Alex Zakupowsky IIR Update Portland, Oregon June 18, 2014

1. Alex ZakupowskyIIR UpdatePortland, OregonJune 18, 2014

2. Status of Industry Issue Resolution Projects • Electric T&D – Rev. Proc. 2011-43, Issued August 11, 2011 • Revision in Process • Do not expect before early 2013 • Now, fourth quarter 2013 • Now, 2014 • Behind Gas T&D • Electric Generation • Awaiting Treasury approval • Rev. Proc. 2013- 24, Issued April 30, 2013 • Gas T&D • No identified problems • Issue identified in Treasury review • Target before yearend, but could slip to first quarter 2013 • Now, expected late summer or early fall 2013 • Now, expected first quarter 2014 • Now, expected fourth quarter 2014

3. Gas Revenue Procedure • “being actively worked and making good progress . . “ • Not very different than the prior draft we saw, other than conformance with regulations. • Key provisions retained. • Bright line test for pipe replacement • Detailed aggregation rules • Meeting in July to review new draft

4. Revisions to Rev. Proc. 2011-43Industry Request Regarding Electric T&D Timing of Full Implementation Revenue procedure provides: For the first three taxable years ending on or after December 31, 2010, a taxpayer using the transmission and distribution property safe harbor method provided by this revenue procedure may determine the percentage of a unit of linear property replaced on the basis of an average circuit within a county. Interpreted as applicable through 2013. IRS has now promised further delay (2016?)

5. The Good News • Treasury and IRS have been thinking through problems in electric T&D revenue procedure and making changes in gas T&D revenue procedure. • Intervening section 263(a) regulations have taken time away from project and have caused problems with some original decisions.

6. Unit of Property Unit of Property • All of the components that are functionally interdependent comprise a single unit of property. • Exceptions • Building – each system is a separate unit of property. • Plant property – each component or group of components that perform a discrete and major function or operation within the functionally interdependent machinery or equipment. • Network Assets – facts and circumstances (e.g., IIRs)

7. Asset • Can be (and frequently is) different than a unit of property. • Generally an accounting concept determined from a taxpayers financial books of account. • An asset is identified to determine gain or loss on dispositions and depreciation.

8. Example: • Unit of property is a hydraulic subsystem within a natural gas distribution system. • An asset is 20 feet of pipe.

9. 2011 Temporary Regulations Disposition Rules • Multiple Asset Accounts (Commonly Used) • Expanded definition of disposition • Required recognition of loss • Basis goes away so there is no more depreciation • Loss (whether taken or not) triggers capitalization of replacement • General Asset Accounts • No loss recognized • Depreciation continues • Replacement as repair or capital under general rules • Flexibility to turn off GAA treatment to recognize loss.

10. Dilemma Presented on Disposition of Asset

11. Buildings Are Problem • Emphasis in regulations was to avoid the duplicate basis rule. • Example. Taxpayer replaces a 10-year old roof, that is only partially depreciated and new roof must be capitalized. As a major component the taxpayer is permitted to deduct the remaining basis in the old roof. • IRS developed a partial asset election that allowed taxpayers to recognize loss on replacement of partial asset.

12. Problem Solved On Disposition of Partial Asset

13. The Rules • Unit of property is the base on which the determination is made whether a replacement of the unit of property or a major component of the unit of property is capital or deductible repair. • Treas. Reg. §1.263(a)-3(k) – A taxpayer must capitalize as an improvement an amount paid to restore a unit of property if the taxpayer has deducted a loss for that component. • In other words, retirement rules drive capitalization when an asset is replaced. • And, you must recognize loss when you dispose of an asset.

14. Disposition Example • Taxpayer replaces 20 feet of pipe (asset) in a 50 mile hydraulic subsystem of a natural gas distribution system. • If loss is available for undepreciated basis the replacement is per se capital. • This was NOT a good result and NOT the intent of the IIR. • The regulation turned the world upside down.

15. Pipe Replacement Examples Each asset would need to go into a GAA to allow the taxpayer to turn off the GAA election and recognize loss when there is a capital replacement

16. There Must be a Better Solution IRR can allow determination of repair or capital first and then that determination drives recognition of gain or loss.

17. Removal costs Treas. Reg. §1.263(a)-3(g)(2). • If a taxpayer disposes of a depreciable asset including a partial disposition and has taken the basis into account in determining gain or loss, then the costs of removing the asset or component are not required to be capitalized. • If a taxpayer disposes of a component of a unit of property and the disposal is not treated as a disposition on which gain or loss is realized, then the taxpayer must deduct or capitalize the costs of removing the component based on whether the removal costs directly benefit or are incurred by reason of a repair or improvement of the unit of property.

18. Applicability to IIR • Removal cost with respect to any replacement determined to be a repair are deducted. • Removal cost with respect to any replacement of an asset on which gain or loss is recognized (a capital replacement) are deducted. • Example – Assume a 20’ length of pipe is the asset. Any amount of pipe replaced in system results in a deduction for removal costs.

19. QUESTIONS? Alex Zakupowsky Miller & Chevalier 655 15th Street, N.W. Washington, D.C. 20005 202-626-5950 azakupowsky@milchev.com

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