Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.250(b)-5   Foreign-derived deduction eligible income (FDDEI) services.
(a) Scope. This section provides rules for determining whether a provision of a service is a FDDEI service. Paragraph (b) of this section defines a FDDEI service. Paragraph (c) of this section provides definitions relevant for determining whether a provision of a service is a FDDEI service. Paragraph (d) of this section provides rules for determining whether a general service is provided to a consumer located outside the United States. Paragraph (e) of this section provides rules for determining whether a general service is provided to a business recipient located outside the United States. Paragraph (f) of this section provides rules for determining whether a proximate service is provided to a recipient located outside the United States. Paragraph (g) of this section provides rules for determining whether a service is provided with respect to property located outside the United States. Paragraph (h) of this section provides rules for determining whether a transportation service is provided to a recipient, or with respect to property, located outside the United States.
(b) Definition of FDDEI service. Except as provided in § 1.250(b)-6(d), the term FDDEI service means a provision of a service described in any one of paragraphs (b)(1) through (5) of this section. If only a portion of a service is treated as provided to a person, or with respect to property, outside the United States, the provision of the service is a FDDEI service only to the extent of the gross income derived with respect to such portion.
(1) The provision of a general service to a consumer located outside the United States (as determined under paragraph (d) of this section).
(2) The provision of a general service to a business recipient located outside the United States (as determined under paragraph (e) of this section).
(3) The provision of a proximate service to a recipient located outside the United States (as determined under paragraph (f) of this section).
(4) The provision of a property service with respect to tangible property located outside the United States (as determined under paragraph (g) of this section).
(5) The provision of a transportation service to a recipient, or with respect to property, located outside the United States (as determined under paragraph (h) of this section).
(c) Definitions. This paragraph (c) provides definitions that apply for purposes of this section and § 1.250(b)-6.
(1) Advertising service. The term advertising service means a general service that consists primarily of transmitting or displaying content (including via the internet) with a purpose to generate revenue based on the promotion of a product or service.
(2) Benefit. The term benefit has the meaning set forth in § 1.482-9(l)(3).
(3) Business recipient. The term business recipient means a recipient other than a consumer and includes all related parties of the recipient. However, if the recipient is a related party of the taxpayer, the term does not include the taxpayer.
(4) Consumer. The term consumer means a recipient that is an individual that purchases a general service for personal use.
(5) Electronically supplied service. The term electronically supplied service means, with respect to a general service other than an advertising service, a service that is delivered primarily over the internet or an electronic network and for which value of the service to the end user is derived primarily from automation or electronic delivery. Electronically supplied services include the provision of access to digital content (as defined in § 1.250(b)-3), such as streaming content; on-demand network access to computing resources, such as networks, servers, storage, and software; the provision or support of a business or personal presence on a network, such as a website or a web page; online intermediation platform services; services automatically generated from a computer via the internet or other network in response to data input by the recipient; and similar services. Electronically supplied services do not include services that primarily involve the application of human effort by the renderer (not considering the human effort involved in the development or maintenance of the technology enabling the electronically supplied services). Accordingly, electronically supplied services do not include certain services (such as legal, accounting, medical, or teaching services) involving primarily human effort that are provided electronically.
(6) General service. The term general service means any service other than a property service, proximate service, or transportation service. The term general service includes advertising services and electronically supplied services.
(7) Property service. The term property service means a service, other than a transportation service, provided with respect to tangible property, but only if substantially all of the service is performed at the location of the property and results in physical manipulation of the property such as through manufacturing, assembly, maintenance, or repair. Substantially all of a service is performed at the location of property only if the renderer spends more than 80 percent of the time providing the service at or near the location of the property.
(8) Proximate service. The term proximate service means a service, other than a property service or a transportation service, provided to a consumer or business recipient, but only if substantially all of the service is performed in the physical presence of the consumer or, in the case of a business recipient, substantially all of the service is performed in the physical presence of persons working for the business recipient such as employees, contractors, or agents. Substantially all of a service is performed in the physical presence of a consumer or persons working for a business recipient only if the renderer spends more than 80 percent of the time providing the service in the physical presence of such persons.
(9) Transportation service. The term transportation service means a service to transport a person or property using aircraft, railroad rolling stock, vessel, motor vehicle, or any other mode of transportation. Transportation services include freight forwarding and similar services.
(d) General services provided to consumers —(1) In general. A general service is provided to a consumer located outside the United States if the consumer of a general service resides outside of the United States when the service is provided. Except as provided in paragraph (d)(2) of this section, if the renderer does not have or cannot after reasonable efforts obtain the consumer's location of residence when the service is provided, the consumer of a general service is treated as residing at the location of the consumer's billing address. However, the rule in the preceding sentence allowing for the use of a consumer's billing address does not apply if the renderer knows or has reason to know that the consumer does not reside outside the United States. A renderer has reason to know that the consumer does not reside outside the United States if the information received as part of the provision of the service indicates that the consumer resides in the United States and the renderer fails to obtain evidence establishing that the consumer resides outside the United States.
(2) Electronically supplied services. The consumer of an electronically supplied service is deemed to reside at the location of the device used to receive the service. Such location may be determined based on the location of the IP address when the electronically supplied service is provided. However, if the renderer does not have or cannot after reasonable efforts obtain the consumer's device location, then the location of the device is treated as being outside the United States if the renderer's billing address for the consumer is outside of the United States, subject to the knowledge and reason to know standards described in paragraph (d)(1) of this section.
(3) Example. The following example illustrates the application of paragraph (d) of this section.
(i) Facts. DC, a domestic corporation, provides a streaming movie service on its website. The terms of the service allow consumers to watch movies over the internet. The terms of the service permit the consumer to view the movies for personal use, but convey no ownership of movies to the consumers.
(ii) Analysis. The streaming service is a FDDEI service under paragraph (d)(1) of this section to the extent that the service is provided to consumers that reside outside the United States. The service that DC provides is a general service, provided to consumers that is an electronically supplied service under paragraph (c)(5) of this section. Therefore, the consumers are deemed to reside at the location of the devices used to receive the service under paragraph (d)(2) of this section. However, if the renderer cannot reasonably obtain the consumers' device location (such as IP addresses), the device location is treated as being outside the United States if their billing addresses are outside the United States. See § 1.250(b)-4(d)(1)(v)(B)( 7 ) for an example of digital content provided to consumers as a sale rather than a service.
(e) General services provided to business recipients —(1) In general. A general service is provided to a business recipient located outside the United States to the extent that the service confers a benefit on the business recipient's operations outside the United States under the rules in paragraph (e)(2) of this section. The location of residence, incorporation, or formation of a business recipient is not relevant to determining the location of the business recipient's operations that benefit from a general service.
(2) Determination of business operations that benefit from the service —(i) In general. Except as otherwise provided in paragraph (e)(2)(ii) and (iii) of this section, the determination of which operations of the business recipient located outside the United States benefit from a general service, and the extent to which such operations benefit, is made under the principles of § 1.482-9 by treating the taxpayer as one controlled taxpayer, the portions of the business recipient's operations within the United States (if any) that may benefit from the general service as one or more controlled taxpayers, and the portions of the business recipient's operations outside the United States (if any) that may benefit from the general service, each as one or more controlled taxpayers. The extent to which a business recipient's operations within or outside of the United States are treated as one or more separate controlled taxpayers is determined under any reasonable method (for example, separate controlled taxpayers may be determined on a per entity or per country basis, or by aggregating all of the business recipient's operations outside the United States as one controlled taxpayer). The determination of the amount of the benefit conferred on the business recipient's operations that are treated as controlled taxpayers is determined under a reasonable method consistent with the principles of § 1.482-9(k), treating the renderer's gross income from the services provided to the business recipient as if it were a “cost” as that term is used in § 1.482-9(k). Reasonable methods may include, for example, allocations based on time spent or costs incurred by the renderer or sales, profits, or assets of the business recipient. The determination is made when the service is provided based on information obtained from the business recipient or on the renderer's own records (such as time spent working with the business recipient's offices located outside the United States).
(ii) Advertising services. With respect to advertising services, the operations of the business recipient that benefit from the advertising service provided by the renderer are deemed to be located where the advertisements are viewed by individuals. If advertising services are displayed via the internet, the advertising services are viewed at the location of the device on which the advertisements are viewed. For this purpose, the IP address may be used to establish the location of a device on which an advertisement is viewed.
(iii) Electronically supplied services. With respect to an electronically supplied service, the operations of the business recipient that benefit from that service provided by the renderer are deemed to be located where the business recipient (including employees, contractors, or agents) accesses or otherwise uses the service. If it cannot be determined whether the location is within or outside the United States (such as where the location of access cannot be reliably determined using the location of the IP address of the device used to receive the service), and the gross receipts from all services with respect to the business recipient are in the aggregate less than $50,000 for the renderer's taxable year, the operations of the business recipient that benefit from the service provided by the renderer are deemed to be located at the recipient's billing address; otherwise, the operations of the business recipient that benefit are deemed to be located in the United States. If the renderer provides a service that is partially an electronically supplied service and partially a general service that is not an electronically supplied service (such as a service that is performed partially online and partially by mail or in person), the location of the business recipient is determined using the rule for electronically supplied services in this paragraph (e)(2)(iii) if the primary purpose of the service is to provide electronically supplied services; otherwise, the rule for general services described in paragraph (e)(2)(i) of this section applies.
(3) Identification of business recipient's operations —(i) In general. For purposes of this paragraph (e), except with respect to advertising services and electronically supplied services, a business recipient is treated as having operations where it maintains an office or other fixed place of business. In general, an office or other fixed place of business is a fixed facility, that is, a place, site, structure, or other similar facility, through which the business recipient engages in a trade or business. For purposes of making the determination in this paragraph (e)(3)(i), the renderer may make reliable assumptions based on the information available to it.
(ii) Advertising services and electronically supplied services. The location of a business recipient that receives advertising services or electronically supplied services will be determined under the rules of paragraph (e)(2)(ii) and (iii) of this section, respectively, even if the business recipient does not maintain an office or other fixed place of business in the locations where the advertisements are viewed (in the case of advertising services) or where the general service is accessed (in the case of electronically supplied services).
(iii) No office or fixed place of business. In the case of general services other than advertising services and other than electronically supplied services, if the business recipient does not have an identifiable office or fixed place of business (including the office of a principal manager or managing owner), the business recipient is deemed to be located at its primary billing address.
(4) Substantiation of the location of a business recipient's operations outside the United States. Except as provided in § 1.250(b)-3(f)(3) (relating to certain loss transactions), a general service provided to a business recipient is treated as a FDDEI service only if the renderer substantiates its determination of the extent to which the service benefits a business recipient's operations outside the United States. A renderer satisfies the preceding sentence if the renderer maintains one or more of the following items—
(i) Credible evidence obtained or created in the ordinary course of business from the business recipient establishing the extent to which operations of the business recipient outside the United States benefit from the service; or
(ii) A written statement prepared by the renderer containing the information described in paragraphs (e)(4)(ii)(A) through (F) of this section corroborated by evidence that is credible and sufficient to support the information provided.
(A) The name of the business recipient;
(B) The date or dates of the service;
(C) The amount of gross income from the service;
(D) A full description of the service;
(E) A description of how the service will benefit the business recipient; and
(F) An explanation of how the renderer determined what portion of the service will benefit the business recipient's operations located outside the United States.
(5) Examples. The following examples illustrate the application of this paragraph (e).
(i) Assumed facts. The following facts are assumed for purposes of the examples—
(A) DC is a domestic corporation.
(B) A and R are not related parties of DC.
(C) Except as otherwise provided, the substantiation requirements described in paragraph (e)(4) of this section are satisfied.
(ii) Examples —
(A) Example 1: Determination of business operations that benefit from the service —( 1 ) Facts. For the taxable year, DC provides a consulting service to R, a company that operates restaurants within and outside of the United States, in exchange for $150x. Fifty percent of the sales earned by R and its related parties are from customers located outside of the United States. However, the consulting service that DC provides relates specifically to a single chain of fast food restaurants that R operates. Sales information that R provides to DC indicates that 70 percent of the sales of the fast food restaurant chain are from locations within the United States and 30 percent of the sales are from Country X. DC determines that the use of sales is a reasonable method under the principles of § 1.482-9(k) to allocate the benefit of the consulting service among R's fast food operations.
( 2 ) Analysis. Under paragraph (e)(1) of this section, DC's service is provided to a person located outside the United States to the extent that DC's service confers a benefit to R's operations outside the United States. Under paragraph (e)(2)(i) of this section, DC, R's fast food operations within the United States, and R's fast food operations in Country X, are treated as if they were controlled taxpayers because only these operations may benefit from DC's service. The principles of § 1.482-9(k) apply to determine the amount of DC's service that benefits R's operations outside the United States. DC's gross income is allocated based on the sales of the fast food chain of restaurants that benefits from DC's service because using sales is a reasonable method. Therefore, 30 percent of the provision of the consulting service is treated as the provision of a service to a person located outside the United States and a FDDEI service under paragraph (b)(2) of this section. Accordingly, $45x ($150x × 0.30) of DC's gross income from the provision of the consulting service is included in DC's gross FDDEI for the taxable year.
(B) Example 2: Determination of business operations that benefit from the service; alternative facts —( 1 ) Facts. The facts are the same as in paragraph (e)(5)(ii)(A)( 1 ) of this section (the facts in Example 1 ), except that DC provides an information technology service to R that benefits R's entire business. DC determines that the use of sales is a reasonable method under the principles of § 1.482-9(k) to allocate the benefit of the information technology service among R's entire business.
( 2 ) Analysis. DC, R's operations within the United States, and R's operations in Country X, are treated as if they were controlled taxpayers because the service that DC provides relates to R's entire business. DC's gross income is allocated based on sales of the entire business because using sales is a reasonable method to determine the amount of DC's service that benefits R's operations outside the United States under the principles of § 1.482-9(k). Therefore, 50 percent of the provision of the information technology service is treated as a service to a person located outside the United States and a FDDEI service under paragraph (b)(2) of this section. Accordingly, $75x ($150x × 0.50) of DC's gross income from the provision of the information technology service is included in DC's gross FDDEI for the taxable year.
(C) Example 3: Advertising services —( 1 ) Facts. The facts are the same as in paragraph (e)(5)(ii)(A)( 1 ) of this section (the facts in Example 1 ), except that DC provides an advertising service to R. DC displays advertisements for R's restaurant chain on its social media website and smartphone application. Based on the IP addresses of the devices on which the advertisements are viewed, 20 percent of the views of the advertisements were from devices located outside the United States.
( 2 ) Analysis. Because the service that DC provides is an advertising service, under paragraph (e)(2)(i) of this section, as modified by paragraph (e)(2)(ii) of this section, R's operations that benefit from DC's advertising service are deemed to be where the advertisements are viewed. Therefore, 20 percent of the provision of the advertising service is treated as a service to a person located outside the United States and a FDDEI service under paragraph (b)(2) of this section. Accordingly, $30x ($150x × 0.20) of DC's gross income from the provision of the advertising service is included in DC's gross FDDEI for the taxable year.
(D) Example 4: No reliable information about which operations benefit from the service or publicly available information —( 1 ) Facts. For the taxable year, DC provides a consulting service to R, a business-facing company that does not advertise its business. All of DC's interaction with R is through R's employees that report to an office in the United States. Statements made by R's employees indicate that the service will benefit R's business operations located within and outside the United States, but do not provide information that would allow DC to reliably determine the extent to which its service will confer a benefit on R's business operations located outside the United States.
( 2 ) Analysis. DC is unable to determine the extent to which its service will confer a benefit on R's business operations located outside the United States under paragraph (e)(2)(i) of this section. Accordingly, DC cannot substantiate a determination of the extent to which the service benefits a business recipient's operations outside the United States under paragraph (e)(4) of this section. Therefore, no portion of DC's service is a FDDEI service.
(E) Example 5: Electronically supplied services that are accessed by the business recipient's employees —( 1 ) Facts. DC provides payroll services for R. As part of this service, DC maintains a website through which R can enter payroll information for its employees and through which R's employees can enter and change their personal information. DC also causes R's employees' paychecks to be directly deposited into their bank accounts and pays R's employment taxes on R's behalf. The primary purpose of the service is to pay R's employees. R has 100 user accounts that access DC's website. Sixty of the user accounts that access DC's website access the website from devices that are located outside the United States and forty of the user accounts access the website from devices that are located inside the United States.
( 2 ) Analysis. Under paragraph (e)(1) of this section, DC's service is provided to a person located outside the United States to the extent that DC's service confers a benefit to R's operations outside the United States. The service that DC provides to R is an electronically supplied service under paragraph (c)(5) of this section. Accordingly, under paragraph (e)(2)(i) of this section, as modified by paragraph (e)(2)(iii) of this section, R's operations that benefit from DC's services are deemed to be located where R accesses the service, which is where R's employees access the website. See paragraph (e)(2)(iii) of this section. Accordingly, the portion of the payroll service that is treated as a service to a person located outside the United States and a FDDEI service under paragraph (b)(2) of this section is determined based on the extent to which the locations where R accesses the website are located outside the United States. Because 60 percent (60/100) of user accounts access DC's website from locations outside the United States, 60 percent of the provision of the payroll service is treated as a service to a person located outside the United States and a FDDEI service under paragraph (b)(2) of this section.
(F) Example 6: Electronically supplied services that are accessed by the business recipient's customers — ( 1 ) Facts. DC maintains an inventory management website for R, a company that sells consumer goods online. R's offices and all of its employees, who use the website, are located in the United States, but R sells its products to customers both within and outside the United States.
( 2 ) Analysis. Under paragraph (e)(1) of this section, DC's service is provided to a person located outside the United States to the extent that DC's service confers a benefit to R's operations outside the United States. The service that DC provides to R is an electronically supplied service under paragraph (c)(5) of this section. Accordingly, under paragraph (e)(2)(i) of this section, as modified by paragraph (e)(2)(iii) of this section, R's operations that benefit from DC's services are deemed to be located where the service is accessed by employees. Therefore, none of the provision of the inventory management website is treated as a service to a person located outside the United States and none is a FDDEI service under paragraph (b)(2) of this section.
(G) Example 7: Service provided to a domestic person —( 1 ) Facts. A, a domestic corporation that operates solely in the United States, enters into a services agreement with R, a company that operates solely outside the United States. Under the agreement, A agrees to perform a consulting service for R. A hires DC to provide a service to A that A will use in the provision of a consulting service to R.
( 2 ) Analysis. Because DC provides a service to A, a person located within the United States, DC's provision of the service to A is not a FDDEI service under paragraph (b)(2) of this section, even though the service is used by A in providing a service to R, a person located outside the United States. See also section 250(b)(5)(B)(ii). However, A's provision of the consulting service to R may be a FDDEI service, in which case A's gross income from the provision of such service would be included in A's gross FDDEI.
(f) Proximate services. A proximate service is provided to a recipient located outside the United States if the proximate service is performed outside the United States. In the case of a proximate service performed partly within the United States and partly outside of the United States, a proportionate amount of the service is treated as provided to a recipient located outside the United States corresponding to the portion of time the renderer spends providing the service outside of the United States.
(g) Property services —(1) In general. Except as provided in paragraph (g)(2) of this section, a property service is provided with respect to tangible property located outside the United States only if the property is located outside the United States for the duration of the period the service is performed.
(2) Exception for services provided with respect to property temporarily in the United States. A property service is deemed to be provided with respect to tangible property located outside the United States if the following conditions are satisfied—
(i) The property is temporarily in the United States for the purpose of receiving the property service;
(ii) After the completion of the service, the property will be primarily hangared, stored, or used outside the United States;
(iii) The property is not used to generate revenue in the United States at any point during the duration of the service; and
(iv) The property is owned by a foreign person that resides or primarily operates outside the United States.
(h) Transportation services. Except as provided in this paragraph (h), a transportation service is provided to a recipient, or with respect to property, located outside the United States only if both the origin and the destination of the service are outside of the United States. However, in the case of a transportation service provided to a recipient, or with respect to property, where either the origin or the destination of the service is outside of the United States, but not both, then 50 percent of the gross income from the transportation service is considered derived from services provided to a recipient, or with respect to property, located outside the United States.
§ 1.250(b)-6   Related party transactions.
(a) Scope. This section provides rules for determining whether a sale of property or a provision of a service to a related party is a FDDEI transaction. Paragraph (b) of this section provides definitions relevant for determining whether a sale of property or a provision of a service to a related party is a FDDEI transaction. Paragraph (c) of this section provides rules for determining whether a sale of general property to a foreign related party is a FDDEI sale. Paragraph (d) of this section provides rules for determining whether the provision of a general service to a business recipient that is a related party is a FDDEI service.
(b) Definitions. This paragraph (b) provides definitions that apply for purposes of this section.
(1) Related party sale. The term related party sale means a sale of general property to a foreign related party. See § 1.250(b)-1(e)(3)(ii)(D) ( Example 4 ) for an illustration of a related party sale in the case of a seller that is a partnership.
(2) Related party service. The term related party service means a provision of a general service to a business recipient that is a related party of the renderer and that is described in § 1.250(b)-5(b)(2) without regard to paragraph (d) of this section.
(3) Unrelated party transaction. The term unrelated party transaction means, with respect to property purchased by a foreign related party (the “purchased property”) in a related party sale from a seller—
(i) A sale of the purchased property by the foreign related party in the ordinary course of its business to a foreign unrelated party with respect to the seller;
(ii) A sale of property by the foreign related party to a foreign unrelated party with respect to the seller, if the purchased property is a constituent part of the property sold to the foreign unrelated party;
(iii) A sale of property by the foreign related party to a foreign unrelated party with respect to the seller, if the purchased property is not a constituent part of the product sold to the foreign unrelated party but rather is used in connection with producing the property sold to the foreign unrelated party; or
(iv) A provision of a service by the foreign related party to a foreign unrelated party with respect to the seller, if the purchased property was used in connection with the provision of the service.
(c) Related party sales —(1) In general. A related party sale of general property is a FDDEI sale only if the requirements described in either paragraph (c)(1)(i) or (ii) of this section are satisfied with respect to the related party sale. This paragraph (c) does not apply in determining whether a sale of intangible property to a foreign related party is a FDDEI sale.
(i) Sale of property in an unrelated party transaction. A related party sale is a FDDEI sale if an unrelated party transaction described in paragraph (b)(3)(i) or (ii) of this section occurs with respect to the property purchased in the related party sale and such unrelated party transaction is described in § 1.250(b)-4(b) (definition of FDDEI sale). The seller in the related party sale may establish that an unrelated party transaction will occur with respect to the property, or what portion of the property will be sold in an unrelated party transaction in the case of sale of a fungible mass of general property, based on contractual terms (including, for example, that the related party is contractually bound to only sell the product to foreign unrelated parties), past practices of the foreign related party (such as practices to only sell products to foreign unrelated parties), a showing that the product sold is designed specifically for a foreign market, or books and records otherwise evidencing that sales will be made to foreign unrelated parties.
(ii) Use of property in an unrelated party transaction. A related party sale is a FDDEI sale if one or more unrelated party transactions described in paragraph (b)(3)(iii) or (iv) of this section occurs with respect to the property purchased in the related party sale and such unrelated party transaction or transactions would be described in § 1.250(b)-4(b) or § 1.250(b)-5(b) (definition of FDDEI service). If the property purchased in the related party sale will be used in unrelated party transactions described in the preceding sentence and other transactions, the amount of gross income from the related party sale that is attributable to a FDDEI sale is equal to the gross income from the related party sale multiplied by a fraction, the numerator of which is the revenue that the related party reasonably expects (as of the FDII filing date) to earn from all unrelated party transactions with respect to the property purchased in the related party sale that would be described in § 1.250(b)-4(b) or § 1.250(b)-5(b) and the denominator of which is the total revenue that the related party reasonably expects (as of the FDII filing date) to earn from all transactions with respect to the property purchased in the related party sale.
(2) Treatment of foreign related party as seller or renderer. For purposes of determining whether a sale of property or provision of a service by a foreign related party is, or would be, described in § 1.250(b)-4(b) or § 1.250(b)-5(b), the foreign related party that sells the property or provides the service is treated as a seller or renderer, as applicable, and the foreign unrelated party is treated as the recipient.
(3) Transactions between related parties. For purposes of determining whether an unrelated party sale has occurred and satisfies the requirements of paragraphs (c)(1) or (2) of this section with respect to a sale to a foreign related party (and not for purposes of determining whether a sale is to a foreign person as required by § 1.250(b)-4(b)), the seller and all related parties of the seller are treated as if they are part of a single foreign related party. For purposes of the preceding sentence, in determining whether a United States person is a member of the seller's modified affiliated group, and therefore a related party of the seller, the definition of the term modified affiliated group in § 1.250(b)-1(c)(17) applies without the substitution of “more than 50 percent” for “at least 80 percent” each place it appears. Accordingly, if a foreign related party sells or uses property purchased in a related party sale in a transaction with a second related party of the seller, transactions between the second related party and an unrelated party may be treated as an unrelated party transaction for purposes of applying paragraph (c)(1) of this section to a related party sale.
(4) Example. The following example illustrates the application of this paragraph (c).
(i) Facts. DC, a domestic corporation, sells a machine to FC, a foreign related party of DC in a transaction described in § 1.250(b)-4(b) (without regard to this paragraph (c)). FC uses the machine solely to manufacture product A. As of the FDII filing date for the taxable year, 75 percent of future revenue from sales by FC to unrelated parties of product A will be from sales that would be described in § 1.250(b)-4(b).
(ii) Analysis. The sale by DC to FC is a related party sale. Because FC uses the machine to make product A, but the machine is not a constituent part of product A because FC does not undertake further manufacturing with respect to the machine itself, FC's sale of product A is an unrelated party transaction described in paragraph (b)(3)(iii) of this section. Therefore, DC's sale of the machine is only a FDDEI sale if the requirements of paragraph (c)(1)(ii) of this section are satisfied. Because 75 percent of the revenue from future sales of product A will be from unrelated party transactions that would be described in § 1.250(b)-4(b), 75 percent of the revenues from DC's sale of the machine to FC constitute FDDEI sales.
(d) Related party services —(1) In general. Except as provided in this paragraph (d)(1), a related party service is a FDDEI service only if the related party service is not substantially similar to a service that has been provided or will be provided by the related party to a person located within the United States. However, if a related party service is substantially similar to a service provided (in whole or in part) by the related party to a person located in the United States solely by reason of paragraph (d)(2)(ii) of this section, the amount of gross income from the related party service attributable to a FDDEI service is equal to the difference between the gross income from the related party service and the amount of the price paid by persons located within the United States that is attributable to the related party service. Section 250(b)(5)(C)(ii) and this paragraph (d)(1) apply only to a general service provided to a related party that is a business recipient and are not applicable with respect to any other service provided to a related party.
(2) Substantially similar services. A related party service is substantially similar to a service provided by the related party to a person located within the United States only if the related party service is used by the related party in whole or part to provide a service to a person located within the United States and either—
(i) 60 percent or more of the benefits conferred by the related party service are directly used by the related party to confer benefits on consumers or business recipients located within the United States; or
(ii) 60 percent or more of the price paid by consumers or business recipients located within the United States for the service provided by the related party is attributable to the related party service.
(3) Special rules. For purposes of paragraph (d) of this section, the rules in paragraphs (d)(3)(i) and (ii) of this section apply.
(i) Rules for determining the location of and price paid by recipients of a service provided by a related party. The location of a consumer or business recipient with respect to services provided by the related party is determined under § 1.250(b)-5(d) and (e)(2), respectively, but treating the related party as the renderer. Accordingly, if the related party provides a service to a business recipient, the related party is treated as conferring benefits on a person located within the United States to the extent that the service confers a benefit on the business recipient's operations located within the United States. Similarly, for purposes of applying paragraph (d)(2)(ii) of this section with respect to business recipients, the price paid by a business recipient to the related party for services is allocated proportionally based on the locations of the business recipient that benefit from the services provided by the related party.
(ii) Rules for allocating the benefits provided by and price paid to the renderer of a related party service. For purposes of applying paragraph (d)(2)(i) of this section with respect to benefits that are directly used by the related party to confer benefits on its recipients, the benefits provided by the renderer to the related party are allocated to the related party's consumers or business recipients within the United States based on the proportion of benefits conferred by the related party on consumers or business recipients located within the United States. For purposes of determining the amount of the price paid by persons located within the United States that is attributable to the related party service in applying paragraph (d)(2)(ii) of this section, if the related party provides services that confer benefits on persons located within the United States and outside the United States, the price paid for the related party service by the related party to the renderer is allocated proportionally based on the benefits conferred on each location by the related party to its recipients.
(4) Examples. The following examples illustrate the application of this paragraph (d).
(i) Assumed facts. The following facts are assumed for purposes of the examples—
(A) DC is a domestic corporation.
(B) FC is a foreign corporation and a foreign related party of DC that operates solely outside the United States.
(C) The service DC provides to FC is a general service provided to a business recipient located outside the United States as described in § 1.250(b)-5(b)(2) without regard to the application of paragraph (d) of this section.
(D) The benefits conferred by DC's service to FC's customers are not indirect or remote within the meaning of § 1.482-9(l)(3)(ii).
(ii) Examples —
(A) Example 1: Services that are substantially similar services under paragraph (d)(2)(i) of this section —( 1 ) Facts. FC enters into a services agreement with R, a company that operates restaurant chains within and outside the United States. Under the agreement, FC agrees to furnish a design for the renovation of a chain of restaurants that R owns; the design will include architectural plans. FC hires DC to provide an architectural service to FC that FC will use in the provision of its design service to R. The architectural service that DC provides to FC will serve no other purpose than to enable FC to provide its service to R. The service that FC provides will benefit only R's operations within the United States. FC pays an arm's length price of $50x to DC for the architectural service and DC recognizes $50x of gross income from the service. FC incurs additional costs to add additional design elements to the plans and charges R a total of $100x for its service.
( 2 ) Analysis. All of the service that DC provides to FC is directly used in the provision of a service to R because FC uses DC's architectural service to provide its design service to R, and the architectural service that DC provides to FC will serve no purpose other than to enable FC to provide its service to R. In addition, FC is treated as conferring benefits only to persons located within the United States under paragraph (d)(3)(i) of this section because only R's operations within the United States benefit from the service provided by FC that used the service provided by DC. Therefore, the service provided by DC to FC is substantially similar to the service provided by FC to R under paragraph (d)(2)(i) of this section. Accordingly, DC's provision of the architectural service to FC is not a FDDEI service under paragraph (d)(1) of this section, and DC's gross income from the architectural service ($50x) is not included in its gross FDDEI.
(B) Example 2: Services that are not substantially similar services under paragraph (d)(2)(i) of this section —( 1 ) Facts. The facts are the same as paragraph (d)(4)(ii)(A)( 1 ) of this section (the facts in Example 1 ), except that 90 percent of R's operations that will benefit from FC's service are located outside the United States.
( 2 ) Analysis —( i ) Analysis under paragraph (d)(2)(i) of this section. All of the service that DC provides to FC is directly used in the provision of a service to R. However, because 90 percent of R's operations that will benefit from FC's service are located outside the United States under paragraph (d)(3)(i) of this section, only 10 percent of the benefits of FC's service are conferred on persons located within the United States. 

Further, because FC's service confers a benefit on R's operations located within and outside the United States, the benefit provided by DC to FC is allocated proportionately based on the locations of R that benefit from the services provided by FC under paragraph (d)(3)(ii) of this section. Therefore, only 10 percent of DC's architectural service are directly used by FC to confer benefits on persons located within the United States under paragraph (d)(3)(ii) of this section. Therefore, the architectural service provided by DC to FC is not substantially similar to the design service provided by FC to persons located within the United States under paragraph (d)(2)(i) of this section.
(C) Example 3: Services that are substantially similar services under paragraph (d)(2)(ii) of this section —( 1 ) Facts. The facts are the same as paragraph (d)(4)(ii)(B)( 1 ) of this section (the facts in Example 2 ), except that FC pays an arm's length price of $75x to DC for the architectural service and DC recognizes $75x of gross income from the service. As in paragraph (d)(4)(ii)(A)( 1 ) and (d)(4)(ii)(B)( 1 ) of this section (the facts in Example 1 and Example 2 ), FC charges R a total of $100x for its service.
( 2 ) Analysis —( i ) Price paid by persons located within the United States. Under paragraph (d)(3)(i) of this section, FC is treated as conferring benefits on a person located within the United States to the extent that R's operations that will benefit from FC's service are located within the United States. Further, because FC's service confers a benefit on R's operations located within and outside the United States, the price paid by R to FC ($100x) is allocated proportionately based on the locations of R that benefit from the services provided by FC under paragraph (d)(3)(i) of this section. Accordingly, because 10 percent of R's operations that will benefit from FC's services are located within the United States, persons located within the United States are treated as paying $10x ($100x × 0.10) for FC's services for purposes of applying the test in paragraph (d)(2)(ii) of this section.
( ii ) Amount attributable to the related party service. The service that FC provides to R is attributable in part to DC's service because FC uses the architectural plans that DC provides to provide a service to R. Under paragraph (d)(3)(ii) of this section, because the benefits of the service provided by FC are conferred on persons located within the United States and outside the United States, a proportionate amount (10 percent) of the price paid to DC for the related party service ($75x), or $7.5x, is treated as attributable to the services provided to persons located within the United States.
( iii ) Application of test in paragraph (d)(2)(ii) of this section. For purposes of applying the test described in paragraph (d)(2)(ii) of this section, the price paid by persons located within the United States for the service provided by the related party (FC) is $10x, as determined in paragraph (d)(4)(ii)(C)( 2 )( i ) of this section (the analysis of this Example 3 ). The amount of the price that is attributable to DC's service is $7.5x, as determined in paragraph (d)(4)(ii)(C)( 2 )( ii ) of this section (the analysis of this Example 3 ). Accordingly, of the price treated as paid to FC by persons located within the United States, 75 percent ($7.5x/$10x) is attributable to the related party service. Because more than 60 percent of the price treated as paid by persons within the United States for FC's service is attributable to DC's service, the service provided by DC to FC is substantially similar to the design service provided by FC to persons located within the United States under paragraph (d)(2)(ii) of this section.
( iv ) Conclusion. Under paragraph (d)(1) of this section, because the related party service provided by DC is substantially similar to the service provided by FC to a person located in the United States solely by reason of paragraph (d)(2)(ii) of this section, the difference between DC's gross income from the related party service and the amount of the price paid by persons located within the United States that is attributable to the related party service is treated as a FDDEI service. Accordingly, $67.5x ($75x—$7.5x) of DC's gross income from the provision of the service to FC is treated as a FDDEI service.
§ 1.261-1   General rule for disallowance of deductions.
In computing taxable income, no deduction shall be allowed, except as otherwise expressly provided in Chapter 1 of the Code, in respect of any of the items specified in Part IX (section 262 and following), Subchapter B, Chapter 1 of the Code, and the regulations thereunder.
§ 1.262-1   Personal, living, and family expenses.
(a) In general. In computing taxable income, no deduction shall be allowed, except as otherwise expressly provided in chapter 1 of the Code, for personal, living, and family expenses.
(b) Examples of personal, living, and family expenses. Personal, living, and family expenses are illustrated in the following examples:
(1) Premiums paid for life insurance by the insured are not deductible. See also section 264 and the regulations thereunder.
(2) The cost of insuring a dwelling owned and occupied by the taxpayer as a personal residence is not deductible.
(3) Expenses of maintaining a household, including amounts paid for rent, water, utilities, domestic service, and the like, are not deductible. A taxpayer who rents a property for residential purposes, but incidentally conducts business there (his place of business being elsewhere) shall not deduct any part of the rent. If, however, he uses part of the house as his place of business, such portion of the rent and other similar expenses as is properly attributable to such place of business is deductible as a business expense.
(4) Losses sustained by the taxpayer upon the sale or other disposition of property held for personal, living, and family purposes are not deductible. But see section 165 and the regulations thereunder for deduction of losses sustained to such property by reason of casualty, etc.
(5) Expenses incurred in traveling away from home (which include transportation expenses, meals, and lodging) and any other transportation expenses are not deductible unless they qualify as expenses deductible under section 162 (relating to trade or business expenses), section 170 (relating to charitable contributions), section 212 (relating to expenses for production of income), section 213 (relating to medical expenses), or section 217 (relating to moving expenses), and the regulations under those sections. The taxpayer's costs of commuting to his place of business or employment are personal expenses and do not qualify as deductible expenses. For expenses paid or incurred before October 1, 2014, a taxpayer's expenses for lodging when not traveling away from home (local lodging) are nondeductible personal expenses. However, taxpayers may deduct local lodging expenses that qualify under section 162 and are paid or incurred in taxable years for which the period of limitation on credit or refund under section 6511 has not expired. For expenses paid or incurred on or after October 1, 2014, a taxpayer's local lodging expenses are personal expenses and are not deductible unless they qualify as deductible expenses under section 162. Except as permitted under section 162 or 212, the costs of a taxpayer's meals not incurred in traveling away from home are nondeductible personal expenses.
(6) Amounts paid as damages for breach of promise to marry, and attorney's fees and other costs of suit to recover such damages, are not deductible.
(7) Generally, attorney's fees and other costs paid in connection with a divorce, separation, or decree for support are not deductible by either the husband or the wife. However, the part of an attorney's fee and the part of the other costs paid in connection with a divorce, legal separation, written separation agreement, or a decree for support, which are properly attributable to the production or collection of amounts includible in gross income under section 71 are deductible by the wife under section 212.
(8) The cost of equipment of a member of the armed services is deductible only to the extent that it exceeds nontaxable allowances received for such equipment and to the extent that such equipment is especially required by his profession and does not merely take the place of articles required in civilian life. For example, the cost of a sword is an allowable deduction in computing taxable income, but the cost of a uniform is not. However, amounts expended by a reservist for the purchase and maintenance of uniforms which may be worn only when on active duty for training for temporary periods, when attending service school courses, or when attending training assemblies are deductible except to the extent that nontaxable allowances are received for such amounts.
(9) Expenditures made by a taxpayer in obtaining an education or in furthering his education are not deductible unless they qualify under section 162 and § 1.162-5 (relating to trade or business expenses).
(c) Cross references. Certain items of a personal, living, or family nature are deductible to the extent expressly provided under the following sections, and the regulations under those sections:
(1) Section 163 (interest).
(2) Section 164 (taxes).
(3) Section 165 (losses).
(4) Section 166 (bad debts).
(5) Section 170 (charitable, etc., contributions and gifts).
(6) Section 213 (medical, dental, etc., expenses).
(7) Section 214 (expenses for care of certain dependents).
(8) Section 215 (alimony, etc., payments).
(9) Section 216 (amounts representing taxes and interest paid to cooperative housing corporation).
(10) Section 217 (moving expenses).
§ 1.263(a)-0   Outline of regulations under section 263(a).
This section lists the paragraphs in §§ 1.263(a)-1 through 1.263(a)-3 and § 1.263(a)-6.
(a) General rule for capital expenditures.
(b) Coordination with other provisions of the Internal Revenue Code.
(c) Definitions.
(1) Amount paid.
(2) Produce.
(d) Examples of capital expenditures.
(e) Amounts paid to sell property.
(1) In general.
(2) Dealer in property.
(3) Examples.
(f) De minimis safe harbor election.
(1) In general.
(i) Taxpayer with applicable financial statement.
(ii) Taxpayer without applicable financial statement.
(iii) Taxpayer with both an applicable financial statement and a non-qualifying financial statement.
(2) Exceptions to de minimis safe harbor.
(3) Additional rules.
(i) Transaction and other additional costs.
(ii) Materials and supplies.
(iii) Sale or disposition.
(iv) Treatment of de minimis amounts.
(v) Coordination with section 263A.
(vi) Written accounting procedures for groups of entities.
(vii) Combined expensing accounting procedures.
(4) Definition of applicable financial statement.
(5) Time and manner of making election.
(6) Anti-abuse rule.
(7) Examples.
(g) Accounting method changes.
(h) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(i) In general.
(ii) Transition rule for de minimis safe harbor election on 2012 or 2013 returns.
(3) Optional application of TD 9564.
(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 property.
(1) Requirement to capitalize.
(2) Examples.
(e) Defense or perfection of title to property.
(1) In general.
(2) Examples.
(f) Transaction costs.
(1) In general.
(2) Scope of facilitate.
(i) In general.
(ii) Inherently facilitative amounts.
(iii) Special rule for acquisitions of real property.
(A) In general.
(B) Acquisitions of real and personal property in a single transaction.
(iv) Employee compensation and overhead costs.
(A) In general.
(B) Election to capitalize.
(3) Treatment of transaction costs.
(i) In general.
(ii) Treatment of inherently facilitative amounts allocable to property not acquired.
(iii) Contingency fees.
(4) Examples.
(g) Treatment of capital expenditures.
(h) Recovery of capitalized amounts.
(1) In general.
(2) Examples.
(i) Accounting method changes.
(j) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(i) In general.
(ii) Transition rule for election to capitalize employee compensation and overhead costs on 2012 or 2013 returns.
(3) Optional application of TD 9564.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(4) Owner.
(c) Coordination with other provisions of the Internal Revenue Code.
(1) In general.
(2) Materials and supplies.
(3) Example.
(d) Requirement to capitalize amounts paid for improvements.
(e) Determining the unit of property.
(1) In general.
(2) Building.
(i) In general.
(ii) Application of improvement rules to a building.
(A) Building structure.
(B) Building system.
(iii) Condominium.
(A) In general.
(B) Application of improvement rules to a condominium.
(iv) Cooperative.
(A) In general.
(B) Application of improvement rules to a cooperative.
(v) Leased building.
(A) In general.
(B) Application of improvement rules to a leased building.
( 1 ) Entire building.
( 2 ) Portion of building.
(3) Property other than a building.
(i) In general.
(ii) Plant property.
(A) Definition.
(B) Unit of property for plant property.
(iii) Network assets.
(A) Definition.
(B) Unit of property for network assets.
(iv) Leased property other than buildings.
(4) Improvements to property.
(5) Additional rules.
(i) Year placed in service.
(ii) Change in subsequent taxable year.
(6) Examples.
(f) Improvements to leased property.
(1) In general.
(2) Lessee improvements.
(i) Requirement to capitalize.
(ii) Unit of property for lessee improvements.
(3) Lessor improvements.
(i) Requirement to capitalize.
(ii) Unit of property for lessor improvements.
(4) Examples.
(g) Special rules for determining improvement costs.
(1) Certain costs incurred during an improvement.
(i) In general.
(ii) Exception for individuals' residences.
(2) Removal costs.
(i) In general.
(ii) Examples.
(3) Related amounts.
(4) Compliance with regulatory requirements.
(h) Safe harbor for small taxpayers.
(1) In general.
(2) Application with other safe harbor provisions.
(3) Qualifying taxpayer.
(i) In general.
(ii) Application to new taxpayers.
(iii) Treatment of short taxable year.
(iv) Definition of gross receipts.
(4) Eligible building property.
(5) Unadjusted basis.
(i) Eligible building property owned by the taxpayer.
(ii) Eligible building property leased to the taxpayer.
(6) Time and manner of election.
(7) Treatment of safe harbor amounts.
(8) Safe harbor exceeded.
(9) Modification of safe harbor amounts.
(10) Examples.
(i) Safe harbor for routine maintenance.
(1) In general.
(i) Routine maintenance for buildings.
(ii) Routine maintenance for property other than buildings.
(2) Rotable and temporary spare parts.
(3) Exceptions.
(4) Class life.
(5) Coordination with section 263A.
(6) Examples.
(j) Capitalization of betterments.
(1) In general.
(2) Application of betterment rules.
(i) In general.
(ii) Application of betterment rules to buildings.
(iii) Unavailability of replacement parts.
(iv) Appropriate comparison.
(A) In general.
(B) Normal wear and tear.
(C) Damage to property.
(4) Examples.
(k) Capitalization of restorations.
(1) In general.
(2) Application of restorations to buildings.
(3) Exception for losses based on salvage value.
(4) Restoration of damage from casualty.
(i) Limitation.
(ii) Amounts in excess of limitation.
(5) Rebuild to like-new condition.
(6) Replacement of a major component or substantial structural part.
(i) In general.
(A) Major component.
(B) Substantial structural part.
(ii) Major components and substantial structural parts of buildings.
(7) Examples.
(l) Capitalization of amounts to adapt property to a new or different use.
(1) In general.
(2) Application of adaptation rule to buildings.
(3) Examples.
(m) Optional regulatory accounting method.
(1) In general.
(2) Eligibility for regulatory accounting method.
(3) Description of regulatory accounting method.
(4) Examples.
(n) Election to capitalize repair and maintenance costs.
(1) In general.
(2) Time and manner of election.
(3) Exception.
(4) Examples.
(o) Treatment of capital expenditures.
(p) Recovery of capitalized amounts.
(q) Accounting method changes.
(r) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(i) In general.
(ii) Transition rule for elections on 2012 and 2013 returns.
(3) Optional application of TD 9564.
(a) Overview.
(b) Capitalization with respect to intangibles.
(1) In general.
(2) Published guidance.
(3) Separate and distinct intangible asset.
(i) Definition.
(ii) Creation or termination of contract rights.
(iii) Amounts paid in performing services.
(iv) Creation of computer software.
(v) Creation of package design.
(4) Coordination with other provisions of the Internal Revenue Code.
(i) In general.
(ii) Example.
(c) Acquired intangibles.
(1) In general.
(2) Readily available software.
(3) Intangibles acquired from an employee.
(4) Examples.
(d) Created intangibles.
(1) In general.
(2) Financial interests.
(i) In general.
(ii) Amounts paid to create, originate, enter into, renew or renegotiate.
(iii) Renegotiate.
(iv) Coordination with other provisions of this paragraph (d).
(v) Coordination with § 1.263(a)-5.
(vi) Examples.
(3) Prepaid expenses.
(i) In general.
(ii) Examples.
(4) Certain memberships and privileges.
(i) In general.
(ii) Examples.
(5) Certain rights obtained from a government agency.
(i) In general.
(ii) Examples.
(6) Certain contract rights.
(i) In general.
(ii) Amounts paid to create, originate, enter into, renew or renegotiate.
(iii) Renegotiate.
(iv) Right.
(v) De minimis amounts.
(vi) Exception for lessee construction allowances.
(vii) Examples.
(7) Certain contract terminations.
(i) In general.
(ii) Certain break-up fees.
(iii) Examples.
(8) Certain benefits arising from the provision, production, or improvement of real property.
(i) In general.
(ii) Exclusions.
(iii) Real property.
(iv) Impact fees and dedicated improvements.
(v) Examples.
(9) Defense or perfection of title to intangible property.
(i) In general.
(ii) Certain break-up fees.
(iii) Example.
(e) Transaction costs.
(1) Scope of facilitate.
(i) In general.
(ii) Treatment of termination payments.
(iii) Special rule for contracts.
(iv) Borrowing costs.
(v) Special rule for stock redemption costs of open-end regulated investment companies.
(2) Coordination with paragraph (d) of this section.
(3) Transaction.
(4) Simplifying conventions.
(i) In general.
(ii) Employee compensation.
(iii) De minimis costs.
(iv) Election to capitalize.
(5) Examples.
(f) 12-month rule.
(1) In general.
(2) Duration of benefit for contract terminations.
(3) Inapplicability to created financial interests and self-created amortizable section 197 intangibles.
(4) Inapplicability to rights of indefinite duration.
(5) Rights subject to renewal.
(i) In general.
(ii) Reasonable expectancy of renewal.
(iii) Safe harbor pooling method.
(6) Coordination with section 461.
(7) Election to capitalize.
(8) Examples.
(g) Treatment of capitalized costs.
(1) In general.
(2) Financial instruments.
(h) Special rules applicable to pooling.
(1) In general.
(2) Method of accounting.
(3) Adopting or changing to a pooling method.
(4) Definition of pool.
(5) Consistency requirement.
(6) Additional guidance pertaining to pooling.
(7) Example.
(i) [Reserved].
(j) Application to accrual method taxpayers.
(k) Treatment of related parties and indirect payments.
(l) Examples.
(m) Amortization.
(n) Intangible interests in land [Reserved]
(o) Effective date.
(p) Accounting method changes.
(1) In general.
(2) Scope limitations.
(3) Section 481(a) adjustment.
(a) General rule.
(b) Scope of facilitate.
(1) In general.
(2) Ordering rules.
(c) Special rules for certain costs.
(1) Borrowing costs.
(2) Costs of asset sales.
(3) Mandatory stock distributions.
(4) Bankruptcy reorganization costs.
(5) Stock issuance costs of open-end regulated investment companies.
(6) Integration costs.
(7) Registrar and transfer agent fees for the maintenance of capital stock records.
(8) Termination payments and amounts paid to facilitate mutually exclusive transactions.
(d) Simplifying conventions.
(1) In general.
(2) Employee compensation.
(i) In general.
(ii) Certain amounts treated as employee compensation.
(3) De minimis costs.
(i) In general.
(ii) Treatment of commissions.
(4) Election to capitalize.
(e) Certain acquisitive transactions.
(1) In general.
(2) Exception for inherently facilitative amounts.
(3) Covered transactions.
(f) Documentation of success-based fees.
(g) Treatment of capitalized costs.
(1) Tax-free acquisitive transactions [Reserved].
(2) Taxable acquisitive transactions.
(i) Acquirer.
(ii) Target.
(3) Stock issuance transactions [Reserved].
(4) Borrowings.
(5) Treatment of capitalized amounts by option writer.
(h) Application to accrual method taxpayers.
(i) [Reserved].
(j) Coordination with other provisions of the Internal Revenue Code.
(k) Treatment of indirect payments.
(l) Examples.
(m) Effective date.
(n) Accounting method changes.
(1) In general.
(2) Scope limitations.
(3) Section 481(a) adjustment.
(a) In general.
(b) Election provisions.
(c) Effective/applicability date.
(1) In general.
(2) Early application of this section.
(3) Optional application of TD 9564.
§ 1.263(a)-1   Capital expenditures; in general.
(a) General rule for capital expenditures. Except as provided in chapter 1 of the Internal Revenue Code, no deduction is allowed for—
(1) Any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate; or
(2) Any amount paid in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.
(b) Coordination with other provisions of the Internal Revenue Code. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the Internal Revenue Code or the Treasury Regulations other than section 162(a) or section 212 and the regulations under those sections. For example, see section 263A, which requires taxpayers to capitalize the direct and allocable indirect costs to property produced by the taxpayer and property acquired for resale. See also section 195 requiring taxpayers to capitalize certain costs as start-up expenditures.
(c) Definitions. For purposes of this section, the following definitions apply:
(1) Amount paid. In the case of a taxpayer using an accrual method of accounting, the terms amount paid and payment mean a liability incurred (within the meaning of § 1.446-1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred.
(2) Produce means construct, build, install, manufacture, develop, create, raise, or grow. This definition is intended to have the same meaning as the definition used for purposes of section 263A(g)(1) and § 1.263A-2(a)(1)(i), except that improvements are excluded from the definition in this paragraph (c)(2) and are separately defined and addressed in § 1.263(a)-3.
(d) Examples of capital expenditures. The following amounts paid are examples of capital expenditures:
(1) An amount paid to acquire or produce a unit of real or personal tangible property. See § 1.263(a)-2.
(2) An amount paid to improve a unit of real or personal tangible property. See § 1.263(a)-3.
(3) An amount paid to acquire or create intangibles. See § 1.263(a)-4.
(4) An amount paid or incurred to facilitate an acquisition of a trade or business, a change in capital structure of a business entity, and certain other transactions. See § 1.263(a)-5.
(5) An amount paid to acquire or create interests in land, such as easements, life estates, mineral interests, timber rights, zoning variances, or other interests in land.
(6) An amount assessed and paid under an agreement between bondholders or shareholders of a corporation to be used in a reorganization of the corporation or voluntary contributions by shareholders to the capital of the corporation for any corporate purpose. See section 118 and § 1.118-1.
(7) An amount paid by a holding company to carry out a guaranty of dividends at a specified rate on the stock of a subsidiary corporation for the purpose of securing new capital for the subsidiary and increasing the value of its stockholdings in the subsidiary. This amount must be added to the cost of the stock in the subsidiary.
(e) Amounts paid to sell property —(1) In general. Commissions and other transaction costs paid to facilitate the sale of property are not currently deductible under section 162 or 212. Instead, the amounts are capitalized costs that reduce the amount realized in the taxable year in which the sale occurs or are taken into account in the taxable year in which the sale is abandoned if a deduction is permissible. These amounts are not added to the basis of the property sold or treated as an intangible asset under § 1.263(a)-4. See § 1.263(a)-5(g) for the treatment of amounts paid to facilitate the disposition of assets that constitute a trade or business.
(2) Dealer in property. In the case of a dealer in property, amounts paid to facilitate the sale of such property are treated as ordinary and necessary business expenses.
(3) Examples. The following examples, which assume the sale is not an installment sale under section 453, illustrate the rules of this paragraph (e):
(f) De minimis safe harbor election —(1) In general. Except as otherwise provided in paragraph (f)(2) of this section, a taxpayer electing to apply the de minimis safe harbor under this paragraph (f) may not capitalize under § 1.263(a)-2(d)(1) or § 1.263(a)-3(d) any amount paid in the taxable year for the acquisition or production of a unit of tangible property nor treat as a material or supply under § 1.162-3(a) any amount paid in the taxable year for tangible property if the amount specified under this paragraph (f)(1) meets the requirements of paragraph (f)(1)(i) or (f)(1)(ii) of this section. However, section 263A and the regulations under section 263A require taxpayers to capitalize the direct and allocable indirect costs of property produced by the taxpayer (for example, property improved by the taxpayer) and property acquired for resale.
(i) Taxpayer with applicable financial statement. A taxpayer electing to apply the de minimis safe harbor may not capitalize under § 1.263(a)-2(d)(1) or § 1.263(a)-3(d) nor treat as a material or supply under § 1.162-3(a) any amount paid in the taxable year for property described in paragraph (f)(1) of this section if—
(A) The taxpayer has an applicable financial statement (as defined in paragraph (f)(4) of this section);
(B) The taxpayer has at the beginning of the taxable year written accounting procedures treating as an expense for non-tax purposes—
( 1 ) Amounts paid for property costing less than a specified dollar amount; or
( 2 ) Amounts paid for property with an economic useful life (as defined in § 1.162-3(c)(4)) of 12 months or less;
(C) The taxpayer treats the amount paid for the property as an expense on its applicable financial statement in accordance with its written accounting procedures; and
(D) The amount paid for the property does not exceed $5,000 per invoice (or per item as substantiated by the invoice) or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)( b ) of this chapter).
(ii) Taxpayer without applicable financial statement. A taxpayer electing to apply the de minimis safe harbor may not capitalize under § 1.263(a)-2(d)(1) or § 1.263(a)-3(d) nor treat as a material or supply under § 1.162-3(a) any amount paid in the taxable year for property described in paragraph (f)(1) of this section if—
(A) The taxpayer does not have an applicable financial statement (as defined in paragraph (f)(4) of this section);
(B) The taxpayer has at the beginning of the taxable year accounting procedures treating as an expense for non-tax purposes—
( 1 ) Amounts paid for property costing less than a specified dollar amount; or
( 2 ) Amounts paid for property with an economic useful life (as defined in § 1.162-3(c)(4)) of 12 months or less;
(C) The taxpayer treats the amount paid for the property as an expense on its books and records in accordance with these accounting procedures; and
(D) The amount paid for the property does not exceed $500 per invoice (or per item as substantiated by the invoice) or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)( b ) of this chapter).
(iii) Taxpayer with both an applicable financial statement and a non-qualifying financial statement. For purposes of this paragraph (f)(1), if a taxpayer has an applicable financial statement defined in paragraph (f)(4) of this section in addition to a financial statement that does not meet requirements of paragraph (f)(4) of this section, the taxpayer must meet the requirements of paragraph (f)(1)(i) of this section to qualify to elect the de minimis safe harbor under this paragraph (f).
(2) Exceptions to de minimis safe harbor. The de minimis safe harbor in paragraph (f)(1) of this section does not apply to the following:
(i) Amounts paid for property that is or is intended to be included in inventory property;
(ii) Amounts paid for land;
(iii) Amounts paid for rotable, temporary, and standby emergency spare parts that the taxpayer elects to capitalize and depreciate under § 1.162-3(d); and
(iv) Amounts paid for rotable and temporary spare parts that the taxpayer accounts for under the optional method of accounting for rotable parts pursuant to § 1.162-3(e).
(3) Additional rules —(i) Transaction and other additional costs. A taxpayer electing to apply the de minimis safe harbor under paragraph (f)(1) of this section is not required to include in the cost of the tangible property the additional costs of acquiring or producing such property if these costs are not included in the same invoice as the tangible property. However, the taxpayer electing to apply the de minimis safe harbor under paragraph (f)(1) of this section must include in the cost of such property all additional costs (for example, delivery fees, installation services, or similar costs) if these additional costs are included on the same invoice with the tangible property. For purposes of this paragraph, if the invoice includes amounts paid for multiple tangible properties and such invoice includes additional invoice costs related to these multiple properties, then the taxpayer must allocate the additional invoice costs to each property using a reasonable method, and each property, including allocable labor and overhead, must meet the requirements of paragraph (f)(1)(i) or paragraph (f)(1)(ii) of this section, whichever is applicable. Reasonable allocation methods include, but are not limited to specific identification, a pro rata allocation, or a weighted average method based on the property's relative cost. For purposes of this paragraph (f)(3)(i), additional costs consist of the costs of facilitating the acquisition or production of such tangible property under § 1.263(a)-2(f) and the costs for work performed prior to the date that the tangible property is placed in service under § 1.263(a)-2(d).
(ii) Materials and supplies. If a taxpayer elects to apply the de minimis safe harbor provided under this paragraph (f), then the taxpayer must also apply the de minimis safe harbor to amounts paid for all materials and supplies (as defined under § 1.162-3) that meet the requirements of § 1.263(a)-1(f). See paragraph (f)(3)(iv) of this section for treatment of materials and supplies under the de minimis safe harbor.
(iii) Sale or disposition. Property to which a taxpayer applies the de minimis safe harbor contained in this paragraph (f) is not treated upon sale or other disposition as a capital asset under section 1221 or as property used in the trade or business under section 1231.
(iv) Treatment of de minimis amounts. An amount paid for property to which a taxpayer properly applies the de minimis safe harbor contained in this paragraph (f) is not treated as a capital expenditure under § 1.263(a)-2(d)(1) or § 1.263(a)-3(d) or as a material and supply under § 1.162-3, and may be deducted under § 1.162-1 in the taxable year the amount is paid provided the amount otherwise constitutes an ordinary and necessary expense incurred in carrying on a trade or business.
(v) Coordination with section 263A. Amounts paid for tangible property described in paragraph (f)(1) of this section may be subject to capitalization under section 263A if the amounts paid for tangible property comprise the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale. See, for example, § 1.263A-1(e)(3)(ii)(R) requiring taxpayers to capitalize the cost of tools and equipment allocable to property produced or property acquired for resale.
(vi) Written accounting procedures for groups of entities. If the taxpayer's financial results are reported on the applicable financial statement (as defined in paragraph (f)(4) of this section) for a group of entities then, for purposes of paragraph (f)(1)(i)(A) of this section, the group's applicable financial statement may be treated as the applicable financial statement of the taxpayer, and for purposes of paragraphs (f)(1)(i)(B) and (f)(1)(i)(C) of this section, the written accounting procedures provided for the group and utilized for the group's applicable financial statement may be treated as the written accounting procedures of the taxpayer.
(vii) Combined expensing accounting procedures. For purposes of paragraphs (f)(1)(i) and (f)(1)(ii) of this section, if the taxpayer has, at the beginning of the taxable year, accounting procedures treating as an expense for non-tax purposes amounts paid for property costing less than a specified dollar amount and amounts paid for property with an economic useful life (as defined in § 1.162-3(c)(4)) of 12 months or less, then a taxpayer electing to apply the de minimis safe harbor under this paragraph (f) must apply the provisions of this paragraph (f) to amounts qualifying under either accounting procedure.
(4) Definition of applicable financial statement. For purposes of this paragraph (f), the taxpayer's applicable financial statement (AFS) is the taxpayer's financial statement listed in paragraphs (f)(4)(i) through (iii) of this section that has the highest priority (including within paragraph (f)(4)(ii) of this section). The financial statements are, in descending priority—
(i) A financial statement required to be filed with the Securities and Exchange Commission (SEC) (the 10-K or the Annual Statement to Shareholders);
(ii) A certified audited financial statement that is accompanied by the report of an independent certified public accountant (or in the case of a foreign entity, by the report of a similarly qualified independent professional) that is used for—
(A) Credit purposes;
(B) Reporting to shareholders, partners, or similar persons; or
(C) Any other substantial non-tax purpose; or
(iii) A financial statement (other than a tax return) required to be provided to the federal or a state government or any federal or state agency (other than the SEC or the Internal Revenue Service).
(5) Time and manner of election. A taxpayer that makes the election under this paragraph (f) must make the election for all amounts paid during the taxable year for property described in paragraph (f)(1) of this section and meeting the requirements of paragraph (f)(1)(i) or paragraph (f)(1)(ii) of this section, as applicable. A taxpayer makes the election by attaching a statement to the taxpayer's timely filed original Federal tax return (including extensions) for the taxable year in which these amounts are paid. Sections 301.9100-1 through 301.9100-3 of this chapter provide the rules governing extensions of the time to make regulatory elections. The statement must be titled “Section 1.263(a)-1(f) de minimis safe harbor election” and include the taxpayer's name, address, taxpayer identification number, and a statement that the taxpayer is making the de minimis safe harbor election under § 1.263(a)-1(f). In the case of a consolidated group filing a consolidated income tax return, the election is made for each member of the consolidated group by the common parent, and the statement must also include the names and taxpayer identification numbers of each member for which the election is made. In the case of an S corporation or a partnership, the election is made by the S corporation or the partnership and not by the shareholders or partners. An election may not be made through the filing of an application for change in accounting method or, before obtaining the Commissioner's consent to make a late election, by filing an amended Federal tax return. A taxpayer may not revoke an election made under this paragraph (f). The manner of electing the de minimis safe harbor under this paragraph (f) may be modified through guidance of general applicability (see §§ 601.601(d)(2) and 601.602 of this chapter).
(6) Anti-abuse rule. If a taxpayer acts to manipulate transactions with the intent to achieve a tax benefit or to avoid the application of the limitations provided under paragraphs (f)(1)(i)(B)( 1 ), (f)(1)(i)(D), (f)(1)(ii)(B)( 1 ), and (f)(1)(ii)(D) of this section, appropriate adjustments will be made to carry out the purposes of this section. For example, a taxpayer is deemed to act to manipulate transactions with an intent to avoid the purposes and requirements of this section if—
(i) The taxpayer applies the de minimis safe harbor to amounts substantiated with invoices created to componentize property that is generally acquired or produced by the taxpayer (or other taxpayers in the same or similar trade or business) as a single unit of tangible property; and
(ii) This property, if treated as a single unit, would exceed any of the limitations provided under paragraphs (f)(1)(i)(B)( 1 ), (f)(1)(i)(D), (f)(1)(ii)(B)( 1 ), and (f)(1)(ii)(D) of this section, as applicable.
(7) Examples. The following examples illustrate the application of this paragraph (f). Unless otherwise provided, assume that section 263A does not apply to the amounts described.
(g) Accounting method changes. Except for paragraph (f) of this section (the de minimis safe harbor election), a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446-1(e) and follow the administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to change its accounting method.
(h) Effective/applicability date —(1) In general. Except for paragraph (f) of this section, this section generally applies to taxable years beginning on or after January 1, 2014. Paragraph (f) of this section applies to amounts paid in taxable years beginning on or after January 1, 2014. Except as provided in paragraph (h)(1) and paragraph (h)(2) of this section, § 1.263(a)-1 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.
(2) Early application of this section —(i) In general. Except for paragraph (f) of this section, a taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012. A taxpayer may choose to apply paragraph (f) of this section to amounts paid in taxable years beginning on or after January 1, 2012.
(ii) Transition rule for de minimis safe harbor election on 2012 or 2013 returns. If under paragraph (h)(2)(i) of this section, a taxpayer chooses to make the election to apply the de minimis safe harbor under paragraph (f) of this section for amounts paid in its taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (f)(5) of this section on its timely filed original Federal tax return for the applicable taxable year, the taxpayer must make the election specified in paragraph (f)(5) of this section for the applicable taxable year by filing an amended Federal tax return for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer's Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.
(3) Optional application of TD 9564. A taxpayer may choose to apply § 1.263(a)-1T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.
§ 1.263(a)-2   Amounts paid to acquire or produce tangible property.
(a) Overview. This section provides rules for applying section 263(a) to amounts paid to acquire or produce a unit of real or personal property. Paragraph (b) of this section contains definitions. Paragraph (c) of this section contains the rules for coordinating this section with other provisions of the Internal Revenue Code (Code). Paragraph (d) of this section provides the general requirement to capitalize amounts paid to acquire or produce a unit of real or personal property. Paragraph (e) of this section provides the requirement to capitalize amounts paid to defend or perfect title to real or personal property. Paragraph (f) of this section provides the rules for determining the extent to which taxpayers must capitalize transaction costs related to the acquisition of tangible property. Paragraphs (g) and (h) of this section address the treatment and recovery of capital expenditures. Paragraph (i) of this section provides for changes in methods of accounting to comply with this section, and paragraph (j) of this section provides the effective and applicability dates for the rules under this section.
(b) Definitions. For purposes of this section, the following definitions apply:
(1) Amount paid. In the case of a taxpayer using an accrual method of accounting, the terms amount paid and payment mean a liability incurred (within the meaning of § 1.446-1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred.
(2) Personal property means tangible personal property as defined in § 1.48-1(c).
(3) Real property means land and improvements thereto, such as buildings or other inherently permanent structures (including items that are structural components of the buildings or structures) that are not personal property as defined in paragraph (b)(2) of this section. Any property that constitutes other tangible property under § 1.48-1(d) is treated as real property for purposes of this section. Local law is not controlling in determining whether property is real property for purposes of this section.
(4) Produce means construct, build, install, manufacture, develop, create, raise, or grow. This definition is intended to have the same meaning as the definition used for purposes of section 263A(g)(1) and § 1.263A-2(a)(1)(i), except that improvements are excluded from the definition in this paragraph (b)(4) and are separately defined and addressed in § 1.263(a)-3.
(c) Coordination with other provisions of the Code —(1) In general. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the Code or the Treasury Regulations other than section 162(a) or section 212 and the regulations under those sections. For example, see section 263A requiring taxpayers to capitalize the direct and allocable indirect costs of property produced by the taxpayer and property acquired for resale. See also section 195 requiring taxpayers to capitalize certain costs as start-up expenditures.
(2) Materials and supplies. Nothing in this section changes the treatment of amounts paid to acquire or produce property that is properly treated as materials and supplies under § 1.162-3.
(d) Acquired or produced tangible property —(1) Requirement to capitalize. Except as provided in § 1.162-3 (relating to materials and supplies) and in § 1.263(a)-1(f) (providing a de minimis safe harbor election), a taxpayer must capitalize amounts paid to acquire or produce a unit of real or personal property (as determined under § 1.263(a)-3(e)), including leasehold improvements, land and land improvements, buildings, machinery and equipment, and furniture and fixtures. Section 1.263(a)-3(f) provides the rules for determining whether amounts are for leasehold improvements. Amounts paid to acquire or produce a unit of real or personal property include the invoice price, transaction costs as determined under paragraph (f) of this section, and costs for work performed prior to the date that the unit of property is placed in service by the taxpayer (without regard to any applicable convention under section 168(d)). A taxpayer also must capitalize amounts paid to acquire real or personal property for resale.
(2) Examples. The following examples illustrate the rules of this paragraph (d). Unless otherwise provided, assume that the taxpayer does not elect the de minimis safe harbor under § 1.263(a)-1(f) and that the property is not acquired for resale under section 263A.
(e) Defense or perfection of title to property —(1) In general. Amounts paid to defend or perfect title to real or personal property are amounts paid to acquire or produce property within the meaning of this section and must be capitalized.
(2) Examples. The following examples illustrate the rule of this paragraph (e):
(f) Transaction costs —(1) In general. Except as provided in § 1.263(a)-1(f)(3)(i) (for purposes of the de minimis safe harbor), a taxpayer must capitalize amounts paid to facilitate the acquisition of real or personal property. See § 1.263(a)-5 for the treatment of amounts paid to facilitate the acquisition of assets that constitute a trade or business. See § 1.167(a)-5 for allocations of facilitative costs between depreciable and non-depreciable property.
(2) Scope of facilitate —(i) In general. Except as otherwise provided in this section, an amount is paid to facilitate the acquisition of real or personal property if the amount is paid in the process of investigating or otherwise pursuing the acquisition. Whether an amount is paid in the process of investigating or otherwise pursuing the acquisition is determined based on all of the facts and circumstances. In determining whether an amount is paid to facilitate an acquisition, the fact that the amount would (or would not) have been paid but for the acquisition is relevant but is not determinative. Amounts paid to facilitate an acquisition include, but are not limited to, inherently facilitative amounts specified in paragraph (f)(2)(ii) of this section.
(ii) Inherently facilitative amounts. An amount is paid in the process of investigating or otherwise pursuing the acquisition of real or personal property if the amount is inherently facilitative. An amount is inherently facilitative if the amount is paid for—
(A) Transporting the property (for example, shipping fees and moving costs);
(B) Securing an appraisal or determining the value or price of property;
(C) Negotiating the terms or structure of the acquisition and obtaining tax advice on the acquisition;
(D) Application fees, bidding costs, or similar expenses;
(E) Preparing and reviewing the documents that effectuate the acquisition of the property (for example, preparing the bid, offer, sales contract, or purchase agreement);
(F) Examining and evaluating the title of property;
(G) Obtaining regulatory approval of the acquisition or securing permits related to the acquisition, including application fees;
(H) Conveying property between the parties, including sales and transfer taxes, and title registration costs;
(I) Finders' fees or brokers' commissions, including contingency fees (defined in paragraph (f)(3)(iii) of this section);
(J) Architectural, geological, survey, engineering, environmental, or inspection services pertaining to particular properties; or
(K) Services provided by a qualified intermediary or other facilitator of an exchange under section 1031.
(iii) Special rule for acquisitions of real property —(A) In general. Except as provided in paragraph (f)(2)(ii) of this section (relating to inherently facilitative amounts), an amount paid by the taxpayer in the process of investigating or otherwise pursuing the acquisition of real property does not facilitate the acquisition if it relates to activities performed in the process of determining whether to acquire real property and which real property to acquire.
(B) Acquisitions of real and personal property in a single transaction. An amount paid by the taxpayer in the process of investigating or otherwise pursuing the acquisition of personal property facilitates the acquisition of such personal property, even if such property is acquired in a single transaction that also includes the acquisition of real property subject to the special rule set out in paragraph (f)(2)(iii)(A) of this section. A taxpayer may use a reasonable allocation method to determine which costs facilitate the acquisition of personal property and which costs relate to the acquisition of real property and are subject to the special rule of paragraph (f)(2)(iii)(A) of this section.
(iv) Employee compensation and overhead costs —(A) In general. For purposes of paragraph (f) of this section, amounts paid for employee compensation (within the meaning of § 1.263(a)-4(e)(4)(ii)) and overhead are treated as amounts that do not facilitate the acquisition of real or personal property. However, section 263A provides rules for employee compensation and overhead costs required to be capitalized to property produced by the taxpayer or to property acquired for resale.
(B) Election to capitalize. A taxpayer may elect to treat amounts paid for employee compensation or overhead as amounts that facilitate the acquisition of property. The election is made separately for each acquisition and applies to employee compensation or overhead, or both. For example, a taxpayer may elect to treat overhead, but not employee compensation, as amounts that facilitate the acquisition of property. A taxpayer makes the election by treating the amounts to which the election applies as amounts that facilitate the acquisition in the taxpayer's timely filed original Federal tax return (including extensions) for the taxable year during which the amounts are paid. Sections 301.9100-1 through 301.9100-3 of this chapter provide the rules governing extensions of the time to make regulatory elections. In the case of an S corporation or a partnership, the election is made by the S corporation or by the partnership, and not by the shareholders or partners. A taxpayer may revoke an election made under this paragraph (f)(2)(iv)(B) with respect to each acquisition only by filing a request for a private letter ruling and obtaining the Commissioner's consent to revoke the election. The Commissioner may grant a request to revoke this election if the taxpayer acted reasonably and in good faith and the revocation will not prejudice the interests of Government. See generally § 301.9100-3 of this chapter. The manner of electing and revoking the election to capitalize under this paragraph (f)(2)(iv)(B) may be modified through guidance of general applicability (see §§ 606.601(d)(2) and 601.602 of this section). An election may not be made or revoked through the filing of an application for change in accounting method or, before obtaining the Commissioner's consent to make the late election or to revoke the election, by filing an amended Federal tax return.
(3) Treatment of transaction costs —(i) In general. Except as provided under § 1.263(a)-1(f)(3)(i) (for purposes of the de minimis safe harbor), all amounts paid to facilitate the acquisition of real or personal property are capital expenditures. Facilitative amounts allocable to real or personal property must be included in the basis of the property acquired.
(ii) Treatment of inherently facilitative amounts allocable to property not acquired. Inherently facilitative amounts allocable to real or personal property are capital expenditures related to such property, even if the property is not eventually acquired. Except for contingency fees as defined in paragraph (f)(3)(iii) of this section, inherently facilitative amounts allocable to real or personal property not acquired may be allocated to those properties and recovered as appropriate in accordance with the applicable provisions of the Code and the Treasury Regulations (for example, sections 165, 167, or 168). See paragraph (h) of this section for the recovery of capitalized amounts.
(iii) Contingency fees. For purposes of this section, a contingency fee is an amount paid that is contingent on the successful closing of the acquisition of real or personal property. Contingency fees must be included in the basis of the property acquired and may not be allocated to the property not acquired.
(4) Examples. The following examples illustrate the rules of paragraph (f) of this section. For purposes of these examples, assume that the taxpayer does not elect the de minimis safe harbor under § 1.263(a)-1(f):
(g) Treatment of capital expenditures. Amounts required to be capitalized under this section are capital expenditures and must be taken into account through a charge to capital account or basis, or in the case of property that is inventory in the hands of a taxpayer, through inclusion in inventory costs.
(h) Recovery of capitalized amounts —(1) In general. Amounts that are capitalized under this section are recovered through depreciation, cost of goods sold, or by an adjustment to basis at the time the property is placed in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable provisions of the Code and regulations relating to the use, sale, or disposition of property.
(2) Examples. The following examples illustrate the rule of paragraph (h)(1) of this section. For purposes of these examples, assume that the taxpayer does not elect the de minimis safe harbor under § 1.263(a)-1(f).
(i) Accounting method changes. Unless otherwise provided under this section, a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446-1(e) and follow the administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to change its accounting method.
(j) Effective/applicability date —(1) In general. Except for paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section, this section generally applies to taxable years beginning on or after January 1, 2014. Paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section apply to amounts paid in taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (j)(1) and (j)(2) of this section, § 1.263(a)-2 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.
(2) Early application of this section —(i) In general. Except for paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section of this section, a taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012. A taxpayer may choose to apply paragraphs (f)(2)(iii), (f)(2)(iv), and (f)(3)(ii) of this section to amounts paid in taxable years beginning on or after January 1, 2012.
(ii) Transition rule for election to capitalize employee compensation and overhead costs on 2012 or 2013 returns. If under paragraph (j)(2)(i) of this section, a taxpayer chooses to make the election to capitalize employee compensation and overhead costs under paragraph (f)(2)(iv)(B) of this section for amounts paid in its taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (f)(2)(iv)(B) of this section on its timely filed original Federal tax return for the applicable taxable year, the taxpayer must make the election specified in paragraph (f)(2)(iv)(B) of this section for the applicable taxable year by filing an amended Federal tax return for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer's Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.
(3) Optional application of TD 9564. Except for § 1.263(a)-2T(f)(2)(iii), (f)(2)(iv), (f)(3)(ii), and (g), a taxpayer may choose to apply § 1.263(a)-2T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014. A taxpayer may choose to apply § 1.263(a)-2T(f)(2)(iii), (f)(2)(iv), (f)(3)(ii) and (g) as contained in TD 9564 (76 FR 81060) December 27, 2011, to amounts paid in taxable years beginning on or after January 1, 2012, and before January 1, 2014.
§ 1.263(a)-3   Amounts paid to improve tangible property.
(a) Overview. This section provides rules for applying section 263(a) to amounts paid to improve tangible property. Paragraph (b) of this section provides definitions. Paragraph (c) of this section provides rules for coordinating this section with other provisions of the Internal Revenue Code (Code). Paragraph (d) of this section provides the requirement to capitalize amounts paid to improve tangible property and provides the general rules for determining whether a unit of property is improved. Paragraph (e) of this section provides the rules for determining the appropriate unit of property. Paragraph (f) of this section provides rules for leasehold improvements. Paragraph (g) of this section provides special rules for determining improvement costs in particular contexts, including indirect costs incurred during an improvement, removal costs, aggregation of related costs, and regulatory compliance costs. Paragraph (h) of this section provides a safe harbor for small taxpayers. Paragraph (i) provides a safe harbor for routine maintenance costs. Paragraph (j) of this section provides rules for determining whether amounts are paid for betterments to the unit of property. Paragraph (k) of this section provides rules for determining whether amounts are paid to restore the unit of property. Paragraph (l) of this section provides rules for amounts paid to adapt the unit of property to a new or different use. Paragraph (m) of this section provides an optional regulatory accounting method. Paragraph (n) of this section provides an election to capitalize repair and maintenance costs consistent with books and records. Paragraphs (o) and (p) of this section provide for the treatment and recovery of amounts capitalized under this section. Paragraphs (q) and (r) of this section provide for accounting method changes and state the effective/applicability date for the rules in this section.
(b) Definitions. For purposes of this section, the following definitions apply:
(1) Amount paid. In the case of a taxpayer using an accrual method of accounting, the terms amounts paid and payment mean a liability incurred (within the meaning of § 1.446-1(c)(1)(ii)). A liability may not be taken into account under this section prior to the taxable year during which the liability is incurred.
(2) Personal property means tangible personal property as defined in § 1.48-1(c).
(3) Real property means land and improvements thereto, such as buildings or other inherently permanent structures (including items that are structural components of the buildings or structures) that are not personal property as defined in paragraph (b)(2) of this section. Any property that constitutes other tangible property under § 1.48-1(d) is also treated as real property for purposes of this section. Local law is not controlling in determining whether property is real property for purposes of this section.
(4) Owner means the taxpayer that has the benefits and burdens of ownership of the unit of property for Federal income tax purposes.
(c) Coordination with other provisions of the Code —(1) In general. Nothing in this section changes the treatment of any amount that is specifically provided for under any provision of the Code or the regulations other than section 162(a) or section 212 and the regulations under those sections. For example, see section 263A requiring taxpayers to capitalize the direct and allocable indirect costs of property produced and property acquired for resale.
(2) Materials and supplies. A material or supply as defined in § 1.162-3(c)(1) that is acquired and used to improve a unit of tangible property is subject to this section and is not treated as a material or supply under § 1.162-3.
(3) Example. The following example illustrates the rules of this paragraph (c):
(d) Requirement to capitalize amounts paid for improvements. Except as provided in paragraph (h) or paragraph (n) of this section or under § 1.263(a)-1(f), a taxpayer generally must capitalize the related amounts (as defined in paragraph (g)(3) of this section) paid to improve a unit of property owned by the taxpayer. However, paragraph (f) of this section applies to the treatment of amounts paid to improve leased property. Section 263A provides the requirement to capitalize the direct and allocable indirect costs of property produced by the taxpayer and property acquired for resale. Section 1016 provides for the addition of capitalized amounts to the basis of the property, and section 168 governs the treatment of additions or improvements for depreciation purposes. For purposes of this section, a unit of property is improved if the amounts paid for activities performed after the property is placed in service by the taxpayer—
(1) Are for a betterment to the unit of property (see paragraph (j) of this section);
(2) Restore the unit of property (see paragraph (k) of this section); or
(3) Adapt the unit of property to a new or different use (see paragraph (l) of this section).
(e) Determining the unit of property —(1) In general. The unit of property rules in this paragraph (e) apply only for purposes of section 263(a) and §§ 1.263(a)-1, 1.263(a)-2, 1.263(a)-3, and 1.162-3. Unless otherwise specified, the unit of property determination is based upon the functional interdependence standard provided in paragraph (e)(3)(i) of this section. However, special rules are provided for buildings (see paragraph (e)(2) of this section), plant property (see paragraph (e)(3)(ii) of this section), network assets (see paragraph (e)(3)(iii) of this section), leased property (see paragraph (e)(2)(v) of this section for leased buildings and paragraph (e)(3)(iv) of this section for leased property other than buildings), and improvements to property (see paragraph (e)(4) of this section). Additional rules are provided if a taxpayer has assigned different MACRS classes or depreciation methods to components of property or subsequently changes the class or depreciation method of a component or other item of property (see paragraph (e)(5) of this section). Property that is aggregated or subject to a general asset account election or accounted for in a multiple asset account (that is, pooled) may not be treated as a single unit of property.
(2) Building —(i) In general. Except as otherwise provided in paragraphs (e)(4), and (e)(5)(ii) of this section, in the case of a building (as defined in § 1.48-1(e)(1)), each building and its structural components (as defined in § 1.48-1(e)(2)) is a single unit of property (“building”). Paragraph (e)(2)(iii) of this section provides the unit of property for condominiums, paragraph (e)(2)(iv) of this section provides the unit of property for cooperatives, and paragraph (e)(2)(v) of this section provides the unit of property for leased buildings.
(ii) Application of improvement rules to a building. An amount is paid to improve a building under paragraph (d) of this section if the amount is paid for an improvement under paragraphs (j), (k), or paragraph (l) of this section to any of the following:
(A) Building structure. A building structure consists of the building (as defined in § 1.48-1(e)(1)), and its structural components (as defined in § 1.48-1(e)(2)), other than the structural components designated as buildings systems in paragraph (e)(2)(ii)(B) of this section.
(B) Building system. Each of the following structural components (as defined in § 1.48-1(e)(2)), including the components thereof, constitutes a building system that is separate from the building structure, and to which the improvement rules must be applied—
( 1 ) Heating, ventilation, and air conditioning (“HVAC”) systems (including motors, compressors, boilers, furnace, chillers, pipes, ducts, radiators);
( 2 ) Plumbing systems (including pipes, drains, valves, sinks, bathtubs, toilets, water and sanitary sewer collection equipment, and site utility equipment used to distribute water and waste to and from the property line and between buildings and other permanent structures);
( 3 ) Electrical systems (including wiring, outlets, junction boxes, lighting fixtures and associated connectors, and site utility equipment used to distribute electricity from the property line to and between buildings and other permanent structures);
( 4 ) All escalators;
( 5 ) All elevators;
( 6 ) Fire-protection and alarm systems (including sensing devices, computer controls, sprinkler heads, sprinkler mains, associated piping or plumbing, pumps, visual and audible alarms, alarm control panels, heat and smoke detection devices, fire escapes, fire doors, emergency exit lighting and signage, and fire fighting equipment, such as extinguishers, and hoses);
( 7 ) Security systems for the protection of the building and its occupants (including window and door locks, security cameras, recorders, monitors, motion detectors, security lighting, alarm systems, entry and access systems, related junction boxes, associated wiring and conduit);
( 8 ) Gas distribution system (including associated pipes and equipment used to distribute gas to and from the property line and between buildings or permanent structures); and
( 9 ) Other structural components identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)( b ) of this chapter) that are excepted from the building structure under paragraph (e)(2)(ii)(A) of this section and are specifically designated as building systems under this section.
(iii) Condominium —(A) In general. In the case of a taxpayer that is the owner of an individual unit in a building with multiple units (such as a condominium), the unit of property (“condominium”) is the individual unit owned by the taxpayer and the structural components (as defined in § 1.48-1(e)(2)) that are part of the unit.
(B) Application of improvement rules to a condominium. An amount is paid to improve a condominium under paragraph (d) of this section if the amount is paid for an improvement under paragraphs (j), (k), or paragraph (l) of this section to the building structure (as defined in paragraph (e)(2)(ii)(A) of this section) that is part of the condominium or to the portion of any building system (as defined in paragraph (e)(2)(ii)(B) of this section) that is part of the condominium. In the case of the condominium management association, the association must apply the improvement rules to the building structure or to any building system described under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section.
(iv) Cooperative —(A) In general. In the case of a taxpayer that has an ownership interest in a cooperative housing corporation, the unit of property (“cooperative”) is the portion of the building in which the taxpayer has possessory rights and the structural components (as defined in § 1.48-1(e)(2)) that are part of the portion of the building subject to the taxpayer's possessory rights (cooperative).
(B) Application of improvement rules to a cooperative. An amount is paid to improve a cooperative under paragraph (d) of this section if the amount is paid for an improvement under paragraphs (j), (k), or (l) of this section to the portion of the building structure (as defined in paragraph (e)(2)(ii)(A) of this section) in which the taxpayer has possessory rights or to the portion of any building system (as defined in paragraph (e)(2)(ii)(B) of this section) that is part of the portion of the building structure subject to the taxpayer's possessory rights. In the case of a cooperative housing corporation, the corporation must apply the improvement rules to the building structure or to any building system as described under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section.
(v) Leased building —(A) In general. In the case of a taxpayer that is a lessee of all or a portion of a building (such as an office, floor, or certain square footage), the unit of property (“leased building property”) is each building and its structural components or the portion of each building subject to the lease and the structural components associated with the leased portion.
(B) Application of improvement rules to a leased building. An amount is paid to improve a leased building property under paragraphs (d) and (f)(2) of this section if the amount is paid for an improvement, under paragraphs (j), (k), or (l) of this section, to any of the following:
( 1 ) Entire building. In the case of a taxpayer that is a lessee of an entire building, the building structure (as defined under paragraph (e)(2)(ii)(A) of this section) or any building system (as defined under paragraph (e)(2)(ii)(B) of this section) that is part of the leased building.
( 2 ) Portion of a building. In the case of a taxpayer that is a lessee of a portion of a building (such as an office, floor, or certain square footage), the portion of the building structure (as defined under paragraph (e)(2)(ii)(A) of this section) subject to the lease or the portion of any building system (as defined under paragraph (e)(2)(ii)(B) of this section) subject to the lease.
(3) Property other than building —(i) In general. Except as otherwise provided in paragraphs (e)(3), (e)(4), (e)(5), and (f)(1) of this section, in the case of real or personal property other than property described in paragraph (e)(2) of this section, all the components that are functionally interdependent comprise a single unit of property. Components of property are functionally interdependent if the placing in service of one component by the taxpayer is dependent on the placing in service of the other component by the taxpayer.
(ii) Plant property —(A) Definition. For purposes of this paragraph (e), the term plant property means functionally interdependent machinery or equipment, other than network assets, used to perform an industrial process, such as manufacturing, generation, warehousing, distribution, automated materials handling in service industries, or other similar activities.
(B) Unit of property for plant property. In the case of plant property, the unit of property determined under the general rule of paragraph (e)(3)(i) of this section is further divided into smaller units comprised of each component (or group of components) that performs a discrete and major function or operation within the functionally interdependent machinery or equipment.
(iii) Network assets —(A) Definition. For purposes of this paragraph (e), the term network assets means railroad track, oil and gas pipelines, water and sewage pipelines, power transmission and distribution lines, and telephone and cable lines that are owned or leased by taxpayers in each of those respective industries. The term includes, for example, trunk and feeder lines, pole lines, and buried conduit. It does not include property that would be included as building structure or building systems under paragraphs (e)(2)(ii)(A) and (e)(2)(ii)(B) of this section, nor does it include separate property that is adjacent to, but not part of a network asset, such as bridges, culverts, or tunnels.
(B) Unit of property for network assets. In the case of network assets, the unit of property is determined by the taxpayer's particular facts and circumstances except as otherwise provided in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)( b ) of this chapter). For these purposes, the functional interdependence standard provided in paragraph (e)(3)(i) of this section is not determinative.
(iv) Leased property other than buildings. In the case of a taxpayer that is a lessee of real or personal property other than property described in paragraph (e)(2) of this section, the unit of property for the leased property is determined under paragraphs (e)(3)(i),(ii), (iii), and (e)(5) of this section except that, after applying the applicable rules under those paragraphs, the unit of property may not be larger than the property subject to the lease.
(4) Improvements to property. An improvement to a unit of property generally is not a unit of property separate from the unit of property improved. For the unit of property for lessee improvements, see also paragraph (f)(2)(ii)) of this section. If a taxpayer elects to treat as a capital expenditure under § 1.162-3(d) the amount paid for a rotable spare part, temporary spare part, or standby emergency spare part, and such part is used in an improvement to a unit of property, then for purposes of applying paragraph (d) of this section to the unit of property improved, the part is not a unit of property separate from the unit of property improved.
(5) Additional rules —(i) Year placed in service. Notwithstanding the unit of property determination under paragraph (e)(3) of this section, a component (or a group of components) of a unit property must be treated as a separate unit of property if, at the time the unit of property is initially placed in service by the taxpayer, the taxpayer has properly treated the component as being within a different class of property under section 168(e) (MACRS classes) than the class of the unit of property of which the component is a part, or the taxpayer has properly depreciated the component using a different depreciation method than the depreciation method of the unit of property of which the component is a part.
(ii) Change in subsequent taxable year. Notwithstanding the unit of property determination under paragraphs (e)(2), (3), (4), or (5)(i) of this section, in any taxable year after the unit of property is initially placed in service by the taxpayer, if the taxpayer or the Internal Revenue Service changes the treatment of that property (or any portion thereof) to a proper MACRS class or a proper depreciation method (for example, as a result of a cost segregation study or a change in the use of the property), then the taxpayer must change the unit of property determination for that property (or the portion thereof) under this section to be consistent with the change in treatment for depreciation purposes. Thus, for example, if a portion of a unit of property is properly reclassified to a MACRS class different from the MACRS class of the unit of property of which it was previously treated as a part, then the reclassified portion of the property should be treated as a separate unit of property for purposes of this section.
(6) Examples. The following examples illustrate the application of this paragraph (e) and assume that the taxpayer has not made a general asset account election with regard to property or accounted for property in a multiple asset account. In addition, unless the facts specifically indicate otherwise, assume that the additional rules in paragraph (e)(5) of this section do not apply:
(ii) In Year 2, P pays an amount to construct an extension to the building to be used for additional warehouse space. Assume that the extension involves the addition of walls, floors, roof, and doors, but does not include the addition or extension of any building systems described in paragraph (e)(2)(ii)(B) of this section. Also assume that the amount paid to build the extension is a betterment to the building structure under paragraph (j) of this section, and is therefore treated as an amount paid for an improvement to the entire building under paragraph (e)(2)(ii) of this section. Accordingly, P capitalizes the amount paid as an improvement to the building under paragraph (d) of this section. Under paragraph (e)(4) of this section, the extension is not a unit of property separate from the building, the unit of property improved. Thus, to determine whether any future expenditure constitutes an improvement to the building under paragraph (e)(2)(ii) of this section, P must determine whether the expenditure constitutes an improvement to the building structure, including the building extension, or to any of the designated building systems.
(f) Improvements to leased property —(1) In general. Except as provided in paragraph (h) of this section (safe harbor for small taxpayers) and under § 1.263(a)-1(f) (de minimis safe harbor), this paragraph (f) provides the exclusive rules for determining whether amounts paid by a taxpayer are for an improvement to a leased property and must be capitalized. In the case of a leased building or a leased portion of a building, an amount is paid to improve a leased property if the amount is paid for an improvement to any of the properties specified in paragraph (e)(2)(ii) of this section (for lessor improvements) or in paragraph (e)(2)(v)(B) of this section (for lessee improvements, except as provided in paragraph (f)(2)(ii) of this section). Section 1.263(a)-4 does not apply to amounts paid for improvements to leased property or to amounts paid for the acquisition or production of leasehold improvement property.
(2) Lessee improvements —(i) Requirement to capitalize. A taxpayer lessee must capitalize the related amounts, as determined under paragraph (g)(3) of this section, that it pays to improve, as defined under paragraph (d) of this section, a leased property except to the extent that section 110 applies to a construction allowance received by the lessee for the purpose of such improvement or when the improvement constitutes a substitute for rent. See § 1.61-8(c) for the treatment of lessee expenditures that constitute a substitute for rent. A taxpayer lessee must also capitalize the related amounts that a lessor pays to improve, as defined under paragraph (d) of this section, a leased property if the lessee is the owner of the improvement, except to the extent that section 110 applies to a construction allowance received by the lessee for the purpose of such improvement. An amount paid for a lessee improvement under this paragraph (f)(2)(i) is treated as an amount paid to acquire or produce a unit of real or personal property under § 1.263(a)-2(d)(1) of the regulations.
(ii) Unit of property for lessee improvements. For purposes of determining whether an amount paid by a lessee constitutes a lessee improvement to a leased property under paragraph (f)(2)(i) of this section, the unit of property and the improvement rules are applied to the leased property in accordance with paragraph (e)(2)(v) (leased buildings) or paragraph (e)(3)(iv) (leased property other than buildings) of this section and include previous lessee improvements. However, if a lessee improvement is comprised of an entire building erected on leased property, then the unit of property for the building and the application of the improvement rules to the building are determined under paragraphs (e)(2)(i) and (e)(2)(ii) of this section.
(3) Lessor improvements —(i) Requirement to capitalize. A taxpayer lessor must capitalize the related amounts, as determined under paragraph (g)(3) of this section, that it pays directly, or indirectly through a construction allowance to the lessee, to improve, as defined in paragraph (d) of this section, a leased property when the lessor is the owner of the improvement or to the extent that section 110 applies to the construction allowance. A lessor must also capitalize the related amounts that the lessee pays to improve a leased property, as defined in paragraph (e) of this section, when the lessee's improvement constitutes a substitute for rent. See § 1.61-8(c) for treatment of expenditures by lessees that constitute a substitute for rent. Amounts capitalized by the lessor under this paragraph (f)(3)(i) may not be capitalized by the lessee. If a lessor improvement is comprised of an entire building erected on leased property, then the amount paid for the building is treated as an amount paid by the lessor to acquire or produce a unit of property under § 1.263(a)-2(d)(1). See paragraph (e)(2) of this section for the unit of property for a building and paragraph (e)(3) of this section for the unit of property for real or personal property other than a building.
(ii) Unit of property for lessor improvements. In general, an amount capitalized as a lessor improvement under paragraph (f)(3)(i) of this section is not a unit of property separate from the unit of property improved. See paragraph (e)(4) of this section. However, if a lessor improvement is comprised of an entire building erected on leased property, then the unit of property for the building and the application of the improvement rules to the building are determined under paragraphs (e)(2)(i) and (e)(2)(ii) of this section.
(4) Examples. The following examples illustrate the application of this paragraph (f) and do not address whether capitalization is required under another provision of the Code (for example, section 263A). For purposes of the following examples, assume that section 110 does not apply to the lessee and the amounts paid by the lessee are not a substitute for rent.
(ii) In Year 2, T pays an amount to construct an extension to the building to be used for additional warehouse space. Assume that this amount is for a betterment (as defined under paragraph (j) of this section) to T's leased building structure and does not affect any building systems. Accordingly, the amount that T pays for the building extension is for a betterment to the leased building structure, and thus, under paragraph (e)(2)(v)(B)( 1 ) of this section, is treated as an improvement to the entire leased building under paragraph (d) of this section. Because T, the lessee, paid an amount to improve a leased building property, T is required to capitalize the amount paid for the building extension as a leasehold improvement under paragraph (f)(2)(i) of this section. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property) under § 1.263(a)-2(d)(1).
(iii) In Year 5, T pays an amount to add a large overhead door to the building extension that it constructed in Year 2 to accommodate the loading of larger products into the warehouse space. Under paragraph (f)(2)(ii) of this section, to determine whether the amount paid by T is for a leasehold improvement, the unit of property and the improvement rules are applied in accordance with paragraph (e)(2)(v) of this section and include T's previous improvements to the leased property. Therefore, under paragraph (e)(2)(v)(A) of this section, the unit of property is the entire leased building, including the extension built in Year 2. In addition, under paragraph (e)(2)(v)(B) of this section, the leased building property is improved if the amount is paid for an improvement to the building structure or any building system. Assume that the amount paid to add the overhead door is for a betterment, under paragraph (j) of this section, to the building structure, which includes the extension. Accordingly, T must capitalize the amounts paid to add the overhead door as a leasehold improvement to the leased building property. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the improvement as the acquisition or production of a unit of property (leasehold improvement property) under § 1.263(a)-2(d)(1). However, to determine whether a future amount paid by T is for a leasehold improvement to the leased building, the unit of property and the improvement rules are again applied in accordance with paragraph (e)(2)(v) of this section and include the new overhead door.
(ii) In Year 5, T pays an amount to add an additional chiller to the portion of the HVAC system that it constructed in Year 2 to accommodate the climate control requirements for new product offerings. Under paragraph (f)(2)(ii) of this section, to determine whether the amount paid by T is for a leasehold improvement, the unit of property and the improvement rules are applied in accordance with paragraph (e)(2)(v) of this section and include T's previous improvements to the leased building property. Therefore, under paragraph (e)(2)(v)(B) of this section, the leased building property is improved if the amount is paid for an improvement to the building structure or any building system. Assume that the amount paid to add the chiller is for a betterment, under paragraph (j) of this section, to the HVAC system, which includes the extension of the system in Year 2. Accordingly, T must capitalize the amounts paid to add the chiller as a leasehold improvement to the leased building property. In addition, paragraph (f)(2)(i) of this section requires T to treat the amount paid for the chiller as the acquisition or production of a unit of property (leasehold improvement property) under § 1.263(a)-2(d)(1). However, to determine whether a future amount paid by T is for a leasehold improvement to the leased building, the unit of property and the improvement rules are again applied in accordance with paragraph (e)(2)(v) of this section and include the new chiller.
(ii) In Year 2, T uses L's construction allowance to construct an extension to the leased building to provide additional warehouse space in the building. Assume that the extension is a betterment (as defined under paragraph (j) of this section) to the building structure, and therefore, the amount paid for the extension results in an improvement to the building under paragraph (d) of this section. Under paragraph (f)(3)(i) of this section, L, the lessor and owner of the improvement, must capitalize the amounts paid to T to construct the extension to the retail sales facility. T is not permitted to capitalize the amounts paid for the lessor-owned improvement. Finally, under paragraph (f)(3)(ii) of this section, the extension to L's building is not a unit of property separate from the building and its structural components.
(g) Special rules for determining improvement costs —(1) Certain costs incurred during an improvement —(i) In general. A taxpayer must capitalize all the direct costs of an improvement and all the indirect costs (including, for example, otherwise deductible repair costs) that directly benefit or are incurred by reason of an improvement. Indirect costs arising from activities that do not directly benefit and are not incurred by reason of an improvement are not required to be capitalized under section 263(a), regardless of whether the activities are performed at the same time as an improvement.
(ii) Exception for individuals' residences. A taxpayer who is an individual may capitalize amounts paid for repairs and maintenance that are made at the same time as capital improvements to units of property not used in the taxpayer's trade or business or for the production of income if the amounts are paid as part of an improvement (for example, a remodeling) of the taxpayer's residence.
(2) Removal costs —(i) In general. If a taxpayer disposes of a depreciable asset, including a partial disposition under Prop. Reg. § 1.168(i)-1(e)(2)(ix) (September 19, 2013), or § 1.168(i)-8(d), for Federal income tax purposes and has taken into account the adjusted basis of the asset or component of the asset in realizing gain or loss, then the costs of removing the asset or component are not required to be capitalized under this section. If a depreciable asset is included in a general asset account under section 168(i)(4), and neither the regulations under section 168(i)(4) and § 1.168(i)-1(e)(3), apply to a disposition of such asset, or a portion of such asset under § 1.168(i)-1(e)(1)(ii), a loss is treated as being realized in the amount of zero upon the disposition of the asset solely for purposes of this paragraph (g)(2)(i). If a taxpayer disposes of a component of a unit of property, but the disposal of the component is not a disposition for Federal tax purposes, 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 to the unit of property or an improvement to the unit of property. But see § 1.280B-1 for the rules applicable to demolition of structures.
(ii) Examples. Thefollowing examples illustrate the application of paragraph (g)(2)(i) of this section and, unless otherwise stated, do not address whether capitalization is required under another provision of this section or another provision of the Code (for example, section 263A). For purposes of the following examples, assume that § 1.168(i)-1(e) or § 1.168(i)-8, applies and that § 1.280B-1 does not apply.
(3) Related amounts. For purposes of paragraph (d) of this section, amounts paid to improve a unit of property include amounts paid over a period of more than one taxable year. Whether amounts are related to the same improvement depends on the facts and circumstances of the activities being performed.
(4) Compliance with regulatory requirements. For purposes of this section, a Federal, state, or local regulator's requirement that a taxpayer perform certain repairs or maintenance on a unit of property to continue operating the property is not relevant in determining whether the amount paid improves the unit of property.
(h) Safe harbor for small taxpayers —(1) In general. A qualifying taxpayer (as defined in paragraph (h)(3) of this section) may elect to not apply paragraph (d) or paragraph (f) of this section to an eligible building property (as defined in paragraph (h)(4) of this section) if the total amount paid during the taxable year for repairs, maintenance, improvements, and similar activities performed on the eligible building property does not exceed the lesser of—
(i) 2 percent of the unadjusted basis (as defined under paragraph (h)(5) of this section) of the eligible building property; or
(ii) $10,000.
(2) Application with other safe harbor provisions. For purposes of paragraph (h)(1) of this section, amounts paid for repairs, maintenance, improvements, and similar activities performed on eligible building property include those amounts not capitalized under the de minimis safe harbor election under § 1.263(a)-1(f) and those amounts deemed not to improve property under the safe harbor for routine maintenance under paragraph (i) of this section.
(3) Qualifying taxpayer —(i) In general. For purposes of this paragraph (h), the term qualifying taxpayer means a taxpayer whose average annual gross receipts as determined under this paragraph (h)(3) for the three preceding taxable years is less than or equal to $10,000,000.
(ii) Application to new taxpayers. If a taxpayer has been in existence for less than three taxable years, the taxpayer determines its average annual gross receipts for the number of taxable years (including short taxable years) that the taxpayer (or its predecessor) has been in existence.
(iii) Treatment of short taxable year. In the case of any taxable year of less than 12 months (a short taxable year), the gross receipts shall be annualized by—
(A) Multiplying the gross receipts for the short period by 12; and
(B) Dividing the product determined in paragraph (h)(3)(iii)(A) of this section by the number of months in the short period.
(iv) Definition of gross receipts. For purposes of applying paragraph (h)(3)(i) of this section, the term gross receipts means the taxpayer's receipts for the taxable year that are properly recognized under the taxpayer's methods of accounting used for Federal income tax purposes for the taxable year. For this purpose, gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of section 103), dividends, rents, royalties, and annuities, regardless of whether such amounts are derived in the ordinary course of the taxpayer's trade of business. Gross receipts are not reduced by cost of goods sold or by the cost of property sold if such property is described in section 1221(a)(1), (3), (4), or (5). With respect to sales of capital assets as defined in section 1221, or sales of property described in section 1221(a)(2) (relating to property used in a trade or business), gross receipts shall be reduced by the taxpayer's adjusted basis in such property. Gross receipts do not include the repayment of a loan or similar instrument (for example, a repayment of the principal amount of a loan held by a commercial lender) and, except to the extent of gain recognized, do not include gross receipts derived from a non-recognition transaction, such as a section 1031 exchange. Finally, gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts include the amounts received that are allocable to the payment of such tax.
(4) Eligible building property. For purposes of this section, the term eligible building property refers to each unit of property defined in paragraph (e)(2)(i) (building), paragraph (e)(2)(iii)(A) (condominium), paragraph (e)(2)(iv)(A) (cooperative), or paragraph (e)(2)(v)(A) (leased building or portion of building) of this section, as applicable, that has an unadjusted basis of $1,000,000 or less.
(5) Unadjusted basis —(i) Eligible building property owned by taxpayer. For purposes of this section, the unadjusted basis of eligible building property owned by the taxpayer means the basis as determined under section 1012, or other applicable sections of Chapter 1, including subchapters O (relating to gain or loss on dispositions of property), C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses). Unadjusted basis is determined without regard to any adjustments described in section 1016(a)(2) or (3) or to amounts for which the taxpayer has elected to treat as an expense (for example, under sections 179, 179B, or 179C).
(ii) Eligible building property leased to the taxpayer. For purposes of this section, the unadjusted basis of eligible building property leased to the taxpayer is the total amount of (undiscounted) rent paid or expected to be paid by the lessee under the lease for the entire term of the lease, including renewal periods if all the facts and circumstances in existence during the taxable year in which the lease is entered indicate a reasonable expectancy of renewal. Section 1.263(a)-4(f)(5)(ii) provides the factors that are significant in determining whether there exists a reasonable expectancy of renewal for purposes of this paragraph.
(6) Time and manner of election. A taxpayer makes the election described in paragraph (h)(1) of this section by attaching a statement to the taxpayer's timely filed original Federal tax return (including extensions) for the taxable year in which amounts are paid for repairs, maintenance, improvements, and similar activities performed on the eligible building property providing that such amounts qualify under the safe harbor provided in paragraph (h)(1) of this section. Sections 301.9100-1 through 301.9100-3 of this chapter provide the rules governing extensions of the time to make regulatory elections. The statement must be titled, “Section 1.263(a)-3(h) Safe Harbor Election for Small Taxpayers” and include the taxpayer's name, address, taxpayer identification number, and a description of each eligible building property to which the taxpayer is applying the election. In the case of an S corporation or a partnership, the election is made by the S corporation or by the partnership, and not by the shareholders or partners. An election may not be made through the filing of an application for change in accounting method or, before obtaining the Commissioner's consent to make a late election, by filing an amended Federal tax return. A taxpayer may not revoke an election made under this paragraph (h). The time and manner of making the election under this paragraph (h) may be modified through guidance of general applicability (see §§ 601.601(d)(2) and 601.602 of this chapter).
(7) Treatment of safe harbor amounts. Amounts paid by the taxpayer for repairs, maintenance, improvements, and similar activities to which the taxpayer properly applies the safe harbor under paragraph (h)(1) of this section and for which the taxpayer properly makes the election under paragraph (h)(6) of this section are not treated as improvements under paragraph (d) or (f) of this section and may be deducted under § 1.162-1 or § 1.212-1, as applicable, in the taxable year these amounts are paid, provided the amounts otherwise qualify for a deduction under these sections.
(8) Safe harbor exceeded. If total amounts paid by a qualifying taxpayer during the taxable year for repairs, maintenance, improvements, and similar activities performed on an eligible building property exceed the safe harbor limitations specified in paragraph (h)(1) of this section, then the safe harbor election is not available for that eligible building property and the taxpayer must apply the general improvement rules under this section to determine whether amounts are for improvements to the unit of property, including the safe harbor for routine maintenance under paragraph (i) of this section. The taxpayer may also elect to apply the de minimis safe harbor under § 1.263(a)-1(f) to amounts qualifying under that safe harbor irrespective of the application of this paragraph (h).
(9) Modification of safe harbor amounts. The amount limitations provided in paragraphs (h)(1)(i), (h)(1)(ii), and (h)(3) of this section may be modified through published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)( b ) of this chapter).
(10) Examples. The following examples illustrate the rules of this paragraph (h). Assume that § 1.212-1 does not apply to the amounts paid.
(ii) The total amount paid by B during Year 1 for repairs, maintenance, improvements and similar activities on Building M ($5,000) does not exceed the lesser of $6,000 (2 percent of the building's unadjusted basis of $300,000) or $10,000. Therefore, under paragraph (h)(1) of this section, for Year 1, B may elect to not apply the capitalization rule under paragraph (d) of this section to the amounts it paid for repairs, maintenance, improvements, and similar activities on Building M. If B properly makes the election under paragraph (h)(6) of this section for Building M and the amounts otherwise constitute deductible ordinary and necessary expenses incurred in carrying on B's trade or business, B may deduct these amounts under § 1.162-1.
(iii) The total amount paid by B during Year 1 for repairs, maintenance, improvements and similar activities on Building N ($7,000) exceeds $6,000 (2 percent of the building's unadjusted basis of $300,000), the lesser of the two limitations provided under paragraph (h)(1) of this section. Therefore, B may not apply the safe harbor under paragraph (h)(1) of this section to the total amounts paid for repairs, maintenance, improvements, and similar activities performed on Building N. Instead, B must apply the general improvement rules under this section to determine which of the total amounts paid for work performed on Building N are for improvements and must be capitalized under paragraph (d) of this section and which amounts are for repair and maintenance under § 1.162-4.
(i) Safe harbor for routine maintenance on property —(1) In general. An amount paid for routine maintenance (as defined in paragraph (i)(1)(i) or (i)(1)(ii) of this section, as applicable) on a unit of tangible property, or in the case of a building, on any of the properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B), (e)(2)(iv)(B), or paragraph (e)(2)(v)(B) of this section, is deemed not to improve that unit of property.
(i) Routine maintenance for buildings. Routine maintenance for a building unit of property is the recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of any of the properties designated in paragraphs (e)(2)(ii), (e)(2)(iii)(B), (e)(2)(iv)(B), or (e)(2)(v)(B) of this section to keep the building structure or each building system in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the building structure or each building system, and the replacement of damaged or worn parts with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the building structure or building systems. However, the activities are routine only if the taxpayer reasonably expects to perform the activities more than once during the 10-year period beginning at the time the building structure or the building system upon which the routine maintenance is performed is placed in service by the taxpayer. A taxpayer's expectation will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the 10-year period, provided that the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service. Factors to be considered in determining whether maintenance is routine and whether a taxpayer's expectation is reasonable include the recurring nature of the activity, industry practice, manufacturers' recommendations, and the taxpayer's experience with similar or identical property. With respect to a taxpayer that is a lessor of a building or a part of the building, the taxpayer's use of the building unit of property includes the lessee's use of its unit of property.
(ii) Routine maintenance for property other than buildings. Routine maintenance for property other than buildings is the recurring activities that a taxpayer expects to perform as a result of the taxpayer's use of the unit of property to keep the unit of property in its ordinarily efficient operating condition. Routine maintenance activities include, for example, the inspection, cleaning, and testing of the unit of property, and the replacement of damaged or worn parts of the unit of property with comparable and commercially available replacement parts. Routine maintenance may be performed any time during the useful life of the unit of property. However, the activities are routine only if, at the time the unit of property is placed in service by the taxpayer, the taxpayer reasonably expects to perform the activities more than once during the class life (as defined in paragraph (i)(4) of this section) of the unit of property. A taxpayer's expectation will not be deemed unreasonable merely because the taxpayer does not actually perform the maintenance a second time during the class life of the unit of property, provided that the taxpayer can otherwise substantiate that its expectation was reasonable at the time the property was placed in service. Factors to be considered in determining whether maintenance is routine and whether the taxpayer's expectation is reasonable include the recurring nature of the activity, industry practice, manufacturers' recommendations, and the taxpayer's experience with similar or identical property. With respect to a taxpayer that is a lessor of a unit of property, the taxpayer's use of the unit of property includes the lessee's use of the unit of property.
(2) Rotable and temporary spare parts. Except as provided in paragraph (i)(3) of this section, for purposes of paragraph (i)(1)(ii) of this section, amounts paid for routine maintenance include routine maintenance performed on (and with regard to) rotable and temporary spare parts.
(3) Exceptions. Routine maintenance does not include the following:
(i) Amounts paid for a betterment to a unit of property under paragraph (j) of this section;
(ii) Amounts paid for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component (other than a casualty loss under § 1.165-7) (see paragraph (k)(1)(i) of this section);
(iii) Amounts paid for the replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component (see paragraph (k)(1)(ii) of this section);
(iv) Amounts paid for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165, subject to the limitation in paragraph (k)(4) of this section (see paragraph (k)(1)(iii) of this section);
(v) Amounts paid to return a unit of property to its ordinarily efficient operating condition, if the property has deteriorated to a state of disrepair and is no longer functional for its intended use (see paragraph (k)(1)(iv) of this section);
(vi) Amounts paid to adapt a unit of property to a new or different use under paragraph (l) of this section;
(vii) Amounts paid for repairs, maintenance, or improvement of network assets (as defined in paragraph (e)(3)(iii)(A) of this section); or
(viii) Amounts paid for repairs, maintenance, or improvement of rotable and temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under § 1.162-3(e).
(4) Class life. The class life of a unit of property is the recovery period prescribed for the property under sections 168(g)(2) and (3) for purposes of the alternative depreciation system, regardless of whether the property is depreciated under section 168(g). For purposes of determining class life under this section, section 168(g)(3)(A) (relating to tax-exempt use property subject to lease) does not apply. If the unit of property is comprised of components with different class lives, then the class life of the unit of property is deemed to be the same as the component with the longest class life.
(5) Coordination with section 263A. Amounts paid for routine maintenance under this paragraph (i) may be subject to capitalization under section 263A if these amounts comprise the direct or allocable indirect costs of other property produced by the taxpayer or property acquired for resale. See, for example, § 1.263A-1(e)(3)(ii)(O) requiring taxpayers to capitalize the cost of repairing equipment or facilities allocable to property produced or property acquired for resale.
(6) Examples. The following examples illustrate the application of this paragraph (i) and, unless otherwise stated, do not address the treatment under other provisions of the Code (for example, section 263A). In addition, unless otherwise stated, assume that the taxpayer has not applied the optional method of accounting for rotable and temporary spare parts under § 1.162-3(e).
(ii) Because the ESVs involve the recurring activities that A expects to perform as a result of its use of the aircraft to keep the aircraft in ordinarily efficient operating condition and consist of maintenance activities that A expects to perform more than once during the 12 year class life of the aircraft, A's ESVs are within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the ESVs are deemed not to improve the aircraft and are not required to be capitalized under paragraph (d) of this section.
(ii) The additional aircraft engines are rotable spare parts under § 1.162-3(c)(2) because they were acquired separately from the aircraft, are removable from the aircraft, and are repaired and reinstalled on other aircraft or stored for later installation. Assume the class life of an engine is the same as the airframe, 12 years. Because the ESVs involve the recurring activities that A expects to perform as a result of its use of the engines to keep the engines in ordinarily efficient operating condition, and consist of maintenance activities that A expects to perform more than once during the 12 year class life of the engine, the ESVs fall within the routine maintenance safe harbor under paragraph (i)(1)(ii) of this section. Accordingly, the amounts paid for the ESVs for the four additional engines are deemed not to improve these engines and are not required to be capitalized under paragraph (d) of this section. For the treatment of amounts paid to acquire the engines, see § 1.162-3(a).
(ii) The majority of B's costs do not qualify under the routine maintenance safe harbor in paragraph (i)(1)(ii) of this section because the costs were incurred primarily as a result of the prior owner's use of the property and not B's use. B acquired the machine just before it had received its three-year scheduled maintenance. Accordingly, the amounts paid for the scheduled maintenance resulted from the prior owner's, and not B's, use of the property and must be capitalized if those amounts result in a betterment under paragraph (i) of this section, including the amelioration of a material condition or defect, or otherwise result in an improvement under paragraph (d) of this section.
(j) Capitalization of betterments —(1) In general. A taxpayer must capitalize as an improvement an amount paid for a betterment to a unit of property. An amount is paid for a betterment to a unit of property only if it—
(i) Ameliorates a material condition or defect that either existed prior to the taxpayer's acquisition of the unit of property or arose during the production of the unit of property, whether or not the taxpayer was aware of the condition or defect at the time of acquisition or production;
(ii) Is for a material addition, including a physical enlargement, expansion, extension, or addition of a major component (as defined in paragraph (k)(6) of this section) to the unit of property or a material increase in the capacity, including additional cubic or linear space, of the unit of property; or
(iii) Is reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the unit of property.
(2) Application of betterment rules —(i) In general. The applicability of each quantitative and qualitative factor provided in paragraphs (j)(1)(ii) and (j)(1)(iii) of this section to a particular unit of property depends on the nature of the unit of property. For example, if an addition or an increase in a particular factor cannot be measured in the context of a specific type of property, this factor is not relevant in the determination of whether an amount has been paid for a betterment to the unit of property.
(ii) Application of betterment rules to buildings. An amount is paid to improve a building if it is paid for a betterment, as defined under paragraph (j)(1) of this section, to a property specified under paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or leased portion of building) of this section. For example, an amount is paid to improve a building if it is paid for an increase in the efficiency of the building structure or any one of its building systems (for example, the HVAC system).
(iii) Unavailability of replacement parts. If a taxpayer replaces a part of a unit of property that cannot reasonably be replaced with the same type of part (for example, because of technological advancements or product enhancements), the replacement of the part with an improved, but comparable, part does not, by itself, result in a betterment to the unit of property.
(iv) Appropriate comparison —(A) In general. In cases in which an expenditure is necessitated by normal wear and tear or damage to the unit of property that occurred during the taxpayer's use of the unit of property, the determination of whether an expenditure is for the betterment of the unit of property is made by comparing the condition of the property immediately after the expenditure with the condition of the property immediately prior to the circumstances necessitating the expenditure.
(B) Normal wear and tear. If the expenditure is made to correct the effects of normal wear and tear to the unit of property that occurred during the taxpayer's use of the unit of property, the condition of the property immediately prior to the circumstances necessitating the expenditure is the condition of the property after the last time the taxpayer corrected the effects of normal wear and tear (whether the amounts paid were for maintenance or improvements) or, if the taxpayer has not previously corrected the effects of normal wear and tear, the condition of the property when placed in service by the taxpayer.
(C) Damage to property. If the expenditure is made to correct damage to a unit of property that occurred during the taxpayer's use of the unit of property, the condition of the property immediately prior to the circumstances necessitating the expenditure is the condition of the property immediately prior to damage.
(3) Examples. The following examples illustrate the application of this paragraph (j) only and do not address whether capitalization is required under another provision of this section or another provision of the Internal Revenue Code (for example, section 263A). Unless otherwise provided, assume that the appropriate comparison in paragraph (j)(2)(iv) of this section is not applicable under the facts.
(ii) The amount that C pays does not qualify under the routine maintenance safe harbor in paragraph (i) of this section, because the cost primarily results from the prior owner's use of the property and not the taxpayer's use. C acquired the machine just before it had received its three-year scheduled maintenance. Accordingly, the amount that C pays for the scheduled maintenance results from the prior owner's use of the property and ameliorates conditions or defects that existed prior to C's ownership of the machine. Nevertheless, considering the purpose and minor nature of the work performed, this amount does not ameliorate a material condition or defect in the machine under paragraph (j)(1)(i) of this section, is not for a material addition to or increase in capacity of the machine under paragraph (j)(1)(ii) of this section, and is not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of the machine under paragraph (j)(1)(iii) of this section. Therefore, C is not required to capitalize the amount paid for the scheduled maintenance as a betterment to the unit of property under this paragraph (j).
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the purpose of the expenditure and the effect of the expenditures on the building structure, the amounts that E paid for repairs and maintenance to the building structure comprise a betterment to the building structure under paragraph (j)(1)(i) of this section because the amounts ameliorate material conditions that existed prior to E's acquisition of the building. Therefore, E must treat the amounts paid for the betterment to the building structure as an improvement to the building and must capitalize the amounts under paragraphs (j) and (d)(1) of this section. Moreover, E is required to capitalize the amounts paid to acquire and install each section 1245 property, including each window treatment, each item of furniture, and each cabinet, in accordance with § 1.263(a)-2(d)(1).
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the facts and circumstances including the purpose of the expenditure, the physical nature of the work performed, and the effect of the expenditure on the buildings' structure and systems, the amounts paid for the refresh of each building are not for any material additions to, or material increases in the capacity of, the buildings' structure or systems as compared with the condition of the structure or systems after the previous refresh. Moreover, the amounts paid are not reasonably expected to materially increase the productivity, efficiency, strength, quality, or output of any building structure or system under as compared to the condition of the structures or systems after the previous refresh. Rather, the work performed keeps F's store buildings' structures and buildings' systems in their ordinarily efficient operating condition. Therefore, F is not required to treat the amounts paid for the refresh of its store buildings' structures and buildings' systems as betterments under paragraphs (j)(1)(ii), (j)(1)(iii), and (j)(2)(iv) of this section. However, F is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with § 1.263(a)-2(d)(1).
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Under paragraph (j)(1)(ii) of this section, the amounts paid by F to add the storage space, loading dock, overhead door, and expand the electrical system are for betterments to F's building structure and to the electrical system because they are for material additions to, and a material increase in capacity of, the structure and the electrical system of F's store building. Accordingly, F must treat the amounts paid for these betterments as improvements to the building unit of property and capitalize these amounts under paragraphs (d)(1) and (j) of this section. However, for the reasons discussed in Example 6, F is not required to treat the amounts paid for the refresh of its store building structure and systems as a betterments under paragraph (j)(1) of this section. In addition, F is not required under paragraph (g)(1) of this section to capitalize the refresh costs described in Example 6 because these costs do not directly benefit and are not incurred by reason of the additions to the building structure and electrical system. As in Example 6, F is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with § 1.263(a)-2(d)(1).
(ii) Under paragraphs (e)(2)(ii) and (j)(2)(ii) of this section, an amount is paid to improve a building unit of property if the amount is paid for a betterment to the building structure or any building system. Considering the facts and circumstances, including the purpose of the expenditure, the physical nature of the work performed, and the effect of the work on the buildings' structures and buildings' systems, the amounts that G pays for the remodeling of its stores result in betterments to the buildings' structures and several of its systems under paragraph (j) of this section. Specifically, the amounts paid to replace large parts of the exterior walls with windows, replace the escalators with a monumental staircase, add a new elevator, rebuild the interior and exterior facades, replace vinyl floors with ceramic flooring, replace the ceiling tiles with acoustical tiles, and to remove and rebuild walls are for material additions, that is the addition of major components, to the building structure under paragraph (j)(1)(ii) of this section and are reasonably expected to increase the quality of the building structure under paragraph (j)(1)(iii) of this section. Similarly, the amounts paid to upgrade the electrical system are to materially increase the capacity of the electrical system under paragraph (j)(1)(ii) of this section and are reasonably expected to increase the quality of this system under paragraph (j)(1)(iii) of this section. In addition, the amounts paid to remodel the bathrooms with higher grade and more resource-efficient materials are reasonably expected to increase the efficiency and quality of the plumbing system under paragraph (j)(1)(iii) of this section. Finally, the amounts paid to clean debris, patch and repaint existing walls with a new color scheme, and to power wash building exteriors, while not betterments by themselves, directly benefitted and were incurred by reason of the improvements to G's store buildings' structures and electrical systems under paragraph (g)(1) of this section. Therefore, G must treat the amounts paid for betterments to the store buildings' structures and systems, including the costs of cleaning, patching, repairing, and power washing the building, as improvements to G's buildings and must capitalize these amounts under paragraphs (d)(1) and (j) of this section. Moreover, G is required to capitalize the amounts paid to acquire and install each section 1245 property in accordance with § 1.263(a)-2(d)(1). For the treatment of amounts paid to remove components of property, see paragraph (g)(2) of this section.
(k) Capitalization of restorations —(1) In general. A taxpayer must capitalize as an improvement an amount paid to restore a unit of property, including an amount paid to make good the exhaustion for which an allowance is or has been made. An amount restores a unit of property only if it—
(i) Is for the replacement of a component of a unit of property for which the taxpayer has properly deducted a loss for that component, other than a casualty loss under § 1.165-7;
(ii) Is for the replacement of a component of a unit of property for which the taxpayer has properly taken into account the adjusted basis of the component in realizing gain or loss resulting from the sale or exchange of the component;
(iii) Is for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment as a result of a casualty loss under section 165, or relating to a casualty event described in section 165, subject to the limitation in paragraph (k)(4) of this section;
(iv) Returns the unit of property to its ordinarily efficient operating condition if the property has deteriorated to a state of disrepair and is no longer functional for its intended use;
(v) Results in the rebuilding of the unit of property to a like-new condition as determined under paragraph (k)(5) of this section after the end of its class life as defined in paragraph (i)(4) of this section; or
(vi) Is for the replacement of a part or combination of parts that comprise a major component or a substantial structural part of a unit of property as determined under paragraph (k)(6) of this section.
(2) Application of restorations to buildings. An amount is paid to improve a building if it is paid to restore, as defined under paragraph (k)(1) of this section, a property specified under paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or portion of building) of this section. For example, an amount is paid to improve a building if it is paid for the replacement of a part or combination of parts that comprise a major component or substantial structural part of the building structure or any one of its building systems (for example, the HVAC system). See paragraph (k)(6) of this section.
(3) Exception for losses based on salvage value. A taxpayer is not required to treat as a restoration amounts paid under paragraph (k)(1)(i) or paragraph (k)(1)(ii) of this section if the unit of property has been fully depreciated and the loss is attributable only to remaining salvage value as computed for federal income tax purposes.
(4) Restoration of damage from casualty —(i) Limitation. For purposes of paragraph (k)(1)(iii) of this section, the amount paid for restoration of damage to the unit of property that must be capitalized under this paragraph (k) is limited to the excess (if any) of—
(A) The amount prescribed by § 1.1011-1 as the adjusted basis of the single, identifiable property (under § 1.167-7(b)(2)(i)) for determining the loss allowable on account of the casualty, over
(B) The amount paid for restoration of damage to the unit of property under paragraph (k)(1)(iii) of this section that also constitutes an improvement under any other provision of paragraph (k)(1) of this section.
(ii) Amounts in excess of limitation. The amounts paid for restoration of damage to a unit of property as described in paragraph (k)(1)(iii) of this section, but that exceed the limitation provided in paragraph (k)(4)(i) of this section, must be treated in accordance with the provisions of the Internal Revenue Code and regulations that are otherwise applicable. See, for example, § 1.162-4 (repairs and maintenance); § 1.263(a)-2 (costs to acquire and produce units of property); and § 1.263(a)-3 (costs to improve units of property).
(5) Rebuild to like-new condition. For purposes of paragraph (k)(1)(v) of this section, a unit of property is rebuilt to a like-new condition if it is brought to the status of new, rebuilt, remanufactured, or a similar status under the terms of any federal regulatory guideline or the manufacturer's original specifications. Generally, a comprehensive maintenance program, even though substantial, does not return a unit of property to a like-new condition.
(6) Replacement of a major component or a substantial structural part —(i) In general. To determine whether an amount is for the replacement of a part or a combination of parts that comprise a major component or a substantial structural part of the unit of property under paragraph (k)(1)(vi) of this section, it is appropriate to consider all the facts and circumstances. These facts and circumstances include the quantitative and qualitative significance of the part or combination of parts in relation to the unit of property.
(A) Major component. A major component is a part or combination of parts that performs a discrete and critical function in the operation of the unit of property. An incidental component of the unit of property, even though such component performs a discrete and critical function in the operation of the unit of property, generally will not, by itself, constitute a major component.
(B) Substantial structural part. A substantial structural part is a part or combination of parts that comprises a large portion of the physical structure of the unit of property.
(ii) Major components and substantial structural parts of buildings. In the case of a building, an amount is for the replacement of a major component or a substantial structural part of the building unit of property if—
(A) The replacement includes a part or combination of parts that comprise a major component (as defined in paragraph (k)(6)(i)(A) of this section), or a significant portion of a major component, of any of the properties designated in paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or leased portion of a building) of this section; or
(B) The replacement includes a part or combination of parts that comprises a large portion of the physical structure of any of the properties designated in paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or portion of building) of this section.
(7) Examples. The following examples illustrate the application of this paragraph (k) only and do not address whether capitalization is required under another provision of this section or another provision of the Code (for example, section 263A). Unless otherwise stated, assume that the taxpayer has not properly deducted a loss for, nor taken into account the adjusted basis on a sale or exchange of, any unit of property, asset, or component of a unit of property that is replaced.
(ii) Under paragraph (k)(1)(vi) of this section, C must capitalize as an improvement the $350,000 amount paid to the contractor to replace the roof structure because the roof structure constitutes a major component and a substantial structural part of the building unit of property. In addition, under paragraphs (k)(1)(iii) and (k)(4)(i), C must treat as a restoration the remaining costs, limited to the excess of the adjusted basis of the building over the amounts paid for the improvement under paragraph (k)(1)(vi). Accordingly, C must treat as a restoration $150,000 ($500,000—$350,000) of the $400,000 paid for the portion of the costs related to repairing and cleaning the building structure under paragraph (k)(1)(iii) of this section. Thus, in addition to the $350,000 to replace the roof structure, C must also capitalize the $150,000 as an improvement to the building unit of property under paragraph (d)(2) of this section. C is not required to capitalize the remaining $250,000 repair and cleaning costs under paragraph (k)(1)(iii) of this section.
(ii) H pays the permit fee to the county on October 15, Year 1. On December 15, Year 1, the contractor completes the removal of the old USTs and bills H for the costs of removal. On January 15, Year 2, the contractor completes the installation of the new USTs and bills H for the remainder of the work. Assume that H computes its taxes on a calendar year basis and H's gasoline pumping system is the unit of property. Under paragraph (k)(1)(vi) of this section, H must capitalize the amounts paid to replace the USTs as a restoration to the gasoline pumping system because the USTs are parts or combinations of parts that comprise a major component and substantial structural part of the gasoline pumping system. Moreover, under paragraph (g)(2) of this section, H must capitalize the costs of removing the old USTs because H has not taken a loss on the disposition of the USTs, and the amounts to remove the USTs directly benefit and are incurred by reason of the restoration of, and improvement to, the gasoline pumping system. In addition, under paragraph (g)(1) of this section, H must capitalize the permit fees because they directly benefit and are incurred by reason of the improvement to the gasoline pumping system. Finally, under paragraph (g)(3) of this section, H must capitalize the related amounts paid to improve the gasoline pumping system, including the permit fees, the amount paid to remove the old USTs, and the amount paid to install the new USTs, even though the amounts were separately invoiced, paid to different parties, and incurred in different tax years.
(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The plumbing system, including the bathtubs, toilets, and sinks, is a building system under paragraph (e)(2)(ii)(B)( 2 ) of this section. All the bathtubs, together, all the toilets, together, and all the sinks together in the hotel building perform discrete and critical functions in the operation of the plumbing system under paragraph (k)(6)(ii)(A) of this section and comprise a large portion of the physical structure of the plumbing system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6)(ii) of this section, these plumbing components comprise major components and substantial structural parts of the plumbing system, and T must treat the amount paid to replace these plumbing components as a restoration of, and improvement to, the building under paragraphs (k)(1)(vi) and (k)(2) of this section. In addition, under paragraph (g)(1)(i) of this section, T must treat the costs of repairing, repainting, and retiling the bathroom walls and floors as improvement costs because these costs directly benefit and are incurred by reason of the improvement to the building. Further, under paragraph (g)(3) of this section, T must treat the costs incurred in Years 1, 2, and 3 for the bathroom remodeling as improvement costs, even though they are incurred over a period of several taxable years, because they are related amounts paid to improve the building unit of property. Accordingly, under paragraph (d)(2) of this section, T must treat all the amounts it incurs to update its hotel restrooms as an improvement to the hotel building and capitalize these amounts. In addition, under § 1.263(a)-2 of the regulations, T must capitalize the amounts paid to acquire and install each section 1245 property.
(ii) Under paragraphs (e)(2)(ii) and (k)(2) of this section, an amount is paid to improve a building if the amount restores the building structure or any building system. The elevator system, including all four elevators, is a building system under paragraph (e)(2)(ii)(B)( 5 ) of this section. The replacement elevator does not perform a discrete and critical function in the operation of elevator system under paragraph (k)(6)(ii)(A) of this section nor does it comprise a large portion of the physical structure of the elevator system under paragraph (k)(6)(ii)(B) of this section. Therefore, under paragraph (k)(6) of this section, the replacement elevator does not constitute the replacement of a major component or substantial structural part of the elevator system. Accordingly, X is not required to treat the amount paid to replace the elevator as a restoration to the building under either paragraph (k)(1)(i) or paragraph (k)(1)(vi) of this section.
(l) Capitalization of amounts to adapt property to a new or different use —(1) In general. A taxpayer must capitalize as an improvement an amount paid to adapt a unit of property to a new or different use. In general, an amount is paid to adapt a unit of property to a new or different use if the adaptation is not consistent with the taxpayer's ordinary use of the unit of property at the time originally placed in service by the taxpayer.
(2) Application of adaption rule to buildings. In the case of a building, an amount is paid to improve a building if it is paid to adapt to a new or different use a property specified under paragraph (e)(2)(ii) (building), paragraph (e)(2)(iii)(B) (condominium), paragraph (e)(2)(iv)(B) (cooperative), or paragraph (e)(2)(v)(B) (leased building or leased portion of building) of this section. For example, an amount is paid to improve a building if it is paid to adapt the building structure or any one of its buildings systems to a new or different use.
(3) Examples. The following examples illustrate the application of this paragraph (l) only and do not address whether capitalization is required under another provision of this section or under another provision of the Code (for example, section 263A). Unless otherwise stated, assume that the taxpayer has not properly deducted a loss for any unit of property, asset, or component of a unit of property that is removed and replaced.
(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve E's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert part of the retail drug store building structure into a medical clinic adapts the building structure to a new and different use, because the use of the building structure to provide clinical medical services is not consistent with E's intended ordinary use of the building structure at the time it was placed in service. Similarly, the amounts paid to add to the plumbing system and the electrical systems to support the new medical services is not consistent with E's intended ordinary use of these systems when the systems were placed in service. Therefore, E must treat the amount paid for the conversion of the building structure, plumbing system, and electrical system as an improvement to the building and capitalize the amount under paragraphs (d)(3) and (l) of this section.
(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve F's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert a part of F's retail grocery into a sushi bar area does not adapt F's building structure, plumbing system, or electrical system to a new or different use, because the sale of sushi is consistent with F's intended, ordinary use of the building structure and these systems in its grocery sales business, which includes selling food to its customers at various specialized counters. Accordingly, the amount paid by F to replace the wall and floor finishes, add wiring, and add plumbing to create the sushi bar space does not improve the building unit of property under paragraph (l) of this section and is not required to be capitalized under paragraph (d)(3) of this section.
(ii) Under paragraphs (l)(2) and (e)(2)(ii) of this section, an amount is paid to improve G's building if it adapts the building structure or any of the building systems to a new or different use. Under paragraph (l)(1) of this section, the amount paid to convert part of G's emergency room into an outpatient surgery center does not adapt G's building structure or electrical system to a new or different use, because the provision of outpatient surgery is consistent with G's intended, ordinary use of the building structure and these systems in its clinical medical care business. Accordingly, the amounts paid by G to relocate interior walls, add additional wiring and outlets, replace floor tiles and doors, and repaint the walls to create outpatient surgery space do not improve the building under paragraph (l) of this section and are not required to be capitalized under paragraph (d)(3) of this section.
(m) Optional regulatory accounting method —(1) In general. This paragraph (m) provides an optional simplified method (the regulatory accounting method) for regulated taxpayers to determine whether amounts paid to repair, maintain, or improve tangible property are to be treated as deductible expenses or capital expenditures. A taxpayer that uses the regulatory accounting method described in paragraph (m)(3) of this section must use that method for property subject to regulatory accounting instead of determining whether amounts paid to repair, maintain, or improve property are capital expenditures or deductible expenses under the general principles of sections 162(a), 212, and 263(a). Thus, the capitalization rules in paragraph (d) (and the routine maintenance safe harbor described in paragraph (i)) of this section do not apply to amounts paid to repair, maintain, or improve property subject to regulatory accounting by taxpayers that use the regulatory accounting method under this paragraph (m).
(2) Eligibility for regulatory accounting method. A taxpayer that is engaged in a trade or business in a regulated industry is a regulated taxpayer and may use the regulatory accounting method under this paragraph (m). For purposes of this paragraph (m), a taxpayer is in a regulated industry only if the taxpayer is subject to the regulatory accounting rules of the Federal Energy Regulatory Commission (FERC), the Federal Communications Commission (FCC), or the Surface Transportation Board (STB).
(3) Description of regulatory accounting method. Under the regulatory accounting method, a taxpayer must follow the method of accounting for regulatory accounting purposes that it is required to follow for FERC, FCC, or STB (whichever is applicable) in determining whether an amount paid repairs, maintains, or improves property under this section. Therefore, a taxpayer must capitalize for Federal income tax purposes an amount paid that is capitalized as an improvement for regulatory accounting purposes. A taxpayer may not capitalize for Federal income tax purposes under this section an amount paid that is not capitalized as an improvement for regulatory accounting purposes. A taxpayer that uses the regulatory accounting method must use that method for all of its tangible property that is subject to regulatory accounting rules. The method does not apply to tangible property that is not subject to regulatory accounting rules. The method also does not apply to property for the taxable years in which the taxpayer elected to apply the repair allowance under § 1.167(a)-11(d)(2). The regulatory accounting method is a method of accounting under section 446(a).
(4) Examples. The following examples illustrate the application of this paragraph (m):
(n) Election to capitalize repair and maintenance costs —(1) In general. A taxpayer may elect to treat amounts paid during the taxable year for repair and maintenance (as defined under § 1.162-4) to tangible property as amounts paid to improve that property under this section and as an asset subject to the allowance for depreciation if the taxpayer incurs these amounts in carrying on the taxpayer's trade or business and if the taxpayer treats these amounts as capital expenditures on its books and records regularly used in computing income (“books and records”). A taxpayer that elects to apply this paragraph (n) in a taxable year must apply this paragraph to all amounts paid for repair and maintenance to tangible property that it treats as capital expenditures on its books and records in that taxable year. Any amounts for which this election is made shall not be treated as amounts paid for repair or maintenance under § 1.162-4.
(2) Time and manner of election. A taxpayer makes this election under this paragraph (n) by attaching a statement to the taxpayer's timely filed original Federal tax return (including extensions) for the taxable year in which the taxpayer pays amounts described under paragraph (n)(1) of this paragraph. Sections 301.9100-1 through 301.9100-3 of this chapter provide the rules governing extensions of the time to make regulatory elections. The statement must be titled “Section 1.263(a)-3(n) Election” and include the taxpayer's name, address, taxpayer identification number, and a statement that the taxpayer is making the election to capitalize repair and maintenance costs under § 1.263(a)-3(n). In the case of a consolidated group filing a consolidated income tax return, the election is made for each member of the consolidated group by the common parent, and the statement must also include the names and taxpayer identification numbers of each member for which the election is made. In the case of an S corporation or a partnership, the election is made by the S corporation or partnership and not by the shareholders or partners. A taxpayer making this election for a taxable year must treat any amounts paid for repairs and maintenance during the taxable year that are capitalized on the taxpayer's books and records as improvements to tangible property. The taxpayer must begin to depreciate the cost of such improvements amounts when they are placed in service by the taxpayer under the applicable provisions of the Code and regulations. An election may not be made through the filing of an application for change in accounting method or, before obtaining the Commissioner's consent to make a late election, by filing an amended Federal tax return. The time and manner of electing to capitalize repair and maintenance costs under this paragraph (n) may be modified through guidance of general applicability (see §§ 601.601(d)(2) and 601.602 of this chapter).
(3) Exception. This paragraph (n) does not apply to amounts paid for repairs or maintenance of rotable or temporary spare parts to which the taxpayer applies the optional method of accounting for rotable and temporary spare parts under § 1.162-3(e).
(4) Examples. The following examples illustrate the application of this paragraph (n):
(ii) On its books and records, Q treats amounts paid for scheduled maintenance on its towboat engines as capital expenditures. For administrative convenience, Q decides to account for these costs in the same way for Federal income tax purposes. Under paragraph (n) of this section, in Year 4, Q may elect to capitalize the amounts paid for the scheduled maintenance on its towboat engines. If Q elects to capitalize such amounts, Q must capitalize all amounts paid for repair and maintenance to tangible property that Q treats as capital expenditures on its books and records in Year 4.
(ii) On its books and records, R treats amounts paid for the two HVAC components as capital expenditures. R determines that it would prefer to account for these amounts in the same way for Federal income tax purposes. Under this paragraph (n), in Year 1, R may elect to capitalize the amounts paid for the new HVAC components. If R elects to capitalize such amounts, R must capitalize all amounts paid for repair and maintenance to tangible property that R treats as capital expenditures on its books and records in Year 1.
(o) Treatment of capital expenditures. Amounts required to be capitalized under this section are capital expenditures and must be taken into account through a charge to capital account or basis, or in the case of property that is inventory in the hands of a taxpayer, through inclusion in inventory costs.
(p) Recovery of capitalized amounts. Amounts that are capitalized under this section are recovered through depreciation, cost of goods sold, or by an adjustment to basis at the time the property is placed in service, sold, used, or otherwise disposed of by the taxpayer. Cost recovery is determined by the applicable Code and regulation provisions relating to the use, sale, or disposition of property.
(q) Accounting method changes. Except as otherwise provided in this section, a change to comply with this section is a change in method of accounting to which the provisions of sections 446 and 481 and the accompanying regulations apply. A taxpayer seeking to change to a method of accounting permitted in this section must secure the consent of the Commissioner in accordance with § 1.446-1(e) and follow the administrative procedures issued under § 1.446-1(e)(3)(ii) for obtaining the Commissioner's consent to change its accounting method.
(r) Effective/applicability date —(1) In general. Except for paragraphs (h), (m), and (n) of this section, this section applies to taxable years beginning on or after January 1, 2014. Paragraphs (h), (m), and (n) of this section apply to amounts paid in taxable years beginning on or after January 1, 2014. Except as provided in paragraphs (r)(2) and (r)(3) of this section, § 1.263(a)-3 as contained in 26 CFR part 1 edition revised as of April 1, 2011, applies to taxable years beginning before January 1, 2014.
(2) Early application of this section —(i) In general. Except for paragraphs (h), (m), and (n) of this section, a taxpayer may choose to apply this section to taxable years beginning on or after January 1, 2012. A taxpayer may choose to apply paragraphs (h), (m), and (n) of this section to amounts paid in taxable years beginning on or after January 1, 2012.
(ii) Transition rule for certain elections on 2012 or 2013 returns. If under paragraph (r)(2)(i) of this section, a taxpayer chooses to make the election to apply the safe harbor for small taxpayers under paragraph (h) of this section or the election to capitalize repair and maintenance costs under paragraph (n) of this section for amounts paid in its taxable year beginning on or after January 1, 2012, and ending on or before September 19, 2013 (applicable taxable year), and the taxpayer did not make the election specified in paragraph (h)(6) or paragraph (n)(2) of this section on its timely filed original Federal tax return for the applicable taxable year, the taxpayer must make the election specified in paragraph (h)(6) or paragraph (n)(2) of this section for the applicable taxable year by filing an amended Federal tax return (including the required statements) for the applicable taxable year on or before 180 days from the due date including extensions of the taxpayer's Federal tax return for the applicable taxable year, notwithstanding that the taxpayer may not have extended the due date.
(3) Optional application of TD 9564. A taxpayer may choose to apply § 1.263(a)-3T as contained in TD 9564 (76 FR 81060) December 27, 2011, to taxable years beginning on or after January 1, 2012, and before January 1, 2014.