprovement to the airframe. X is not required, how-ever, to capitalize to the improvement of the airframeany amounts paid for the HMV that do not directlybenefit or are not incurred by reason of the improve-ment to the airframe.

Example 18. Restoration of major component tolike-new condition; coordination with section 263A.(i) X is a Class I railroad that owns a fleet of locomo-

tives. In 1994, X purchased a new locomotive (Lo-comotive A) with an economic useful life (as definedin paragraph (f)(2) of this section) of 20 years (from1994 - 2014). X performed cyclical maintenance onLocomotive A in 2000, and again in 2008. In 2000,X replaced the power cylinders on Locomotive A’sengine, and performed work on other components ofLocomotive A. In 2008, X removed the engine and re-placed it with one it had previously remanufactured tothe manufacturer’s original specifications, and againperformed work on other components of LocomotiveA. The engine that X removed from Locomotive Ain 2008 was remanufactured to the manufacturer’soriginal specifications and installed on LocomotiveB later in 2008.

(ii) Assume the locomotive (which includes theengine) is the appropriate unit of property. The re-placement of the power cylinders and the other workperformed on Locomotive A in 2000 did not prolongthe economic useful life of Locomotive A under para-graph (f)(3) of this section. However, the amountspaid in 2008 to remove the engine and replace it witha previously manufactured engine must be capitalizedunder paragraph (f)(3)(ii) of this section. Assume theamounts paid in 2008 to perform work on other com-ponents of Locomotive A are not required to be cap-italized as a separate improvement to Locomotive A.Under section 263A, all indirect costs, including oth-erwise deductible repair costs that directly benefit orare incurred by reason of the improvement must becapitalized as part of the improvement. Therefore,X must capitalize to the improvement of Locomo-tive A (the installation of the remanufactured engine)amounts paid that usually would be ordinary and nec-essary repair costs, including any amounts paid forwork on other components that directly benefit or areincurred by reason of the improvement to Locomo-tive A. X is not required, however, to capitalize to theimprovement of Locomotive A any amounts paid forwork performed on other components that do not di-rectly benefit or are not incurred by reason of the im-provement to Locomotive A. Further, X must capital-ize to the improvement of Locomotive B (the instal-lation of remanufactured engine) the amounts paid toremanufacture the engine removed from LocomotiveA and amounts paid to install the remanufactured en-gine on Locomotive B.

(g) Repair allowance method—(1) Ingeneral. This paragraph (g) provides anoptional simplified method (the repair al-lowance method) for determining whetheramounts paid to repair, maintain, or im-prove certain tangible property are to betreated as deductible expenses or capitalexpenditures. A taxpayer that elects touse the repair allowance method describedin paragraph (g)(3) of this section mayuse that method instead of determiningwhether amounts paid to repair, maintain,or improve property are capital expendi-tures or deductible expenses under the gen-eral principles of sections 162(a), 212, and263(a). Thus, except for the rules in para-graph (d)(2) of this section for determiningthe appropriate unit of property, the cap-

italization rules in §1.263(a)–3(d) do notapply to property for which the taxpayeruses the repair allowance method underthis paragraph (g). See section 263A forthe scope of costs required to be capital-ized to property produced by the taxpayeror to property acquired for resale.

(2) Election of repair allowancemethod. In the case of repair allowanceproperty (as defined in paragraph (g)(6)of this section), a taxpayer may elect touse the repair allowance method describedin paragraph (g)(3) of this section. Seeparagraph (g)(9) of this section for themanner of electing the repair allowance.A taxpayer that elects to use the repairallowance method must use that methodfor all of its repair allowance propertyin all MACRS classes (including prop-erty classified into a MACRS class forpurposes of the repair allowance methodunder paragraph (g)(6)(ii) of this section).A taxpayer electing the repair allowancemethod must use that method consistentlyfor all future years unless the taxpayerrevokes the election in accordance withparagraph (g)(10) of this section.

(3) Application of repair allowancemethod. Under the repair allowancemethod, a taxpayer must treat all amountspaid (other than amounts paid for ex-cluded additions, as defined in paragraph(g)(7) of this section) for materials andlabor to repair, maintain, or improve allthe repair allowance property in a particu-lar MACRS class as deductible expensesunder section 162 for the taxable year, upto the repair allowance amount (as deter-mined in paragraph (g)(4) of this section)for that MACRS class, and treat the excessof all amounts paid to repair, maintain, orimprove all the repair allowance prop-erty in that MACRS class (the capitalizedamount) in accordance with paragraph(g)(5) of this section.

(4) Repair allowance amount—(i) Ingeneral. Except as provided in paragraph(g)(4)(iv) of this section (with regard tobuildings), under the repair allowancemethod for a particular taxable year, therepair allowance amount for a particularMACRS class consisting of repair al-lowance property is an amount equal tothe average unadjusted basis (as definedin paragraph (g)(4)(ii) of this section) ofrepair allowance property in the MACRSclass multiplied by the repair allowance

September 25, 2006 564 2006–39 I.R.B.

percentage in effect for the MACRS classfor the taxable year.

(ii) Average unadjusted basis. For pur-poses of this section, average unadjustedbasis is the average of the unadjusted basis(as defined in paragraph (g)(4)(iii) of thissection) of all repair allowance property inthe MACRS class at the beginning of thetaxable year and the unadjusted basis of allrepair allowance property in the MACRSclass at the end of the taxable year.

(iii) Unadjusted basis. For purposesof this section, unadjusted basis is the ba-sis as determined under section 1012, orother applicable sections of subchapter O,and subchapters C (relating to corporatedistributions and adjustments), K (relatingto partners and partnerships), and P (re-lating to capital gains and losses). Un-adjusted basis is determined without re-gard to any adjustments described in sec-tion 1016(a)(2) or (3) or to amounts forwhich the taxpayer has elected to treat asan expense (for example, under section179, 179B, or 179C), but with regard to ba-sis reductions which are required becauseof credits taken on the property (for exam-ple, under section 44, 45G, 45H, or 50(c)).Unadjusted basis also must reflect the re-duction in basis for the percentage of thetaxpayer’s use of property for the taxableyear other than for use in the taxpayer’strade or business (or for the production ofincome).

(iv) Buildings. In the case of buildingsand structural components that are repairallowance property, the repair allowancemethod is applied separately with respectto each unit of property.

(5) Capitalized amount—(i) In general.Under the repair allowance method fora particular taxable year, the capitalizedamount is the excess of all amounts paid torepair, maintain, or improve all the repairallowance property in a MACRS classover the repair allowance amount for thatMACRS class. In addition, the capitalizedamount includes all of the indirect costs ofproducing the repair allowance propertyin the MACRS class, which must be cap-italized in accordance with the taxpayer’smethod of accounting for section 263Acosts. Except as provided in paragraphs(g)(5)(iv), (g)(5)(v), and (g)(5)(vi) of thissection, a taxpayer may choose to treatthe capitalized amount as a single assetunder paragraph (g)(5)(ii) of this sectionor, alternatively, may choose to allocate

the capitalized amount to specific repairallowance property in the MACRS classin accordance with paragraph (g)(5)(iii) ofthis section.

(ii) Single asset treatment of capital-ized amount. In general, the capitalizedamount for a particular MACRS class maybe treated by the taxpayer as a separatesingle asset and depreciated in accordancewith that MACRS class. The single assetis treated as a section 168(i)(6) improve-ment and is treated as placed in service bythe taxpayer on the last day of the first halfof the taxable year in which the amountis paid, before application of the conven-tion under section 168(d). Except for asale of assets constituting a trade or busi-ness, no gain or loss is recognized on cap-italized amounts treated as a single assetunder this paragraph (g)(5)(ii) upon dispo-sition of any repair allowance property towhich the capitalized amounts are related.A disposition includes the sale, exchange,retirement, physical abandonment, or de-struction of property. Taxpayers must con-tinue to depreciate the single asset over theremainder of the MACRS applicable re-covery period.

(iii) Allocation treatment of capitalizedamount. Instead of treating the capitalizedamount as a single asset under paragraph(g)(5)(ii) of this section, a taxpayer may al-locate the capitalized amount for a partic-ular MACRS class to all repair allowanceproperty in the particular MACRS class inproportion to the unadjusted basis of theproperty in that MACRS class as of the be-ginning of the taxable year. The capital-ized amount allocated to repair allowanceproperty is treated as a section 168(i)(6)improvement to the underlying repair al-lowance property and is treated as placedin service by the taxpayer on the last dayof the first half of the taxable year in whichthe amount is paid, before application ofthe convention under section 168(d).

(iv) Section 168(g) repair allowanceproperty. If any repair allowance propertyin a particular MACRS class as of thebeginning of the taxable year is depre-ciated under section 168(g) pursuant tosection 168(g)(1)(A) through (D) or otherprovisions of the Internal Revenue Code,the portion of the capitalized amount forthat MACRS class that is attributable toall section 168(g) repair allowance prop-erty in that MACRS class (section 168(g)total capitalized amount) is determined

by multiplying the capitalized amount forthat MACRS class (as determined underparagraph (g)(5)(i) of this section) by apercentage that is equal to the unadjustedbasis of all section 168(g) repair allowanceproperty in that MACRS class as of the be-ginning of the taxable year divided by theunadjusted basis of all repair allowanceproperty in that MACRS class as of thebeginning of the taxable year. The section168(g) total capitalized amount for a par-ticular MACRS class then is allocated toeach section 168(g) repair allowance prop-erty in that MACRS class by multiplyingthe section 168(g) total capitalized amountfor that MACRS class by a percentagethat is equal to the unadjusted basis of theparticular section 168(g) repair allowanceproperty in that MACRS class as of thebeginning of the taxable year divided bythe unadjusted basis of all section 168(g)repair allowance property in that MACRSclass as of the beginning of the taxableyear. The capitalized amount allocatedto each section 168(g) repair allowanceproperty is depreciated in accordance withsection 168(g), is treated as a section168(i)(6) improvement to the underlyingrepair allowance property, and is treatedas placed in service by the taxpayer on thelast day of the first half of the taxable yearin which the amount is paid, before ap-plication of the convention under section168(d).

(v) Section 168(g) election. If a tax-payer makes an election under section168(g)(7) for a particular MACRS classwith respect to property placed in servicein the current taxable year, the electionapplies to the capitalized amount for thatMACRS class. If such an election is made,the taxpayer must allocate the capitalizedamount for that MACRS class to all repairallowance property in the MACRS classin proportion to the unadjusted basis ofthe property in that MACRS class as ofthe beginning of the taxable year. Thecapitalized amount is treated as a section168(i)(6) improvement to the underlyingrepair allowance property and is treated asplaced in service by the taxpayer on thelast day of the first half of the taxable yearin which the amount is paid, before ap-plication of the convention under section168(d). The depreciation of the capital-ized amount allocated to repair allowanceproperty must be determined under section168(g) whether or not the repair allowance

2006–39 I.R.B. 565 September 25, 2006

property in the MACRS class as of the be-ginning of the taxable year is depreciatedunder section 168(g).

(vi) Public utility property. If any re-pair allowance property in a particularMACRS class is public utility property(as defined in section 168(i)(10) or for-mer section 167(l)(3)(A)), the portion ofthe capitalized amount for that MACRSclass that is attributable to all public util-ity property in that MACRS class (publicutility property total capitalized amount)is determined by multiplying the capital-ized amount for that MACRS class (asdetermined under paragraph (g)(5)(i) ofthis section) by a percentage that is equalto the unadjusted basis of all public utilityproperty in that MACRS class as of the be-ginning of the taxable year divided by theunadjusted basis of all repair allowanceproperty in that MACRS class as of thebeginning of the taxable year. The publicutility property total capitalized amountfor a particular MACRS class then is sub-tracted from the unadjusted basis of allrepair allowance property in that MACRSclass as of beginning of the taxable yearto determine the non-public utility prop-erty total capitalized amount. A taxpayermay choose to treat the public utilityproperty total capitalized amount for aparticular MACRS class as a single assetin accordance with paragraph (g)(5)(ii)of this section, and the non-public utilityproperty total capitalized amount for thatMACRS class as another single asset inaccordance with paragraph (g)(5)(ii) ofthis section. Alternatively, the taxpayermay choose to allocate the public utilityproperty total capitalized amount for aparticular MACRS class in proportion tothe unadjusted basis of the public utilityproperty in that MACRS class as of the

beginning of the taxable year in accor-dance with paragraph (g)(5)(iii) of thissection, and allocate the non-public util-ity property total capitalized amount fora particular MACRS class in proportionto the unadjusted basis of the non-publicutility property in that MACRS class asof the beginning of the taxable year inaccordance with paragraph (g)(5)(iii) ofthis section. In either case, the publicutility property total capitalized amountfor a particular MACRS class is subject tothe normalization requirements of section168(i)(9).

(6) Repair allowance property—(i) Ingeneral. Except as provided in paragraph(g)(6)(iii) of this section, repair allowanceproperty means real or personal propertysubject to section 168 of the Internal Rev-enue Code of 1986, or treated as subjectto section 168 under paragraph (g)(6)(ii) ofthis section, that is used in the taxpayer’strade or business or for the production ofincome.

(ii) Certain property not subject to sec-tion 168. Repair allowance property in-cludes tangible depreciable property nototherwise in a MACRS class if the tax-payer classifies the property, only for pur-poses of the repair allowance method inparagraph (g)(4) of this section, to deter-mine the appropriate MACRS class andeither the taxpayer placed the property inservice before the effective date of section168 of the Internal Revenue Code of 1986or the taxpayer properly elected out of sec-tion 168 with regard to the property.

(iii) Exclusions from repair allowanceproperty. Repair allowance propertydoes not include any property for whichthe taxpayer has elected to use the as-set guideline class repair allowance in§1.167(a)–11(d)(2); the method of ac-

counting provided in section 263(d) (withregard to certain railroad rolling stock);the method of accounting provided in Rev.Proc. 2001–46, 2001–2 C.B. 263, or Rev.Proc. 2002–65, 2002–2 C.B. 700 (with re-gard to railroad track) (see §601.601(d)(2)of this chapter); or any other property ormethod of accounting that is designated inguidance published in the Federal Regis-ter or the Internal Revenue Bulletin (see§601.601(d)(2) of this chapter).

(7) Excluded additions—(i) In general.Excluded addition means any amountpaid—

(A) For the acquisition or production ofa specific unit of property;

(B) For work that ameliorates a condi-tion or defect that either existed prior to thetaxpayer’s acquisition of the unit of prop-erty or arose during the production of theunit of property, whether or not the tax-payer was aware of the condition or defectat the time of acquisition or production;

(C) For work performed prior to thedate the unit of property is placed in ser-vice by the taxpayer (without regard toany applicable convention under section168(d));

(D) That adapts the unit of property toa new or different use; or

(E) That increases the cubic or squarespace of a building.

(ii) Treatment of excluded additions.Any amount paid for an excluded additionis treated as a capital expenditure undersections 263(a) and 263A.

(8) Repair allowance percentage. Ex-cept as provided in any future guidancepublished in the Federal Register or theInternal Revenue Bulletin, the repair al-lowance percentage in effect for eachMACRS class for a particular taxable yearis as follows:

MACRS Class MACRS RecoveryPeriod

Repair AllowancePercentage

3-year property 3 years 16.55-year property 5 years 107-year property 7 years 7.1410-year property 10 years 515-year property 15 years 3.3320-year property 20 years 2.5Water utility property 25 years 2Residential rental property 27.5 years 1.82Nonresidental rental property 39 years 1.28Railroad grading or tunnel bore 50 years 1

September 25, 2006 566 2006–39 I.R.B.

(9) Manner of election. [Reserved](10) Manner of revoking election. A

taxpayer may revoke an election made un-der the repair allowance method only byobtaining the Commissioner’s consent torevoke the election. An election must berevoked prospectively and may not be re-voked through the filing of an amendedFederal income tax return. A taxpayer thatrevokes an election may not re-elect therepair allowance method for a period ofat least five taxable years, beginning withthe year of the revocation unless, based ona showing of unusual and compelling cir-cumstances, consent is specifically grantedby the Commissioner to re-elect the repairallowance at an earlier time.

(11) Examples. The following exam-ples illustrate the rules of this paragraph(g) and assume that none of the rules inparagraph (g)(5)(iv) or (g)(5)(v) of thissection applies:

Example 1. X elects the repair allowance methoddescribed in this paragraph (g). X’s total unadjustedbasis of all of its MACRS 10-year property as of Jan-uary 1, 2008 is $10 million. X’s total unadjusted ba-sis of all MACRS 10-year property as of December31, 2008 is $15 million (computed without regard toamounts capitalized under this repair allowance pro-vision). During 2008, X pays $1,000,000 to repair,maintain, or improve MACRS 10-year property. As-sume that none of X’s property is an excluded ad-dition as defined in paragraph (g)(7) of this section.The repair allowance percentage for MACRS 10-yearproperty is 5 percent. X’s repair allowance amountand capitalized amount are computed as follows:

(i) X determines its average unadjusted ba-sis of MACRS 10-year property: ($10,000,000 +$15,000,000)/2 = $12,500,000.

(ii) X multiplies its average unadjusted basis ofMACRS 10-year property by the prescribed repairallowance percentage for MACRS 10-year propertyto arrive at the repair allowance amount: $12,500,000x 5% = $625,000.

(iii) Because X’s amounts paid to repair,maintain, or improve MACRS 10-year property($1,000,000) exceed the repair allowance amountfor MACRS 10-year property ($625,000), X deductsunder section 162(a) amounts paid to the extent of therepair allowance amount ($625,000) and capitalizesthe amounts paid in excess of the repair allowanceamount ($1,000,000 - $625,000 = $375,000).

(iv) The capitalized amount ($375,000) is treatedas an improvement under section 168(i)(6). The im-provement is depreciated as 10-year property undersection 168 and is considered placed in service on thelast day of the first half of 2008.

Example 2. X elects the repair allowance methoddescribed in this paragraph (g). X uses a car inproviding a taxi service. X’s unadjusted basis inthe car is $25,000. Assume that the unit of prop-erty (as determined under paragraph (d)(2) of thissection) is the car. In 2008, X incurs various coststo maintain, repair, and improve the car, including:$4,500 for gasoline; $550 for car washes and de-

tailing, $2,200 for scheduled maintenance such asoil changes, tire rotation, new brakes, minor parts,and fluid replacements, etc.; $80 for new headlights;$250 for new tires; and $4,800 to rebuild the engineafter the car overheated. Assume that none of X’sexpenditures are an excluded addition as defined inparagraph (g)(7) of this section. The car is classifiedas MACRS 5-year property. Assume that X has noother MACRS 5-year property. The repair allowancepercentage for MACRS 5-year property is 10 per-cent. X’s repair allowance amount and capitalizedamount are computed as follows:

(i) X determines its average unadjusted basis ofMACRS 5-year property is $25,000.

(ii) X multiplies its average unadjusted basis ofMACRS 5-year property by the prescribed repair al-lowance percentage for MACRS 5-year property toarrive at the repair allowance amount: $25,000 x 10%= $2,500.

(iii) Because X’s amounts to repair, maintain, orimprove MACRS 5-year property ($2,200 + $80 +$250 + $4,800 = $7,330) exceed the repair allowanceamount for MACRS 5-year property ($2,500), Xtreats $2,500 as an otherwise deductible ordinaryand necessary expenditure under section 162(a) andcapitalizes $4,830 as the amounts paid in excess ofthe repair allowance amount.

(iv) The capitalized amount ($4,830) is treated asan improvement under section 168(i)(6). The im-provement is depreciated as 5-year property undersection 168 and is considered placed in service on thelast day of the first half of 2008.

(h) Treatment of capital expenditures.Amounts required to be capitalized un-der this section are capital expendituresand must be taken into account througha charge to capital account or basis, or inthe case of property that is inventory inthe hands of a taxpayer, through inclusionin inventory costs. See section 263A forthe treatment of amounts referred to inthis section as well as other amounts paidin connection with the production of realproperty and personal property, includ-ing films, sound recordings, video tapes,books, or similar properties.

(i) Recovery of capitalized amounts.Amounts that are capitalized under thissection are recovered through deprecia-tion, cost of goods sold, or by an adjust-ment to basis at the time the property isplaced in service, sold, used, or otherwisedisposed of by the taxpayer. Cost recoveryis determined by the applicable InternalRevenue Code and regulation provisionsrelating to the use, sale, or disposition ofproperty.

(j) Effective date. The rules in this sec-tion apply to taxable years beginning on orafter the date of publication of the Treasurydecision adopting these rules as final reg-ulations in the Federal Register.

(k) Accounting method changes. [Re-served]

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

(Filed by the Office of the Federal Register on August 18,2006, 8:45 a.m., and published in the issue of the FederalRegister for August 21, 2006, 71 F.R. 48590)

Notice of ProposedRulemaking and Notice ofPublic Hearing

User Fees Relating toEnrollment

REG–145154–05

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemakingand notice of public hearing.

SUMMARY: This document contains pro-posed amendments to the regulations re-lating to user fees for the special enroll-ment examination to become an enrolledagent, the application for enrollment of en-rolled agents, and the renewal of this en-rollment. The charging of user fees is au-thorized by the Independent Offices Ap-propriations Act (IOAA) of 1952. Thisdocument also contains a notice of publichearing on these proposed regulations.

DATES: Written or electronically-gen-erated comments must be received bySeptember 28, 2006. Outlines of topics tobe discussed at the public hearing sched-uled for September 29, 2006, must bereceived by September 28, 2006.

ADDRESSES: Comments are encour-aged to be submitted to: CC:PA:LPD:PR(REG–145154–05), room 5203, Inter-nal Revenue Service, P.O. Box 7604,Ben Franklin Station, Washington, DC20044. Submissions may be sent elec-tronically via the IRS Internet site atwww.irs.gov/regs or via the Federal eRule-making Portal at www.regulations.gov(IRS–REG–145154–05).

FOR FURTHER INFORMATIONCONTACT: Concerning submissionsof comments and/or to be placed

2006–39 I.R.B. 567 September 25, 2006

on the building access list to at-tend the hearing, Richard Hurst atRichard.A.Hurst@irscounsel.treas.govor at (202) 622-7180; concerning costmethodology, Eva Williams at (202)622–6400; concerning the proposedregulations, Matthew Cooper at (202)622–4940 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

Section 330 of Title 31 of the UnitedStates Code authorizes the Secretary of theTreasury to regulate practice before theTreasury Department. Pursuant to section330 of Title 31, the Secretary has publishedregulations governing practice before theIRS in 31 CFR part 10 and reprinted themas Treasury Department Circular No. 230(Circular 230). These regulations are ad-ministered by the IRS Office of Profes-sional Responsibility (OPR).

Section 10.3 of Circular 230 generallyauthorizes attorneys, certified public ac-countants, enrolled agents and enrolled ac-tuaries to practice before the IRS. An en-rolled agent is defined as an individual en-rolled as an agent pursuant to the provi-sions of Circular 230. The provisions ofCircular 230 provide that an individual de-siring to become an enrolled agent is eligi-ble for enrollment through either the suc-cessful passing of a written examinationor through demonstration of sufficient ex-pertise in tax administration based on for-mer employment with the IRS. Specifi-cally, section 10.4(a) authorizes the Direc-tor of OPR to grant enrollment to an ap-plicant who demonstrates special compe-tence in tax matters by passing a writtenexamination administered by, or adminis-tered under the oversight of, the Directorof OPR and who has not engaged in anyconduct that would justify the censure, sus-pension, or disbarment of any practitionerunder the provisions of Circular 230. Ac-cordingly, every year OPR develops andadministers a Special Enrollment Exami-nation (SEE) that is given to all applicantsdesiring to become enrolled agents so thatthey can practice before the IRS. The IRScharged applicants a user fee of $55 ($45if taking the examination in part) in orderto take the 2005 SEE.

Section 10.4(b) authorizes the Directorof OPR to grant enrollment for former IRS

employees if the former employee meetscertain requirements, including length ofemployment with the IRS and substantivetax expertise. Application for enrollmentbased on former employment with the IRSmust be made within three years from thedate of separation from such employment.

Once eligible for enrollment, by eitherpassing the examination or because of for-mer employment with the IRS, an appli-cant must file an application for enroll-ment on Form 23, “Application for Enroll-ment to Practice Before the Internal Rev-enue Service,” with the Director of OPR.As part of the application for enrollmentprocess, the applicant must enclose a checkor money order payable to the IRS in theamount set forth on Form 23, which consti-tutes a fee charged to each applicant for en-rollment. The fee is nonrefundable regard-less of whether the applicant is granted en-rollment. The current user fee for enroll-ment on the Form 23 (Rev. February 2005)is $80. The Director of OPR will act uponan application for enrollment and issue anenrollment card to each individual whoseapplication for enrollment to practice be-fore the IRS is approved.

Pursuant to section 10.6(d), each indi-vidual, once enrolled, is required to renewthe enrollment every three years to main-tain an active enrollment to practice beforethe IRS. In order to qualify for renewal,an applicant must certify the completion ofthe continuing professional education re-quirements set forth in section 10.6(e) ofCircular 230. A nonrefundable user fee of$80 is currently charged for each applica-tion for renewal of enrollment filed withthe Director of OPR on Form 8554, “Appli-cation for Renewal of Enrollment to Prac-tice Before the Internal Revenue Service.”

Contracting Out of Special EnrollmentExamination

OPR has recently contracted out certainfunctions pertaining to the SEE to a pri-vate contractor. The contractor will fur-nish the resources, facilities, and servicesnecessary to administer the entire SEE pro-gram, which includes examination devel-opment, administration of SEE, notifica-tion to IRS of candidates who took the ex-amination, and the results of the exami-nation. The contractor will receive pay-ment for its services by charging a fee toexam applicants. OPR will, nonetheless,

still maintain an oversight role with respectto the SEE. The contractor will collect auser fee on behalf of the IRS based on thefull costs incurred by the IRS. These pro-posed regulations only establish a user feewith respect to the government costs foroverseeing the SEE and do not include anyfee that the contractor may charge for itsservices. Accordingly, while the user feeimposed pursuant to these regulations isless than the user fee that applicants werecharged in 2005, the total fee that appli-cants will be charged is greater. The IRSestimates that by using a contractor, how-ever, the total fees incurred will be lessthan the total fees that would otherwise becharged by the IRS in order to recover thefull cost of the IRS administering all as-pects of the SEE.

User Fees for Special EnrollmentExamination, Enrollment, and Renewalof Enrollment

The user fee that the IRS currentlycharges applicants in order to take the SEEis being modified to reflect the change inIRS costs of administering the exam pro-gram as a result of the contracting outof the exam. The user fees that the IRScurrently charge applicants for the enroll-ment and renewal of enrollment processare less than the actual cost of oversee-ing the enrollment process. The IRS isproposing new user fees to take the SEE tobecome an enrolled agent, the applicationfor enrollment and the renewal of suchenrollment.

Proposed section 300.4 establishes an$11 per part user fee for the SEE. Proposedsections 300.5 and 300.6 establish separate$125 user fees for the enrollment and re-newal of enrollment process.

Authority

The IOAA of 1952 (31 U.S.C. 9701)authorizes agencies to prescribe regula-tions that establish charges for servicesprovided by the agency. The charges mustbe fair and be based on the costs to theGovernment, the value of the service tothe recipient, the public policy or inter-est served, and other relevant facts. TheIOAA of 1952 provides that regulationsimplementing user fees are subject to poli-cies prescribed by the President, which arecurrently set forth in OMB Circular A–25,

September 25, 2006 568 2006–39 I.R.B.

58 FR 38142 (July 15, 1993) (the OMBCircular).

The OMB Circular encourages userfees for Government-provided servicesthat confer benefits on identifiable re-cipients over and above those benefitsreceived by the general public. Under theOMB Circular, an agency that seeks toimpose a user fee for Government-pro-vided services must calculate its full costof providing those services. In general,a user fee should be set at an amount inorder for the agency to recover the cost ofproviding the special service, unless theOffice of Management and Budget grantsan exception. Pursuant to the guidelinesin the OMB Circular, the IRS has calcu-lated its cost of providing services underthe enrolled agents program. The IRS hasdetermined that the full cost to the IRSof overseeing the SEE is $11 per part perapplicant. The IRS has determined thatthe full cost of administering the enroll-ment and renenrollment process is $125per enrolled agent.

The proposed user fees will be imple-mented under the authority of the IOAA of1952 and the OMB Circular.

Proposed Effective Date

These regulations are proposed to applythirty days after the date of publication inthe Federal Register of the final regula-tions.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significantregulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatory as-sessment is not required. It is hereby cer-tified that these regulations will not have asignificant economic impact on a substan-tial number of small entities. Accordingly,a regulatory flexibility analysis is not re-quired. This certification is based on theinformation that follows. The economicimpact of these regulations on any smallentity would result from a small entity, in-cluding a sole proprietor, being requiredto pay a fee prescribed by these regula-tions in order to obtain a particular service.The dollar amount of the fee is not, how-ever, substantial enough to have a signif-icant economic impact on any entity sub-ject to the fee. Moreover, payment of the

fee is voluntary. The only persons sub-ject to the fee are those who elect to takethe special enrollment exam. Persons whoelect to take the exam will have determinedthat it is in their economic interest to doso. Pursuant to section 7805(f) of the In-ternal Revenue Code, this notice of pro-posed rulemaking will be submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment onits impact.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written (a signed origi-nal and eight (8) copies) or electronic com-ments that are submitted timely to the IRS.The IRS and Treasury Department requestcomments on the substance of the pro-posed regulations, as well as on the clarityof the proposed rules and how they can bemade easier to understand. All commentswill be available for public inspection andcopying.

A public hearing has been scheduledfor September 29, 2006, at 10 a.m. inthe 11th floor conference room at 1901 S.Bell Street, Arlington, VA 22202. Due tobuilding security procedures, all visitorsmust present photo identification to enterthe building. Because of access restric-tions, visitors will not be admitted beyondthe immediate entrance area more than 30minutes before the hearing starts. For in-formation about having your name placedon the building access list to attend thehearing, see the “FOR FURTHER INFOR-MATION CONTACT” section of this pre-amble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit electronic or written comments andan outline of the comments to be discussedand the time to be devoted to each topic(signed original and eight (8) copies) bySeptember 28, 2006. A period of ten (10)minutes will be allotted to each person formaking comments. An agenda showingthe scheduling of the speakers will be pre-pared after the deadline for receiving out-lines has passed. Copies of the agenda willbe available free of charge at the hearing.

Drafting Information

The principal author of these regula-tions is Matthew S. Cooper of the Officeof the Associate Chief Counsel (Procedure& Administration), Administrative Provi-sions & Judicial Practice Division.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR Part 300 is pro-posed to be amended as follows:

PART 300—USERS FEES

Paragraph 1. The authority citation forpart 300 continues to read as follows:

Authority: 31 U.S.C. 9701.Par. 2. Section 300.0 is amended as

follows:1. Paragraphs (b)(4), (5), and (6) are

added.2. Paragraph (c) is revised.The additions and revision read as fol-

lows:

§300.0 User fees, in general.

* * * * *(b) * * *(4) Taking the special enrollment exam-

ination to become an enrolled agent.(5) Enrolling an enrolled agent.(6) Renewing the enrollment of an en-

rolled agent.(c) Effective Date. This part 300 is ap-

plicable March 16, 1995, except that theuser fee for processing offers in compro-mise is applicable November 1, 2003, andthe user fee for the special enrollment ex-amination, enrollment, and renewal of en-rollment for enrolled agents is applicablethirty days after the date of publication inthe Federal Register of the final regula-tions.

Par. 3. Section 300.4 is added to readas follows:

§300.4 Special enrollment examinationfee.

(a) Applicability. This section appliesto the special enrollment examination tobecome an enrolled agent pursuant to 31CFR 10.4(a).

(b) Fee. The fee for taking the specialenrollment examination is $11.00 per part.

2006–39 I.R.B. 569 September 25, 2006

(c) Person liable for the fee. The personliable for the special enrollment examina-tion fee is the applicant taking the exami-nation.

Par. 4. Section 300.5 is added to readas follows:

§300.5 Enrollment of enrolled agent fee.

(a) Applicability. This section appliesto the initial enrollment of enrolled agentswith the IRS Office of Professional Re-sponsibility pursuant to 31 CFR 10.5(b).

(b) Fee. The fee for initially enrollingas an enrolled agent with the IRS Office ofProfessional Responsibility is $125.00.

(c) Person liable for the fee. The per-son liable for the enrollment fee is the ap-plicant filing for enrollment as an enrolledagent with the IRS Office of ProfessionalResponsibility.

Par. 5. Section 300.6 is added to readas follows:

§300.6 Renewal of enrollment of enrolledagent fee.

(a) Applicability. This section appliesto the renewal of enrollment of enrolledagents with the IRS Office of Profes-sional Responsibility pursuant to 31 CFR10.6(d)(6).

(b) Fee. The fee for renewal of enroll-ment as an enrolled agent with the IRSOffice of Professional Responsibility is$125.00.

(c) Person liable for the fee. The personliable for the renewal of enrollment fee isthe person renewing their enrollment asan enrolled agent with the IRS Office ofProfessional Responsibility.

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

(Filed by the Office of the Federal Register on August 25,2006, 12:09 p.m., and published in the issue of the FederalRegister for August 29, 2006, 71 F.R. 51179)

Notice of ProposedRulemaking byCross-Reference toTemporary Regulations

Determination of InterestExpense Deduction of ForeignCorporations

REG–120509–06

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Notice of proposed rulemakingby cross-reference to temporary regula-tions.

SUMMARY: In this issue of the Bulletin,the IRS is issuing temporary regulations(T.D. 9281) under sections 882 and 884relating to the determination of the inter-est expense deduction of foreign corpora-tions engaged in a trade or business withinthe United States. These regulations up-date the 1996 final interest expense allo-cation rules for foreign corporations andtake into account changes in the foreignbanking industry. The rule changes arenecessary to conform the final regulationsmore closely to current operating condi-tions in the foreign banking industry, andto harmonize the deemed earnings repa-triation from a foreign corporation’s tradeor business within the United States, withthe manner in which dividends are repatri-ated from U.S. resident companies to theirforeign shareholders. These regulationsare expected to simplify compliance bur-dens for many foreign corporations that al-locate interest expense to effectively con-nected income and provide greater latitudeto taxpayers in determining when their ef-fectively connected earnings are treated asremitted. The text of these regulations alsoserves as the text of these proposed regu-lations.

DATES: Written or electronic commentsand requests for a public hearing must bereceived by November 15, 2006.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–120509–06), In-ternal Revenue Service, PO Box 7604,Ben Franklin Station, Washington, DC20044. Submissions may be sent elec-tronically, via the IRS Internet site at

www.irs.gov/regs or via the Federal eRule-making Portal at www.regulations.gov(IRS REG–120509–06).

FOR FURTHER INFORMATIONCONTACT: Concerning the regula-tions, Gregory Spring or Paul Epstein,(202) 622–3870, concerning submis-sions of comments, Richard A. Hurst,Richard.A.Hurst@irscounsel.treas.gov, or(202) 622–7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information containedin this notice of proposed rulemaking hasbeen submitted to the Office of Manage-ment and Budget for review in accordancewith the Paperwork Reduction Act of 1995(44 U.S.C. 3507(d)). Comments on thecollection of information should be sent tothe Office of Management and Budget,Attn: Desk Officer for the Department ofTreasury, Office of Information and Reg-ulatory Affairs, Washington, DC 20503,with copies to the Internal Revenue Ser-vice, Attn: IRS Reports Clearance Officer,SE:W:CAR:MP:T:T:SP, Washington, DC20224. Comments on the collection of in-formation should be received by October16, 2006. Comments are requested specif-ically concerning:

Whether the proposed collection of in-formation is necessary for the proper per-formance of the functions of the InternalRevenue Service, including whether theinformation will have practical utility;

The accuracy of the estimated burdenassociated with the proposed collection ofinformation (see below);

How the quality, utility, and clarity ofthe information to be collected may be en-hanced;

How the burden of complying with theproposed collection of information may beminimized, including through the appli-cation or automated collection techniquesor other forms of information technology;and

Estimates of capital or start-up costsand costs of operation, maintenance, andpurchase of service to provide information.

The collections of informationin these proposed regulations arein §§1.882–5T(d)(5)(ii)(B) and1.884–1T(e)(3)(iv). This collectionof information is required to facilitate

September 25, 2006 570 2006–39 I.R.B.

administrability of reporting of allocableexpense from without the United States.Section 1.882–5T(d)(5)(ii)(B) providesa simplified procedure for taxpayers tocalculate an allocable amount of U.S. dol-lar denominated interest expense bookedby foreign banks in foreign locations.The collection of information providescertainty of application and immediateverification in the advance review andresolution of such treatment on examina-tion. Section 1.884–1T(e)(3)(iv) providesthe identical collection of information thatwas promulgated in final regulations inT.D. 8432, 1992–2 C.B. 157. The ruleprovides an election to reduce liabilitiesfor purposes of treating effectively con-nected earnings and profits as reinvested.It also requires that U.S. connectedliabilities be reduced for purposes ofdetermining the allocation of interestexpense to effectively connected income.The collection of information facilitatesidentification and verification of thecoordinated treatment of the sections 882and 884 provisions in accordance withthe time, place and manner restrictionsfor making the election. The collectionsof information are mandatory. The likelyrespondents are foreign banks.

Estimated total annual reporting bur-den: 37.5.

Estimated average annual burden hoursper respondent: 1/2 hour.

Estimated number of respondents: 75.Estimated annual frequency of re-

sponses: annually.An agency may not conduct or sponsor,

and a person is not required to respond to, acollection of information unless it displaysa valid control number assigned by the Of-fice of Management and Budget.

Books and records relating to a collec-tion of information must be retained aslong as their contents may become mate-rial in the administration of any internalrevenue law. Generally, tax returns and taxreturn information are confidential, as re-quired by 26 U.S.C. 6103.

Background

In this issue of the Bulletin, the IRS isissuing temporary regulations under sec-tions 882 and 884 relating to the determi-nation of the interest expense deduction offoreign corporations engaged in a trade orbusiness within the United States. The text

of those regulations published in this issueof the Bulletin also serves as the text ofthese proposed regulations. The preambleto those temporary regulations explains thetemporary regulations and these proposedregulations.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a signifi-cant regulatory action as defined in Exec-utive Order 12866. Therefore, a regula-tory assessment is not required. It has alsobeen determined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to these reg-ulations, and because the regulations donot impose a collection of information onsmall entities, the Regulatory FlexibilityAct (5 U.S.C. chapter 6) does not apply.Pursuant to section 7805(f) of the Code,this regulation has been submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment onits impact on small business.

Comments and Requests for PublicHearing

Before these proposed regulations areadopted as final regulations, considera-tion will be given to any written (a signedoriginal and eight (8) copies) or electroniccomments that are submitted timely to theIRS. The IRS and the Treasury Depart-ment specifically request comments onthe clarity of the proposed regulations andhow they can be made easier to under-stand. All comments will be available forpublic inspection and copying. A publichearing will be scheduled if requested byany person who timely submits comments.If a public hearing is scheduled, notice ofthe date, time and place for the hearingwill be published in the Federal Register.

Drafting Information

The principal authors of theseregulations are Paul S. Epstein andGregory A. Spring of the Office of As-sociate Chief Counsel (International).

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR 1 is proposed tobe amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.882–5 is amended to

read as follows:1. Paragraphs (a)(1), (a)(1)(i),

(a)(1)(ii), (a)(1)(ii)(A), (a)(1)(ii)(B),(a)(2), (a)(7), (a)(7)(i), (a)(7)(ii),(b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4),(d)(2)(ii)(A)(2), (d)(2)(ii)(A)(3),(d)(2)(iii)(A), and (d)(5)(ii) are re-vised.

2. Paragraph (d)(6) Example 5 is added.The revisions and addition read as fol-

lows:

§1.882–5 Determination of interestdeduction.

(a) * * *(a)(1) through (a)(2) [The text of this

proposed amendment is the same as thetext of §1.882–5T(a)(1) through (a)(2)published elsewhere in this issue of theBulletin].

* * * * *(a)(7) [The text of this proposed

amendment is the same as the text of§1.882–5T(a)(7) published elsewhere inthis issue of the Bulletin].

* * * * *(b) * * *(2) * * *(ii) * * *(b)(2)(ii)(A) [The text of this proposed

amendment is the same as the text of§1.882–5T(b)(2)(ii)(A) published else-where in this issue of the Bulletin].

* * * * *(b)(2)(iv) [The text of this proposed

amendment is the same as the text of§1.882–5T(b)(2)(iv) published elsewherein this issue of the Bulletin].

* * * * *(b)(3) [The text of this proposed

amendment is the same as the text of§1.882–5T(b)(3) published elsewhere inthis issue of the Bulletin].

* * * * *

2006–39 I.R.B. 571 September 25, 2006

(c) * * *(2) * * *(c)(2)(iv) [The text of this proposed

amendment is the same as the text of§1.882–5T(c)(2)(iv) published elsewherein this issue of the Bulletin].

* * * * *(c)(4) [The text of this proposed

amendment is the same as the text of§1.882–5T(c)(4) published elsewhere inthis issue of the Bulletin].

* * * * *(d) * * *(2) * * *(ii) * * *(A) * * *(d)(2)(ii)(A)(2) through (3) [The text of

these proposed amendments are the sameas the text of §1.882–5T(d)(2)(ii)(A)(2)through (3) published elsewhere in this is-sue of the Bulletin].

* * * * *(d)(2)(iii)(A) [The text of this proposed

amendment is the same as the text of

§1.882–5T(d)(2)(iii)(A) published else-where in this issue of the Bulletin].

* * * * *(5) * * *(i) * * *(d)(5)(ii) [The text of this proposed

amendment is the same as the text of§1.882–5T(d)(5)(ii) published elsewherein this issue of the Bulletin].

* * * * *(d)(6) Example 5 [The text of this pro-

posed amendment is the same as the textof §1.882–5T(d)(6) Example 5 publishedelsewhere in this issue of the Bulletin].

* * * * *Par. 3. Section 1.884–1 is amended

by revising the entries for paragraphs§1.884–1(e)(3)(ii), (e)(3)(iv) and (e)(5)Example 2 to read as follows:

§1.884–1 Determination of interestdeduction

* * * * *(e) * * *

(3) * * *(e)(3)(ii) [The text of this proposed

amendment is the same as the text of§1.884–1T(e)(3)(ii) published elsewherein this issue of the Bulletin].

* * * * *(e)(3)(iv) [The text of this proposed

amendment is the same as the text of§1.884–1T(e)(3)(iv) published elsewherein this issue of the Bulletin].

* * * * *(5) * * *(e)(5) Example 2 [The text of this pro-

posed amendment is the same as the textof §1.884–1T(e)(5) Example 2 publishedelsewhere in this issue of the Bulletin].

* * * * *

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

(Filed by the Office of the Federal Register on August 15,2006, 8:45 a.m., and published in the issue of the FederalRegister for August 17, 2006, 71 F.R. 47459)

Announcement of Disciplinary Actions InvolvingAttorneys, Certified Public Accountants, Enrolled Agents,and Enrolled Actuaries — Suspensions, Censures,Disbarments, and ResignationsAnnouncement 2006-57

Under Title 31, Code of Federal Regu-lations, Part 10, attorneys, certified publicaccountants, enrolled agents, and enrolledactuaries may not accept assistance from,or assist, any person who is under disbar-ment or suspension from practice beforethe Internal Revenue Service if the assis-tance relates to a matter constituting prac-tice before the Internal Revenue Serviceand may not knowingly aid or abet another

person to practice before the Internal Rev-enue Service during a period of suspen-sion, disbarment, or ineligibility of suchother person.

To enable attorneys, certified publicaccountants, enrolled agents, and enrolledactuaries to identify persons to whomthese restrictions apply, the Director, Of-fice of Professional Responsibility, willannounce in the Internal Revenue Bulletin

their names, their city and state, their pro-fessional designation, the effective dateof disciplinary action, and the period ofsuspension. This announcement will ap-pear in the weekly Bulletin at the earliestpracticable date after such action and willcontinue to appear in the weekly Bulletinsfor five successive weeks.

September 25, 2006 572 2006–39 I.R.B.

Consent Suspensions From Practice Before the InternalRevenue Service

Under Title 31, Code of Federal Regu-lations, Part 10, an attorney, certified pub-lic accountant, enrolled agent, or enrolledactuary, in order to avoid the institutionor conclusion of a proceeding for his orher disbarment or suspension from prac-tice before the Internal Revenue Service,

may offer his or her consent to suspensionfrom such practice. The Director, Officeof Professional Responsibility, in his dis-cretion, may suspend an attorney, certifiedpublic accountant, enrolled agent, or en-rolled actuary in accordance with the con-sent offered.

The following individuals have beenplaced under consent suspension frompractice before the Internal Revenue Ser-vice:

Name Address Designation Date of Suspension

Crane, Stephen Palm Springs, CA Enrolled Agent May 4, 2006toAugust 3, 2007

Cohen, Ronald J. Newburgh, NY Attorney IndefinitefromJune 21, 2006

Layson, David A. Corydon, IN Attorney April 7, 2006toOctober 6, 2007

Brough, Donald L. Salem, IN CPA July 1, 2006toJune 30, 2010

Gulian, Yervant Great Neck, NY CPA April 17, 2006toDecember 16, 2007

Rivera-Smith, Dawn Brick, NJ CPA May 30, 2006toNovember 29, 2008

Eckstein, Matthew Woodbury, NY CPA June 15, 2006toMarch 14, 2007

Hecht, Jodee L. Clifton, VA CPA IndefinitefromJune 19, 2006

Finch, Phillip W. Yorktown, VA CPA IndefinitefromJune 22, 2006

Troese Jr., Henry A. Clarion, PA Enrolled Agent IndefinitefromJune 22, 2006

Robbins, Ronald E. Pittsford, VT CPA June 24, 2006toJune 23, 2008

Shapiro, Sidney C. West Palm Beach, FL CPA IndefinitefromJuly 1, 2006

2006–39 I.R.B. 573 September 25, 2006

Name Address Designation Date of Suspension

Martini, Anthony Stamford, CT CPA June 18, 2006toDecember, 17, 2007

Cunningham, William Philadelphia, PA CPA July 1, 2006toMarch 31, 2007

Simontacchi, Joseph F. Morris Plains, NJ CPA IndefinitefromJuly 1, 2006

Carroccio, Ronald P. Staten Island, NY CPA IndefinitefromJuly 1, 2006

Miller, Walter P. Roanoke, VA CPA IndefinitefromJuly 1, 2006

Aneji, Patrick Houston, TX CPA IndefinitefromJune 22, 2006

Rosenbloom, Mark L. Chicago, IL Attorney August 15, 2006toAugust 14, 2007

Viener, Ira S. Fort Lee, NJ CPA IndefinitefromAugust 1, 2006

Ganz, Sheldon M. Great Neck, NJ CPA IndefinitefromAugust 1, 2006

Tomasulo, Maria Wantagh, NY CPA IndefinitefromAugust 7, 2006

Galpern, Joel G. North Miami, FL CPA IndefinitefromSeptember 1, 2006

September 25, 2006 574 2006–39 I.R.B.

Expedited Suspensions From Practice Before the InternalRevenue Service

Under Title 31, Code of Federal Regu-lations, Part 10, the Director, Office of Pro-fessional Responsibility, is authorized toimmediately suspend from practice beforethe Internal Revenue Service any practi-tioner who, within five years from the date

the expedited proceeding is instituted (1)has had a license to practice as an attor-ney, certified public accountant, or actuarysuspended or revoked for cause or (2) hasbeen convicted of certain crimes.

The following individuals have beenplaced under suspension from practice be-fore the Internal Revenue Service by virtueof the expedited proceeding provisions:

Name Address Designation Date of Suspension

Dolan Jr., John L. Memphis, TN Attorney IndefinitefromApril 3, 2006

St. Mary, Randall L. Snohomish, WA Attorney IndefinitefromApril 3, 2006

Theriault, Michael J. Bel Air, MD Attorney IndefinitefromApril 3, 2006

Smith, Bernard P. Marblehead, MA Attorney IndefinitefromApril 3, 2006

Bradley, Phillip M. West Point, VA Attorney IndefinitefromApril 3, 2006

Haefele, Richard J. Wayzata, MN Attorney IndefinitefromApril 3, 2006

Decker, William E. Mandeville, LA Attorney IndefinitefromApril 3, 2006

Arbour, John J. Monroe, LA Attorney IndefinitefromApril 3, 2006

Keller, John S. Martin Kenner, LA Attorney IndefinitefromApril 3, 2006

Fallon, Charles D. Neptune, NJ Attorney IndefinitefromApril 3, 2006

Agresti, Thomas J. Centennial, CO Attorney IndefinitefromApril 3, 2006

Kirsch, Craig F. Pittsburgh, PA CPA IndefinitefromApril 3, 2006

2006–39 I.R.B. 575 September 25, 2006

Name Address Designation Date of Suspension

Hall, Lenny G. McDowell, KY CPA IndefinitefromApril 11, 2006

Hultgren, Jerry R. Fresno, CA Attorney IndefinitefromApril 11, 2006

Loutos, Peter A. Chicago, IL Attorney IndefinitefromApril 11, 2006

Smith III, Frank L. Bushnell, FL Attorney IndefinitefromApril 11, 2006

Morley, Michael J. Springfield, PA CPA IndefinitefromApril 11, 2006

Waters, Richard W. Smithfield, UT CPA IndefinitefromApril 11, 2006

Hartgraves, Travis M. Abilene, TX Attorney IndefinitefromApril 14, 2006

Dunn, George T. Lockhart, TX Attorney IndefinitefromApril 14, 2006

Adkins, Thomas R. Houston, TX Attorney IndefinitefromApril 14, 2006

Hairston, John W. Sugar Land, TX Attorney IndefinitefromApril 26, 2006

Marcone, Frank J. Upper Providence, PA Attorney IndefinitefromMay 1, 2006

Fraley, Donald J. Minneapolis, MN Attorney IndefinitefromMay 3, 2006

Tooke, S. Judd Shreveport, LA Attorney IndefinitefromMay 3, 2006

Reilly, Michael G. Council Bluffs, IA Attorney IndefinitefromMay 3, 2006

Faneuil, Robert A. Newton, MA Attorney IndefinitefromMay 3, 2006

September 25, 2006 576 2006–39 I.R.B.

Name Address Designation Date of Suspension

Maignan, Peter R. Upper Marlboro, MD Attorney IndefinitefromMay 3, 2006

Son, David Phoenix, AZ Attorney IndefinitefromMay 5, 2006

Susman, Warren I. New York, NY Attorney IndefinitefromMay 8, 2006

Wurst, Jerome Arlington, TX Attorney IndefinitefromMay 8, 2006

O’Shea, Joseph G. Jackson Heights, NY Attorney IndefinitefromMay 8, 2006

Biegelson, Alan Brooklyn, NY Attorney IndefinitefromMay 8, 2006

Leonard, Robert K. Winston-Salem, NC Attorney IndefinitefromMay 8, 2006

Cassidy, Michael M. Madison, WI Attorney IndefinitefromMay 8, 2006

Dobkin, Daniel B. New Hyde Park, NY Attorney IndefinitefromMay 8, 2006

Nealy, Joseph L. Sugarland, TX Attorney IndefinitefromMay 16, 2006

Conmey, Edwin W. Oconomowoc, WI Attorney IndefinitefromMay 16, 2006

Knott Jr., Robert T. Los Angeles, CA Attorney IndefinitefromMay 16, 2006

Diamond, Howard S. Mendham, NJ Attorney IndefinitefromMay 16, 2006

Fitzgerald, Bill L. Lubbock, TX Attorney IndefinitefromMay 16, 2006

Brubaker, Gregory A. San Francisco, CA Attorney IndefinitefromMay 18, 2006

Dodenbier, Robert F. Lehi, UT Attorney IndefinitefromMay 18, 2006

2006–39 I.R.B. 577 September 25, 2006

Name Address Designation Date of Suspension

Young, Paul J. Taft, CA Attorney IndefinitefromJune 8, 2006

Dahodwala, Fatema Andover, MA Attorney IndefinitefromJune 8, 2006

Mendola, Joseph E. Monessen, PA CPA IndefinitefromJune 8, 2006

Rooney, Edward F. Minneapolis, MN Attorney IndefinitefromJune 8, 2006

Long, Rebecca L. Wichita, KS Attorney IndefinitefromJune 8, 2006

West, Clifton C. Fayetteville, NC Attorney IndefinitefromJune 8, 2006

Silva, Zoilo I. City Island, NY Attorney IndefinitefromJune 8, 2006

Tyler Jr., Earle S. Bangor, ME Attorney IndefinitefromJune 12, 2006

Horneber, Alice S. Sioux City, IA Attorney IndefinitefromJune 12, 2006

Donnelly, Christine M. Blue Springs, MO Attorney IndefinitefromJune 12, 2006

Driscoll Jr., Peter Columbia, MD Attorney IndefinitefromJune 12, 2006

Souza, John C. Pocatello, ID Attorney IndefinitefromJune 12, 2006

Crockett, Kevin J. Midvale, UT Attorney IndefinitefromJune 12, 2006

White, Debra M. Wyatt Navasota, TX CPA IndefinitefromJune 12, 2006

Wilkins, Daniel J. Chelmsford, MA Attorney IndefinitefromJune 12, 2006

Merica, Chad L. Murray, UT CPA IndefinitefromJune 12, 2006

September 25, 2006 578 2006–39 I.R.B.

Name Address Designation Date of Suspension

Wintroub, David S. Omaha, NE Attorney IndefinitefromJune 12, 2006

Smith, Roderick E. Kansas City, MO Attorney IndefinitefromJune 12, 2006

Guida, Joseph M. Aberdeen, MD Attorney IndefinitefromJune 12, 2006

Sonibare, Nash St. Paul, MN CPA IndefinitefromJune 12, 2006

Braun, Marc W. St. Louis, MO Attorney IndefinitefromJune 12, 2006

Coffey, John J. Rye, NH Attorney IndefinitefromJune 12, 2006

Whitehead, H. Allen New York, NY Attorney IndefinitefromJune 12, 2006

Lansky, Sidney Mattapoisett, MA Attorney IndefinitefromJune 12, 2006

Pazniokas, Paul M. Norwood, MA Attorney IndefinitefromJune 12, 2006

Bajgrowicz, James J. Santa Rosa, CA Attorney IndefinitefromJune 12, 2006

Davis, Bret J. Los Angeles, CA Attorney IndefinitefromJune 12, 2006

McAvoy, Timothy Chicago, IL Attorney IndefinitefromJune 12, 2006

Loffadelli, Thomas C. Studio City, CA Attorney IndefinitefromJune 12, 2006

Emeziem, Kelechi C. Antioch, CA Attorney IndefinitefromJune 12, 2006

Pugh, William C. Wayzata, MN Attorney IndefinitefromJune 12, 2006

Lamanna, Eugene C. Reading, PA Attorney IndefinitefromJune 12, 2006

2006–39 I.R.B. 579 September 25, 2006

Name Address Designation Date of Suspension

Bartels, John R. St. Paul, MN Attorney IndefinitefromJune 12, 2006

Shapiro, Kenneth S. Bala Cynwyd, PA CPA IndefinitefromJune 14, 2006

Stone, Jerry W. Austin, TX Attorney IndefinitefromJune 21, 2006

Vanriper, Philip E. Binghamton, NY Attorney IndefinitefromJune 21, 2006

Simuro, Valerie T. Gardiner, NY Attorney IndefinitefromJune 21, 2006

Simms, William K. Brooklyn, NY Attorney IndefinitefromJune 21, 2006

Weaver, Terring M. Clarksburg, WV CPA IndefinitefromJuly 1, 2006

Norman, Clarence Brooklyn, NY Attorney IndefinitefromAugust 3, 2006

Knight, John G. Winston-Salem, NC Attorney IndefinitefromAugust 3, 2006

Kronegold, Sheldon H. Englewood, NJ Attorney IndefinitefromAugust 3, 2006

Foushee, Wayne H. Winston-Salem, NC Attorney IndefinitefromAugust 3, 2006

Suspensions From Practice Before the Internal RevenueService After Notice and an Opportunity for a Proceeding

Under Title 31, Code of Federal Reg-ulations, Part 10, after notice and an op-portunity for a proceeding before an ad-

ministrative law judge, the following indi-viduals have been placed under suspension

from practice before the Internal RevenueService:

Name Address Designation Effective Date

Kahn, Harold Hollis, NY CPA June 26, 2006toJune 25, 2010

September 25, 2006 580 2006–39 I.R.B.

Disbarments From Practice Before the Internal RevenueService After Notice and an Opportunity for a Proceeding

Under Title 31, Code of Federal Regu-lations, Part 10, after notice and an oppor-

tunity for a proceeding before an adminis-trative law judge, the following individu-

als have been disbarred from practice be-fore the Internal Revenue Service:

Name Address Designation Effective Date

Gailey, James N. Huntersville, NC CPA June 5, 2006

Censure Issued by ConsentUnder Title 31, Code of Federal Reg-

ulations, Part 10, in lieu of a proceedingbeing instituted or continued, an attorney,certified public accountant, enrolled agent,

or enrolled actuary, may offer his or herconsent to the issuance of a censure. Cen-sure is a public reprimand.

The following individuals have con-sented to the issuance of a Censure:

Name Address Designation Date of Censure

Williams, Daniel S. Carlsbad, CA Attorney March 29, 2006

Azan, Reinaldo L. Miami Beach, FL CPA July 24, 2006

Golub, Stephen B. Norwalk, CT CPA August 3, 2006

2006–39 I.R.B. 581 September 25, 2006

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling is be-ing made clear because the language hascaused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more than re-state the substance and situation of a previ-ously published ruling (or rulings). Thus,the term is used to republish under the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situationsto show that the previous published rul-ings will not be applied pending somefuture action such as the issuance of newor amended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.

PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

September 25, 2006 i 2006–39 I.R.B.

Numerical Finding List1

Bulletins 2006–27 through 2006–39

Announcements:

2006-42, 2006-27 I.R.B. 48

2006-43, 2006-27 I.R.B. 48

2006-44, 2006-27 I.R.B. 49

2006-45, 2006-31 I.R.B. 121

2006-46, 2006-28 I.R.B. 76

2006-47, 2006-28 I.R.B. 78

2006-48, 2006-31 I.R.B. 135

2006-49, 2006-29 I.R.B. 89

2006-50, 2006-34 I.R.B. 321

2006-51, 2006-32 I.R.B. 222

2006-52, 2006-33 I.R.B. 254

2006-53, 2006-33 I.R.B. 254

2006-54, 2006-33 I.R.B. 254

2006-55, 2006-35 I.R.B. 342

2006-56, 2006-35 I.R.B. 342

2006-57, 2006-35 I.R.B. 343

2006-58, 2006-36 I.R.B. 388

2006-59, 2006-36 I.R.B. 388

2006-60, 2006-36 I.R.B. 389

2006-61, 2006-36 I.R.B. 390

2006-62, 2006-37 I.R.B. 444

2006-63, 2006-37 I.R.B. 445

2006-64, 2006-37 I.R.B. 447

2006-65, 2006-37 I.R.B. 447

2006-66, 2006-37 I.R.B. 448

2006-67, 2006-38 I.R.B. 509

2006-68, 2006-38 I.R.B. 510

2006-69, 2006-37 I.R.B. 449

Notices:

2006-56, 2006-28 I.R.B. 58

2006-57, 2006-27 I.R.B. 13

2006-58, 2006-28 I.R.B. 59

2006-59, 2006-28 I.R.B. 60

2006-60, 2006-29 I.R.B. 82

2006-61, 2006-29 I.R.B. 85

2006-62, 2006-29 I.R.B. 86

2006-63, 2006-29 I.R.B. 87

2006-64, 2006-29 I.R.B. 88

2006-65, 2006-31 I.R.B. 102

2006-66, 2006-30 I.R.B. 99

2006-67, 2006-33 I.R.B. 248

2006-68, 2006-31 I.R.B. 105

2006-69, 2006-31 I.R.B. 107

2006-70, 2006-33 I.R.B. 252

2006-71, 2006-34 I.R.B. 316

2006-72, 2006-36 I.R.B. 363

2006-73, 2006-35 I.R.B. 339

2006-74, 2006-35 I.R.B. 339

2006-75, 2006-36 I.R.B. 366

2006-76, 2006-38 I.R.B. 459

Notices— Continued:

2006-82, 2006-39 I.R.B. 529

Proposed Regulations:

REG-135866-02, 2006-27 I.R.B. 34

REG-146893-02, 2006-34 I.R.B. 317

REG-159929-02, 2006-35 I.R.B. 341

REG-148864-03, 2006-34 I.R.B. 320

REG-168745-03, 2006-39 I.R.B. 532

REG-109512-05, 2006-30 I.R.B. 100

REG-145154-05, 2006-39 I.R.B. 567

REG-112994-06, 2006-27 I.R.B. 47

REG-118775-06, 2006-28 I.R.B. 73

REG-118897-06, 2006-31 I.R.B. 120

REG-120509-06, 2006-39 I.R.B. 570

REG-124152-06, 2006-36 I.R.B. 368

REG-125071-06, 2006-36 I.R.B. 375

Revenue Procedures:

2006-29, 2006-27 I.R.B. 13

2006-30, 2006-31 I.R.B. 110

2006-31, 2006-27 I.R.B. 32

2006-32, 2006-28 I.R.B. 61

2006-33, 2006-32 I.R.B. 140

2006-34, 2006-38 I.R.B. 460

2006-35, 2006-37 I.R.B. 434

2006-36, 2006-38 I.R.B. 498

2006-37, 2006-38 I.R.B. 499

2006-38, 2006-39 I.R.B. 530

Revenue Rulings:

2006-35, 2006-28 I.R.B. 50

2006-36, 2006-36 I.R.B. 353

2006-37, 2006-30 I.R.B. 91

2006-38, 2006-29 I.R.B. 80

2006-39, 2006-32 I.R.B. 137

2006-40, 2006-32 I.R.B. 136

2006-41, 2006-35 I.R.B. 331

2006-42, 2006-35 I.R.B. 337

2006-43, 2006-35 I.R.B. 329

2006-44, 2006-36 I.R.B. 361

2006-45, 2006-37 I.R.B. 423

2006-46, 2006-39 I.R.B. 511

2006-47, 2006-39 I.R.B. 511

2006-48, 2006-39 I.R.B. 516

Treasury Decisions:

9265, 2006-27 I.R.B. 1

9266, 2006-28 I.R.B. 52

9267, 2006-34 I.R.B. 313

9268, 2006-30 I.R.B. 94

9269, 2006-30 I.R.B. 92

9270, 2006-33 I.R.B. 237

9271, 2006-33 I.R.B. 224

9272, 2006-35 I.R.B. 332

9273, 2006-37 I.R.B. 394

Treasury Decisions— Continued:

9274, 2006-33 I.R.B. 244

9275, 2006-35 I.R.B. 327

9276, 2006-37 I.R.B. 424

9277, 2006-33 I.R.B. 226

9278, 2006-34 I.R.B. 256

9279, 2006-36 I.R.B. 355

9280, 2006-38 I.R.B. 450

9281, 2006-39 I.R.B. 517

9282, 2006-39 I.R.B. 512

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin2006–26, dated June 26, 2006.

2006–39 I.R.B. ii September 25, 2006

Finding List of Current Actions onPreviously Published Items1

Bulletins 2006–27 through 2006–39

Announcements:

2005-59

Updated and superseded by

Ann. 2006-45, 2006-31 I.R.B. 121

Notices:

2002-45

Amplified by

Rev. Rul. 2006-36, 2006-36 I.R.B. 353

2006-20

Supplemented and modified by

Notice 2006-56, 2006-28 I.R.B. 58

2006-53

Modified by

Notice 2006-71, 2006-34 I.R.B. 316

Proposed Regulations:

REG-135866-02

Corrected by

Ann. 2006-65, 2006-37 I.R.B. 447Ann. 2006-64, 2006-37 I.R.B. 447

REG-134317-05

Corrected by

Ann. 2006-47, 2006-28 I.R.B. 78

Revenue Procedures:

2002-9

Modified and amplified by

Notice 2006-67, 2006-33 I.R.B. 248

2004-63

Superseded by

Rev. Proc. 2006-34, 2006-38 I.R.B. 460

2005-41

Superseded by

Rev. Proc. 2006-29, 2006-27 I.R.B. 13

2005-49

Superseded by

Rev. Proc. 2006-33, 2006-32 I.R.B. 140

2006-12

Modified by

Rev. Proc. 2006-37, 2006-38 I.R.B. 499

Revenue Rulings:

81-35

Amplified and modified by

Rev. Rul. 2006-43, 2006-35 I.R.B. 329

81-36

Amplified and modified by

Rev. Rul. 2006-43, 2006-35 I.R.B. 329

Revenue Rulings— Continued:

87-10

Amplified and modified by

Rev. Rul. 2006-43, 2006-35 I.R.B. 329

2002-41

Amplified by

Rev. Rul. 2006-36, 2006-36 I.R.B. 353

2003-43

Amplified by

Notice 2006-69, 2006-31 I.R.B. 107

2005-24

Amplified by

Rev. Rul. 2006-36, 2006-36 I.R.B. 353

Treasury Decisions:

9254

Corrected by

Ann. 2006-44, 2006-27 I.R.B. 49Ann. 2006-66, 2006-37 I.R.B. 448

9258

Corrected by

Ann. 2006-46, 2006-28 I.R.B. 76

9260

Corrected by

Ann. 2006-67, 2006-38 I.R.B. 509

9262

Corrected by

Ann. 2006-56, 2006-35 I.R.B. 342

9264

Corrected by

Ann. 2006-46, 2006-28 I.R.B. 76

9272

Corrected by

Ann. 2006-68, 2006-38 I.R.B. 510

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin 2006–26, dated June 26, 2006.

September 25, 2006 iii 2006–39 I.R.B.

INDEXInternal Revenue Bulletins 2006–27 through2006–39

The abbreviation and number in parenthesis following the index entryrefer to the specific item; numbers in roman and italic type followingthe parenthesis refers to the Internal Revenue Bulletin in which the itemmay be found and the page number on which it appears.

Key to Abbreviations:Ann AnnouncementCD Court DecisionDO Delegation OrderEO Executive OrderPL Public LawPTE Prohibited Transaction ExemptionRP Revenue ProcedureRR Revenue RulingSPR Statement of Procedural RulesTC Tax ConventionTD Treasury DecisionTDO Treasury Department Order

EMPLOYEE PLANSAnti-cutback rules, section 411(d)(6) protected benefits (TD

9280) 38, 450Disaster relief, additional postponement under section 7508A for

filing certain 2004 and 2005 individual tax returns by certaintaxpayers affected by Hurricane Katrina (Notice 56) 28, 58

Employee stock ownership plan (ESOP), disallowance of deduc-tion for reacquisition payments (TD 9282) 39, 512

Exempt organization employees, minimum coverage require-ments of section 410(b) (TD 9275) 35, 327

Full funding limitations, weighted average interest rate:For July 2006 (Notice 66) 30, 99For August 2006 (Notice 74) 35, 339Pension Protection Act of 2006 modifications (Notice 75) 36,

366Nonbank trustee and nonbank custodian, approval list (Ann 45)

31, 122Qualified retirement plans:

Government pick-up plans, employer contributions (RR 43)35, 329

Prohibited transaction excise tax, amount involved in electivedeferral (RR 38) 29, 80

Regulations:26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ-

ees of 501(c)(3) organizations in 401(k) and 401(m) plans(TD 9275) 35, 327

26 CFR 1.411(a)–8, amended; 1.411(d)–3, amended; section411(d)(6) protected benefits (TD 9280) 38, 450

26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividendspaid deduction for stock held in employee stock ownershipplan (TD 9282) 39, 512

Roth IRAs, distributions of designated Roth contributions, publichearing on REG–146459–05 (Ann 42) 27, 48

EMPLOYMENT TAXControlled services transactions under section 482, treatment, al-

location of income and deductions from intangibles, and stew-ardship expense (TD 9278) 34, 256; (REG–146893–02) 34,317

Disaster relief:Additional postponement under section 7508A for filing cer-

tain 2004 and 2005 individual tax returns by certain taxpay-ers affected by Hurricane Katrina (Notice 56) 28, 58

Leave-sharing plans (Notice 59) 28, 60Disclosure of return information, Bureau of Economic Analysis

(TD 9267) 34, 313; (REG–148864–03) 34, 320Federal Insurance Contributions Act (FICA), application to pay-

ments made for certain services (TD 9266) 28, 52Offers in compromise, nonrefundable down payments required

(Notice 68) 31, 105Proposed Regulations:

26 CFR 31.3121(s)–1, amended; treatment of services undersection 482, allocation of income and deductions from in-tangibles, stewardship expense (REG–146893–02) 34, 317

26 CFR 301.6103(j)(1)–1, amended; disclosure of re-turn information to the Bureau of Economic Analysis(REG–148864–03) 34, 320

Regulations:26 CFR 31.3102–1, amended; 31.3121(a)–2, (a)(7)–1,

(a)(8)–1, (i)–1, amended; 31.3121(a)(10)–1, revised; ap-plication of the Federal Insurance Contributions Act topayments made for certain services (TD 9266) 28, 52

26 CFR 31.3121(s)–1, amended; 31.3121(s)–1T, added; treat-ment of services under section 482, allocation of incomeand deductions from intangibles, stewardship expense (TD9278) 34, 256

26 CFR 31.3401(a)–1, –4, amended; 31.3402(g)–1, amended;31.3402(j)–1, amended; 31.3402(n)–1, revised; flat ratesupplemental wage withholding (TD 9276) 37, 423

26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,added; disclosure of return information to the Bureau ofEconomic Analysis (TD 9267) 34, 313

Supplemental wages, withholding (TD 9276) 37, 423Tip reporting, Attributed Tip Income Program (ATIP) (RP 30)

31, 110

ESTATE TAXDisaster relief, additional postponement under section 7508A for

filing certain 2004 and 2005 individual tax returns by certaintaxpayers affected by Hurricane Katrina (Notice 56) 28, 58

Disclosure of return information, Bureau of Economic Analysis(TD 9267) 34, 313; (REG–148864–03) 34, 320

Offers in compromise, nonrefundable down payments required(Notice 68) 31, 105

Proposed Regulations:26 CFR 301.6103(j)(1)–1, amended; disclosure of re-

turn information to the Bureau of Economic Analysis(REG–148864–03) 34, 320

2006–39 I.R.B. iv September 25, 2006

ESTATE TAX—Cont.Regulations:

26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,added; disclosure of return information to the Bureau ofEconomic Analysis (TD 9267) 34, 313

EXCISE TAXDisaster relief, additional postponement under section 7508A for

filing certain 2004 and 2005 individual tax returns by certaintaxpayers affected by Hurricane Katrina (Notice 56) 28, 58

Disclosure of return information, Bureau of Economic Analysis(TD 9267) 34, 313; (REG–148864–03) 34, 320

Disclosure requirements with respect to prohibited tax sheltertransactions to which tax-exempt entities are parties (Notice65) 31, 102

Excise taxes with respect to prohibited tax shelter transactions towhich tax-exempt entities are parties (Notice 65) 31, 102

Health Savings Accounts (HSAs) under section 4980G, em-ployer comparable contributions (TD 9277) 33, 226

Offers in compromise, nonrefundable down payments required(Notice 68) 31, 105

Proposed Regulations:26 CFR 301.6103(j)(1)–1, amended; disclosure of re-

turn information to the Bureau of Economic Analysis(REG–148864–03) 34, 320

Regulations:26 CFR 54.4980G–0 thru –5, added; employer comparable

contributions to Health Savings Accounts under section4980G (TD 9277) 33, 226

26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,added; disclosure of return information to the Bureau ofEconomic Analysis (TD 9267) 34, 313

EXEMPT ORGANIZATIONSDisaster relief, additional postponement under section 7508A for

filing certain 2004 and 2005 individual tax returns by certaintaxpayers affected by Hurricane Katrina (Notice 56) 28, 58

Disclosure requirements with respect to prohibited tax sheltertransactions to which tax-exempt entities are parties (Notice65) 31, 102

Excise taxes with respect to prohibited tax shelter transactions towhich tax-exempt entities are parties (Notice 65) 31, 102

List of organizations classified as private foundations (Ann 51)32, 222

Revocations (Ann 48) 31, 136; (Ann 54) 33, 254; (Ann 55) 35,342; (Ann 60) 36, 389; (Ann 69) 37, 449

GIFT TAXDisaster relief, additional postponement under section 7508A for

filing certain 2004 and 2005 individual tax returns by certaintaxpayers affected by Hurricane Katrina (Notice 56) 28, 58

Disclosure of return information, Bureau of Economic Analysis(TD 9267) 34, 313; (REG–148864–03) 34, 320

GIFT TAX—Cont.Offers in compromise, nonrefundable down payments required

(Notice 68) 31, 105Proposed Regulations:

26 CFR 301.6103(j)(1)–1, amended; disclosure of re-turn information to the Bureau of Economic Analysis(REG–148864–03) 34, 320

Regulations:26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,

added; disclosure of return information to the Bureau ofEconomic Analysis (TD 9267) 34, 313

INCOME TAXAccounting methods:

Advance consent to change procedures (RP 37) 38, 499Revised instructions for Form 3115, Application for Change

in Accounting Method (Ann 52) 33, 254Capitalization of amounts paid to acquire, produce, or improve

tangible property (REG–168745–03) 39, 532Collection, IRS’s use of private collection agencies (PCAs) in

2006 (Ann 63) 37, 445Computer software, domestic production activities deduction un-

der section 199(c)(5)(B):Change in hearing location for REG–111578–06 (Ann 53) 33,

254Correction to TD 9262 (Ann 56) 35, 342

Conservation Security Program (CSP), cost-share payments (RR46) 39, 511

Consolidated returns, basis reallocation, loss suspension, and ex-piration of losses on certain stock dispositions, correction toTD 9254 (Ann 44) 27, 49; correction (Ann 66) 37, 448

Controlled services cost method under section 482 regulations,identification of specified eligible covered services (Ann 50)34, 321

Controlled services transactions under section 482, treatment, al-location of income and deductions from intangibles, and stew-ardship expense (TD 9278) 34, 256; (REG–146893–02) 34,317

Corporations:Attribution of earnings and profits to stock of controlled

foreign corporations (REG–135866–02) 27, 34; correction(Ann 64) 37, 447; additional corrections (Ann 65) 37, 447

Distributions of interests in a loss corporation from qualifiedtrusts (TD 9269) 30, 92

Foreign corporation interest expense allocations, branch prof-its tax election, branch profits tax liability reduction (TD9281) 39, 517; (REG–120509–06) 39, 570

Information returns required with respect to certain foreigncorporations and certain foreign-owned domestic corpora-tions (TD 9268) 30, 94; (REG–109512–05) 30, 100

Inversions, surrogate foreign corporations (Notice 70) 33, 252Look-through treatment of dividends from noncontrolled sec-

tion 902 corporations, correction to TD 9260 (Ann 67) 38,509

September 25, 2006 v 2006–39 I.R.B.

INCOME TAX—Cont.Surrogate foreign corporation status for purposes of section

7874 (TD 9265) 27, 1; (REG–112994–06) 27, 47Credits:

Enhanced oil recovery credit, 2006 inflation adjustment (No-tice 62) 29, 86

For income, war profits, excess profits taxes paid to foreigncountry or U.S. possession (REG–124152–06) 36, 368

Low-income housing credit:Carryovers to qualified states, 2006 National Pool (RP 38)

39, 530Satisfactory bond, “bond factor” amounts for the period:

January through September 2006 (RR 37) 30, 91New markets tax credit, low-income community business

(Notice 60) 29, 82Nonbusiness energy property, siding not component specifi-

cally and primarily designed to reduce heat loss or gain ofdwelling (Notice 71) 34, 316

Work opportunity and welfare-to-work tax credits (Ann 49)29, 89

Debit cards used to reimburse participants in self-insured medicalreimbursement plans and dependent care assistance programs(Notice 69) 31, 107

Disaster relief:Additional postponement under section 7508A for filing cer-

tain 2004 and 2005 individual tax returns by certain taxpay-ers affected by Hurricane Katrina (Notice 56) 28, 58

Casualty and theft loss deductions attributable to HurricanesKatrina, Rita, and Wilma, safe harbor methods for individ-uals, personal-use residential real property and certain per-sonal belongings (RP 32) 28, 61

Depreciation, Gulf Opportunity (GO) Zone additional firstyear depreciation deduction (Notice 67) 33, 248

Leave-sharing plans (Notice 59) 28, 60Disciplinary actions involving attorneys, certified public accoun-

tants, enrolled agents, and enrolled actuaries (Ann 57) 35, 343Disclosure of return information:

Bureau of Economic Analysis (TD 9267) 34, 313;(REG–148864–03) 34, 320

By certain officers and employees for investigative purposes(TD 9274) 33, 244

E-file, guidance necessary to facilitate business electronic filingand burden reduction, correction to TD 9264 (Ann 46) 28, 76;correction to REG–134317–05 (Ann 47) 28, 78

Effect of elections in certain multi-step transactions (TD 9271)33, 224

Employee stock ownership plan (ESOP), disallowance of deduc-tion for reacquisition payments (TD 9282) 39, 512

Exempt organization employees, minimum coverage require-ments of section 410(b) (TD 9275) 35, 327

Fast Track Settlement (FTS) for SB/SE taxpayers to expeditecase resolution (Ann 61) 36, 390

Forms:1042-S, Foreign Person’s U.S. Source Income Subject to

Withholding, specifications for filing electronically ormagnetically (RP 34) 38, 460

INCOME TAX—Cont.1098, 1099, 5498 and W-2G, requirements for filing electron-

ically or magnetically (revised 8-2006) (RP 33) 32, 1403115, Application for Change in Accounting Method, instruc-

tions revised May 2006 (Ann 52) 33, 2548027, Employer’s Annual Information Return of Tip Income

and Allocated Tips, specifications for filing electronicallyor magnetically (RP 29) 27, 13

8802, Application for United States Residency Certification,user fees for processing (RP 35) 37, 434

8830, Enhanced Oil Recovery Credit, credit phased out for2006 (Ann 62) 37, 444

8840, Closer Connection Exception Statement for Aliens, re-vision (Notice 73) 35, 339

8898, Statement for Individuals Who Begin or End Bona FideResidence in a U.S. Possession, postponement of filing datefor tax years 2001 through 2005 (Notice 57) 27, 13; revision(Notice 73) 35, 339

Health reimbursement arrangements, taxable benefits of benefi-ciaries (RR 36) 36, 353

Health Savings Accounts (HSAs) under section 4980G, em-ployer comparable contributions (TD 9277) 33, 226

Indian tribal governments, limitation on issuance of tax-ex-empt bonds, advance notice of proposed rulemaking(REG–118788–06) (Ann 59) 36, 388

Information reporting:For payments to attorneys, reporting of gross proceeds pay-

ments (TD 9270) 33, 237Requirements for qualified tuition and related expenses (No-

tice 72) 36, 363Insurance companies:

Life-nonlife tacking rule, correction to TD 9258 (Ann 46) 28,76

Recomputed differential earnings rate for 2004 (RR 45) 37,423

Interest:Investment:

Federal short-term, mid-term, and long-term rates for:July 2006 (RR 35) 28, 50August 2006 (RR 39) 32, 137September 2006 (RR 44) 36, 361

Portfolio interest rules as applied to payments made to part-nerships and simple or grantor trusts (REG–118775–06) 28,73; hearing rescheduled (Ann 58) 36, 388

Inventory:LIFO, price indexes used by department stores for:

May 2006 (RR 40) 32, 136June 2006 (RR 41) 35, 331July 2006 (RR 48) 39, 516

Involuntary conversions, livestock sold on account of drought,extension of replacement period (Notice 82) 39, 529

Levy, use of superpriority lien arguments as a defense to (RR 42)35, 337

Marginal production rates, 2006 (Notice 61) 29, 85Nonqualified deferred compensation, permitted accelerated pay-

ment (Notice 64) 29, 88

2006–39 I.R.B. vi September 25, 2006

INCOME TAX—Cont.Offers in compromise, nonrefundable down payments required

(Notice 68) 31, 105Partnerships, portfolio interest rules as applied to payments made

to partnerships and simple or grantor trusts (REG–118775–06)28, 73

Postponement of filing date for Form 8898, Statement for Indi-viduals Who Begin or End Bona Fide Residence in a U.S. Pos-session, for tax years 2001 through 2005 (Notice 57) 27, 13

Private foundations, organizations now classified as (Ann 51) 32,222

Procedures for requesting special statistical studies and compila-tions involving return information (RP 36) 38, 498

Proposed Regulations:26 CFR 1.162–4, revised; 1.263(a)–0, amended; 1.263(a)–1

thru –3, revised; guidance regarding deduction and cap-italization of expenditures related to tangible property(REG–168745–03) 39, 532

26 CFR 1.367(b)–2, –4, revised; 1.1248–1, –2, –3, –7, re-vised; 1.1248–8, added; section 1248 attribution principles(REG–135866–02) 27, 34; correction (Ann 64) 37, 447; ad-ditional corrections (Ann 65) 37, 447

26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–9,added; 1.861–8, amended; 1.6038A–3(a)(3), amended;1.6662–6, amended; treatment of services under section482, allocation of income and deductions from intangibles,stewardship expense (REG–146893–02) 34, 317

26 CFR 1.671–5, amended; reporting rules for widely heldfixed investment trusts (REG–125071–06) 36, 375

26 CFR 1.706–1, amended; 1.901–2, revised; definition oftaxpayer for purposes of section 901 and related matters(REG–124152–06) 36, 368

26 CFR 1.860A–1, amended; 1.860G–3, amended; 1.863–1,amended; 1.1441–2, amended; REMIC residual interests-accounting for REMIC net income (including any excessinclusions (foreign holders) (REG–159929–02) 35, 341

26 CFR 1.871–14, amended; 1.881–2, amended; revisions toregulations relating to repeal of tax on interest of nonres-ident alien individuals and foreign corporations receivedfrom certain portfolio debt investments (REG–118775–06)28, 73; hearing rescheduled (Ann 58) 36, 388

26 CFR 1.882–5, amended; 1.884–1, amended; determina-tion of interest expense deduction of foreign corporations(REG–120509–06) 39, 570

26 CFR 1.985–3, amended; United States dollar approximateseparate transactions method (REG–118897–06) 31, 121

26 CFR 1.6038–2, amended; 1.6038A–2, amended; informa-tion returns required with respect to certain foreign cor-porations and certain foreign-owned domestic corporations(REG–109512–05) 30, 100

26 CFR 1.7874–2, added; guidance regarding expatriated en-tities and their foreign parents (REG–112994–06) 27, 47

26 CFR 300.0, amended; 300.4, .5, .6, added; user fees relat-ing to enrollment (REG–145154–05) 39, 567

26 CFR 301.6103(j)(1)–1, amended; disclosure of re-turn information to the Bureau of Economic Analysis(REG–148864–03) 34, 320

INCOME TAX—Cont.Publications:

1187, Specifications for Filing Form 1042-S, Foreign Per-son’s U.S. Source Income Subject to Withholding, Elec-tronically or Magnetically, revised (RP 34) 38, 460

1220, Specifications for Filing Forms 1098, 1099, 5498 andW-2G Electronically or Magnetically, 2006 revision (RP33) 32, 140

1239, Specifications for Filing Form 8027, Employer’s An-nual Information Return of Tip Income and Allocated Tips,Electronically or Magnetically, revised (RP 29) 27, 13

Real Estate Investment Trust (REIT) income tests, rents from realproperty (Notice 58) 28, 59

Real Estate Mortgage Investment Conduit (REMIC), allocationof income to foreign persons by certain entities (TD 9272) 35,332; correction (Ann 68) 38, 510; (REG–159929–02) 35, 341

Record retention requirements for tax-exempt bonds (Notice 63)29, 87

Regulations:26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividends

paid deduction for stock held in employee stock ownershipplan (TD 9282) 39, 512

26 CFR 1.199–3T, –8T, amended; computer software undersection 199(c)(5)(B), correction to TD 9262 (Ann 56) 35,342

26 CFR 1.338–3, amended; 1.338(h)(10)–1, amended;1.338(h)(10)–1T, removed; effect of elections in certainmulti-step transactions (TD 9271) 33, 224

26 CFR 1.367(b)–0 thru –3, amended; 1.367(b)–6, revised;1.367(b)–7, –8, –9, added; 1.381(a)–1, revised; stock trans-fer rules, carryover of earnings and taxes (TD 9273) 37, 394

26 CFR 1.382–1, amended; 1.382–10, added; 1.382–10T, re-moved; distributions of interests in a loss corporation fromqualified trusts (TD 9269) 30, 92

26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ-ees of 501(c)(3) organizations in 401(k) and 401(m) plans(TD 9275) 35, 327

26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–0T, –1T,–2T, –4T, –6T, –8T, –9T, added; 1.861–8, –8T, amended;1.6038–3(a)(3), amended; 1.6038A–3T, added; 1.6662–6,amended; 1.6662–6T, added; treatment of services undersection 482, allocation of income and deductions from in-tangibles, stewardship expense (TD 9278) 34, 256

26 CFR 1.671–5, amended; 1.671–5T, added; reporting rulesfor widely held fixed investment trusts (TD 9279) 36, 355

26 CFR 1.860A–0, –1, amended; 1.860A–1T, added;1.860G–3, amended; 1.860G–3T, added; 1.863–0, –1,amended; 1.863–1T, added; 1.1441–0, –2, amended;1.1441–2T, added; REMIC residual interests-accountingfor REMIC net income (including any excess inclusions)(foreign holders) (TD 9272) 35, 332; correction (Ann 68)38, 510

26 CFR 1.882–0, –5, amended; 1.882–5T, added; 1.884–1,amended; 1.884–1T, added; 602.101, amended; determina-tion of interest expense deduction of foreign corporations(TD 9281) 39, 517

September 25, 2006 vii 2006–39 I.R.B.

INCOME TAX—Cont.26 CFR 1.904–4, amended; application of separate limitations

to dividends from noncontrolled section 902 corporations,correction to TD 9260 (Ann 67) 38, 509

26 CFR 1.1502–35, amended; suspension of losses on certainstock dispositions, correction to TD 9254 (Ann 44) 27, 49;correction (Ann 66) 37, 448

26 CFR 1.1502–76T, amended; 1.1563–1, amended; 602.101,amended; amendment of tacking rule requirements of life-nonlife consolidated regulations, and guidance necessary tofacilitate business electronic filing and burden reduction,correction to TD 9258 and TD 9264 (Ann 46) 28, 76

26 CFR 1.6038–2, –2T, amended; 1.6038A–2, –2T, amended;602.101(b), amended; information returns required with re-spect to certain foreign corporations and certain foreign-owned domestic corporations (TD 9268) 30, 94

26 CFR 1.6041–1, –3, amended; 1.6045–5, added; reportingof gross proceeds payments to attorneys (TD 9270) 33, 237

26 CFR 1.7874–2T, added; guidance regarding expatriatedentities and their foreign parents (TD 9265) 27, 1

26 CFR 54.4980G–0 thru –5, added; employer comparablecontributions to Health Savings Accounts under section4980G (TD 9277) 33, 226

26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,added; disclosure of return information to the Bureau ofEconomic Analysis (TD 9267) 34, 313

26 CFR 301.6103(k)(6)–1, added; 301.6103(k)(6)–1T, re-moved; disclosure of return information by certain officersand employees for investigative purposes (TD 9274) 33,244

Revocations, exempt organizations (Ann 48) 31, 136; (Ann 54)33, 254; (Ann 55) 35, 342; (Ann 60) 36, 389; (Ann 69) 37, 449

Revoking an election under section 83(b) (RP 31) 27, 32Standard Industry Fare Level (SIFL) formula (RR 47) 39, 511Stock transfer rules, carryover of earnings and taxes (TD 9273)

37, 394Tax Exempt Bond (TEB) Mediation Pilot Program, one-year re-

newal (Ann 43) 27, 48Tuition and related expenses, qualified, information reporting re-

quirements (Notice 72) 36, 363United States dollar approximate separate transactions method

(DASTM) (REG–118897–06) 31, 121U.S. possessions, examples for determining whether income is

U.S. possession source or effectively connected with trade orbusiness in U.S. possession (Notice 76) 38, 459

User fees:Enrollment examinations, enrollment of enrolled agents, re-

newal of enrollment (REG–145154–05) 39, 567Processing Form 8802, Application for United States Resi-

dency Certification (RP 35) 37, 434Widely held fixed investment trusts (WHFITs), reporting re-

quirements (TD 9279) 36, 355; (REG–125071–06) 36, 375

SELF-EMPLOYMENT TAXDisaster relief, additional postponement under section 7508A for

filing certain 2004 and 2005 individual tax returns by certaintaxpayers affected by Hurricane Katrina (Notice 56) 28, 58

Offers in compromise, nonrefundable down payments required(Notice 68) 31, 105

2006–39 I.R.B. viii September 25, 2006

September 25, 2006 2006–39 I.R.B.

2006–39 I.R.B. September 25, 2006

September 25, 2006 2006–39 I.R.B.

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