When the IRS issued the final regulations that took effect in 2014 for determining if amounts expended are to improve tangible property under Reg. §1.263(a)‑3, one of the key issues is whether there has been a replacement of a major component or substantial structural part of an asset [Reg. §1.263(a)‑3(k)(6)]. The IRS specifically rejected provided any sort of “percentage” test to be used to make such a determination.
However, in the Large Business and International Division’s memorandum LB&I‑04‑0315‑002 we discover that it’s not only practitioners that like numeric guidance. This guidance is meant to give guidance to agents examining taxpayers who generate steam or electric power and are changing to a method of accounting for steam or electric generation property under Rev. Proc. 2013‑24.
Of interest is the fact that one of the issues involved in that procedure and its accounting method is determining when there has be a replacement of a major component or substantial structural part of an asset. While not directly interpreting the general regulation, this method of accounting does make use of those general rules in its application.
In the memorandum, the division directs agents not to challenge a taxpayer’s position on whether a major component has been replaced if the taxpayer uses a an 80% cut-off. That is, if 80% of that component (or unit of property if the item has no major components) is replaced, then the component (or unit) has been replaced and generally would have to be capitalized under Reg. §1.263(a)‑3(k).
The memorandum does point out that even if there is not a replacement of a major component, capitalization may still be required under other provisions of Reg. §1.263(a)‑3(k). And, as was noted, this technically applies only to the narrow issue for one industry applying one particular Revenue Procedure.
But it is one of the first indications we have of the IRS’s actual “real world” working view of just what represents a replacement of “substantially all” of a major component or asset for purposes of applying the post-2014 tangible property regulations. At the very least an adviser may refer an agent who is wanting to treat a replacement of a much smaller portion of a component as triggering capitalization under the “major component” or “substantial structural part” of an asset provisions of Reg. §1.263(a)‑3(k)(6).
While this would not mean the item would not need to be capitalized (for instance, if expenditure increased capacity of the asset capitalization would still be required), it does get away from what is an automatic capitalization under the “major component/substantial part” provisions and moves the discussion to items that are more open to interpretation (and thus not as easy for the IRS to prevail upon if the matter moves forward).