The IRS issued final tangible property regulations at the end of 2013 that are mandatory and effective for 2014. The regulations affect all businesses regardless of size, industry, or location that acquire, produce or improve property. Put simply, these regulations affect the capitalization and expensing of physical assets that a company purchases, repairs, improves or disposes.
These regulations are not an all-or-nothing proposition affecting just one issue. Businesses could experience beneficial provisions in one area and adverse effects in others. Although action is required, with proper planning, businesses may find opportunities for tax savings as well as to do the best job of mitigating potential tax risks.
Businesses can adopt the regulations via three channels:
- An income tax return, in which they simply report a position;
- Attaching affirmative “election” statement(s) to an income tax return; and
- Requesting permission from the IRS through a “change in accounting method.”
In addition, the rules may require internal changes to accounting practices and procedures for financial and tax accounting purposes. Businesses should plan for and expect to adopt the regulations through each of these channels. Failure to act could result in reporting a position on a tax return that potentially results in an unintended, impermissible or suboptimal position.
Financial Accounting and Tax Conformity
Two beneficial options in the rules require conformity between financial accounting and tax reporting: the de minimis expensing safe harbor and the election to capitalize repair and maintenance costs. The de minimis expensing safe harbor allows companies to set a minimum capitalization threshold — a specific dollar amount beneath which amounts will not be capitalized for financial or tax accounting. If a business follows the de minimis rules in the regulations, the IRS will not question this expensing practice. However, the de minimis policy must be followed equally on a businesses’ financial statements and federal income tax return.
Some action is typically required to adopt the de minimis expensing safe harbor rules, including changes to financial accounting practices and policies. The de minimis expensing safe harbor should be addressed before the end of 2014 to make sure practices are in order for the beginning of 2015. The de minimis expensing amount may be changed annually to reflect changing procurement decisions. Because the de minimis expensing safe harbor will affect financial earnings, this expensing practice may also be influenced by existing covenants, performance and compensation and other non-tax indicators.
The second area requiring financial and tax accounting conformity is the election to capitalize repair and maintenance costs. This election is optional. While taking the option will generally defer the timing of tax deductions, it will provide the benefit of simplifying the capitalization process by eliminating a difference between financial and tax accounting. In certain instances of the regulations, an expenditure may be a deductible repair expenditure for tax purposes but a capital expenditure for financial accounting. Some businesses may be interested in minimizing differences between financial and tax accounting. Thus, they may elect to capitalize for tax purposes otherwise deductible repair costs if these costs are capitalized for financial accounting.
Both the de minimis expensing safe harbor and the election to capitalize repair and maintenance costs are annual elections. Businesses have the flexibility to decide each year whether they wish to adopt either of these provisions.
Other Financial Accounting Implications
Even though the following are tax rules, they may have added effects on financial accounting:
- Current provision for income taxes. Determination of taxable income for the current period.
- Deferred income taxes. Recognition and measurement of deferred taxes related to tangible property and the balance sheet classification of these deferred taxes.
- Effective tax rate. The regs generally affect the timing (rather than the amount) of deductions. While timing-related items generally should not change the effective rate, sometimes there are indirect effects on a valuation allowances, interest expenses and special deductions which are tied to taxable income and may cause a change to the effective tax rate.
- Uncertain Tax Positions. Taxpayers may take or expect to take tax return positions which are not supported under the new regulations. Uncertain tax liabilities (ASC 740) and interest may arise from timing-related uncertain positions.
Certain accounting-method changes, even though they are effective beginning in 2014, are implemented retroactively. That is, the accounting method change requires a cumulative catch-up tax adjustment. This cumulative adjustment can be significant and result in an increase or decrease in tax deductions depending on a business’s historical capitalization practices.
It’s Not Too Late for Action
The de minimis expensing safe harbor and the election to capitalize repair and maintenance costs are just two of the elections businesses must consider. There are many other elections that also must be evaluated and acted upon. Further, the IRS expects most businesses to file accounting method changes with their 2014 tax returns due March 15, 2015 for a calendar year taxpayer or September 15, 2015 if filed on extension. Implementing compliance will require planning and analysis to identify the current practices that require modification and then take the steps necessary to implement these changes.
Businesses should take a proactive approach, so they may plan for and manage any changes to financial accounting results and processes and the necessary tax-reporting regarding elections, disclosures and accounting-method changes.
Nathan P. Clark is a senior director at BDO USA.