Capital Expenditures under Treas. Reg. 1.150-1(b); Capital Assets under Treas. Reg. 1.1221-1

Context:

Treas. Reg. 1.150-1(b) defines working capital expenditures as any expenditures that are not capital expenditures.  In order to avoid analysis under the special working capital rules, therefore, it is important to determine whether expenditures constitute “capital expenditures.”

What Are Capital Expenditures:

A “capital expenditure” is any cost of a type that, under general federal income tax principles, is properly chargeable to a capital account or would be so chargeable with a proper election.  Examples include costs to acquire, construct or improve land, buildings and equipment.  Whether an expenditure is a capital expenditure is determined at the time the expenditure is paid, and future changes in law do not affect that determination.  Treas. Reg. 1.150-(b).

Sections 263 and 263A of the Code and the related regulations and rulings provide some guidance as to general federal tax principles relating to capitalization of costs.  In general, a capital asset must have a useful life in excess of one year.  Often courts have also looked to whether a separate, identifiable asset is created to determine whether costs are capital costs, but in INDOPCO (503 U.S. 79 (1992)), the court specifically found that the creation or enhancement of a separate and distinct asset is not an exclusive test for identifying a capital expenditure.  The Court also stated that it is important to determine whether a taxpayer will realize benefits that are not just incidental future benefits beyond the year in which the expenditure is incurred.

Clean-up costs are capitalizable to the land (and, since the land is not depreciable, would simply add to the basis and only be recoverable on the sale of the land). See PLR 9519020.  But see Rev. Rul. 94-38 in which the IRS determined that such costs are currently deductible, and see Announcement 2002-9 in a notice of proposed rulemaking for the capitalization of specific categories of expenditures in connection with intangible assets or benefits (prepaid items, amounts paid in respect of tangible property owned by another and transaction costs).

Certain regulations under Section 263 permit costs that otherwise are deducted to be capitalized, and vice versa.  See Treas. Reg. 1.263(a)-3.  For example, under Section 266, carrying costs, including interest costs during construction, may be capitalized.  Therefore, because Sections 148 and 150 state that capitalizable costs may be treated as actual capital costs, true capitalized interest can be treated as a capital cost and not as working capital.  For purposes of the tax-exempt bond rules, “construction” ends when the facility is “placed-in-service” within the meaning of Treas. Reg. 1.150-2(c) (operating at substantially its design level).

Capitalization Examples:

  • Demolition Costs:  The following discussion was included at TaxAlmanac regarding capitalization of demolition costs:
    • The treatment of demolition costs depends on how much of the building was demolished. If a structure is demolished, the cost of the demolition is not deductible, nor can it be added to the depreciable basis of any replacement structure; it is capitalized into the cost of the land. IRC Sec. 280B.
    • Modification of a building is not treated as a demolition subject to these rules if at least 75% of the existing external walls remain in place as external or internal walls, and at least 75% of the internal structure of the building remains in place. Rev. Proc. 95-27, 1995-1 CB 704. If Sec. 280B is not applicable, then generally the demo costs would be capitalized as part of the depreciable cost of the improvements under IRC Sec. 263A (UNICAP).
  • Software:  Capitalization of software is required under Section 197(a) and Section 167(f)(1), generally.  However, capitalization is not required for off-the-shelf software.
    • Instructional software is treated as a supply expenditure in the same manner as textbooks and other instructional supplies are treated.  This should not be treated as a capital expenditure.
    • Operating (non-instructional) system software should be treated as a fixed asset that can be capitalized and depreciated over time as any other asset based on the following criteria: (1) meets any local capitalization thresholds (e.g., $1,000); (2) lasts more than one year; (3) software faults like equipment faults are more likely to be repaired than replaced; (4) the typical capitalization requirement that the equipment be an independent unit rather than being incorporated into another item does not apply in the case of software; (5) the value of software and normal licensing requirements may take the place of typical inventory tagging procedures; (6) the software does not replace or enhance textbooks or other instructional supplies.
    • The administrative guideline for the useful life of software in Rev. Proc. 62-21 set forth a five-year useful life of computer software.  In 1993, I.R.C. 167(f)(1) provided for a three-year life for depreciation purposes.
    • See PLR 200515006: “The Issuer intends to issue bonds in a maximum principal amount not to exceed $a (the “Bonds”) to finance all or a portion of the costs of certain computer software which it will use to perform administrative functions, including financial accounting, procurement, payroll, and personnel administration (the “Computer Software”). The Issuer does not request a ruling as to the average reasonably expected economic life of the Computer Software. The Issuer requests this ruling to help the Issuer determine whether the Bonds will meet the safe harbor against the creation of replacement proceeds under § 1.148-1(c)(4)(i)(B)(2) of the Income Tax Regulations and whether the Bonds will have an average maturity that is no longer than reasonably necessary for the governmental purposes of the Bonds.”
    • See also Treas. Reg. 1.148-7(g)(4), regarding the treatment of specially developed computer software as a construction expenditure for purposes of the two-year spending exception.
    • See CCA 201549024 (December 7, 2015) treating the cost of an Enterprise Resource Planning (ERP) software (including the sales tax) as a capital expenditure pursuant to I.R.C. 263(a) and under I.R.C. 167(f) was amortizable ratably over 36 months, beginning in the month the software was placed in service.  Because the taxpayer was unable to use the ERP software without the option selection and implementation of templates, the cost of the templates was capitalized as part of the ERP software.
  • Repairs:  See http://www.irs.gov/businesses/article/0,,id=231440,00.html#14. Do not capitalize:
    • Improvements that keep property in efficient operating condition
    • Restorations of property to its previous condition (note that some restorations might be capitalizable, under Treas. Reg. 1.263(a)-3T(i))
    • Repairs that protect the underlying property through routine maintenance
    • Repairs that consist of incidental repairs to property
    • Unless Treas. Reg. 1.263(a)-3T(i) applies, it may be prudent not to capitalize (or treat as a capital expenditure) carpet replacements.  But, consider viewing the carpet replacement as a related working capital expenditure under the de minimis working capital rules.
  • Litigation Costs:  See, for example, 410 F.2d 313 (8th App), affirming 49 T.C. 377 (1969)
    • The cost of defending or perfecting title to property is a capital expenditure.
    • Look to the primary purpose of the litigation to determine deductibility.
    • If the litigation cost relates to acquisition of a capital assets, the cost is generally capitalizable and there is no need to review the primary purpose of the litigation.
  • Tax Credits:  See, e.g., Temple v. Commissioner, 136 T.C. 341 (April 5, 2011), on whether Colorado income tax credits are capital assets and whether the seller of a Colorado income tax credit may treat the gain on sale of the credit as a capital asset.  The court concludes that the credit is a capital asset.
  • Purchase Options:  An option to purchase land, for example, is treated as a capital asset under I.R.C. 1234(a), whether or not the option is exercised.
    • Can a lapsed option be tax-exempt financed with reimbursement bond proceeds? Probably not. One would need a valid reimbursement resolution.  However, the lapsed option would have no useful life left.  May be difficult to argue that it is still a good capital asset for tax-exempt bond purposes if the asset doesn’t have any life when it is financed.  It may be necessary to treat the cost as a related working capital cost.
    • Can an outstanding option be tax-exempt financed? Yes, but one might need to caution that the useful life will likely be short.

See Also:

Section 1.263(a)-5(a) of the Regulations concerning capitalization of facilitating payments.

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