Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property, 48590-48623 [06-6969]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 161 (Monday, August 21, 2006)]
[Proposed Rules]
[Pages 48590-48623]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-6969]



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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



 Guidance Regarding Deduction and Capitalization of Expenditures 
Related to Tangible Property; Proposed Rule

Federal Register / Vol. 71, No. 161 / Monday, August 21, 2006 / 
Proposed Rules

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-168745-03]
RIN 1545-BE18


Guidance Regarding Deduction and Capitalization of Expenditures 
Related to Tangible Property

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations that explain how 
section 263(a) of the Internal Revenue Code (Code) applies to amounts 
paid to acquire, produce, or improve tangible property. The proposed 
regulations clarify and expand the standards in the current regulations 
under section 263(a), as well as provide some bright-line tests (for 
example, a 12-month rule for acquisitions and a repair allowance for 
improvements). The proposed regulations will affect all taxpayers that 
acquire, produce, or improve tangible property. This document also 
provides a notice of public hearing on the proposed regulations.

DATES: Written or electronic comments must be received by November 20, 
2006. Requests to speak and outlines of topics to be discussed at the 
public hearing scheduled for Tuesday, December 19, 2006, at 10 a.m., 
must be received by November 28, 2006.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-168745-03), room 
5203, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. Alternatively, comments may be sent 
electronically, via the IRS Internet site at https://www.irs.gov/regs or 
via the Federal eRulemaking Portal at https://www.regulations.gov (IRS-
REG-168745-03). The public hearing will be held in the auditorium of 
the New Carrollton Federal Building, 5000 Ellin Road, Lanham, MD 20706 
at 10 a.m.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Kimberly L. Koch, (202) 622-7739; concerning submission of comments, 
the hearing, and/or to be placed on the building access list to attend 
the hearing, Richard A. Hurst at Richard.A.Hurst@irscounsel.treas.gov 
or at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    In recent years, much debate has focused on the extent to which 
section 263(a) of the Code requires taxpayers to capitalize as an 
improvement amounts paid to restore property to its former working 
condition; that is, whether, or the extent to which, the amounts paid 
to restore or improve the property are capital expenditures or 
deductible ordinary and necessary repair and maintenance expenses. 
There has been controversy, for example, regarding what tests to apply 
for determining capitalization or expensing, how to apply the tests, 
and the appropriate unit of property with respect to which to apply the 
tests. On January 20, 2004, the IRS and Treasury Department published 
Notice 2004-6 (2004-3 I.R.B. 308), announcing an intention to propose 
regulations providing guidance in this area. The notice identified 
issues under consideration by the IRS and Treasury Department and 
invited public comment on whether these or other issues should be 
addressed in the regulations and, if so, what specific rules and 
principles should be provided. To respond to various comments and 
provide a more comprehensive set of rules regarding tangible property, 
the proposed regulations include the treatment of amounts paid to 
acquire or produce tangible property.

Explanation of Provisions

I. Introduction

    The proposed regulations under section 263(a) of the Code set forth 
the general statutory principles of capitalization and provide that 
capital expenditures generally include amounts paid to sell, acquire, 
produce, or improve tangible property. The proposed regulations, if 
promulgated as final regulations, would replace current Sec. Sec.  
1.263(a)-1, 1.263(a)-2, and 1.263(a)-3 of the Income Tax Regulations. 
The treatment of amounts paid to acquire or create intangibles was 
addressed with the publication of Sec. Sec.  1.263(a)-4 and 1.263(a)-5 
in the Federal Register on January 5, 2004 (TD 9107; 69 FR 436).
    Certain sections of the current regulations under section 263(a) 
are proposed to be removed entirely and are not restated in the 
proposed regulations. Section 1.263(a)-1(c) of the current regulations 
lists several Code and regulation sections to which the capitalization 
provisions do not apply. Section 1.263(a)-3 (election to deduct or 
capitalize certain expenditures) lists several Code sections under 
which a taxpayer may elect to treat certain capital expenditures as 
either deductible or deferred expenses, or to treat deductible expenses 
as capital expenditures. These two sections have not been carried over 
to the proposed regulations because the lists of items in these 
sections are outdated. This language is intended to have the same 
general effect as current Sec. Sec.  1.263(a)-1(c) and 1.263(a)-3, 
without citing to specific Code and regulation sections that may have 
been repealed and without omitting specific Code and regulation 
sections that may have been added.
    Certain portions of Sec.  1.263(a)-2 of the current regulations 
(examples of capital expenditures) also are not restated in the 
proposed regulations, or are incorporated into other sections of the 
proposed regulations. Section 1.263(a)-2(a) of the current regulations 
(the cost of acquisition of property with a useful life substantially 
beyond the taxable year) is incorporated into and expanded upon in 
Sec.  1.263(a)-2 of the proposed regulations (amounts paid to acquire 
or produce tangible property). Section 1.263(a)-2(b) of the current 
regulations (amounts expended for securing a copyright and plates) is 
proposed to be removed because these amounts are now addressed by Sec.  
1.263(a)-4(d)(5) and section 263A. The rules in Sec.  1.263(a)-2(c) of 
the current regulations (the cost of defending or perfecting title to 
property) are addressed in Sec.  1.263(a)-4(d)(9) of the current 
regulations with regard to intangibles and in Sec.  1.263(a)-2(d)(2) of 
the proposed regulations with regard to tangible property. Section 
1.263(a)-2(d) of the current regulations (amounts expended for 
architect's services) is proposed to be removed because those amounts 
are now included in section 263A. The rules in Sec.  1.263(a)-2(f) and 
(g) of the current regulations (relating to certain capital 
contributions) essentially are restated in Sec.  1.263(a)-1(b) of the 
proposed regulations. Finally, Sec.  1.263(a)-2(h) of the current 
regulations (the cost of goodwill in connection with the acquisition of 
the assets of a going concern) is proposed to be removed because this 
cost is now addressed by Sec.  1.263(a)-4(c)(1)(x).
    Taking into account the provisions that are proposed to be removed 
and other modifications to the current regulations noted above, the 
remaining guidance in the current regulations is contained in Sec.  
1.263(a)-1(a) and (b) of the proposed regulations. Section 1.263(a)-
01(a) of the current regulations restates the statutory rules from 
section 263(a), which are carried over in Sec.  1.263(a)-1(a) of the 
proposed regulations. The rules in Sec.  1.263(a)-1(b) of the current 
regulations address

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amounts paid to add to the value, or substantially prolong the useful 
life, of property owned by the taxpayer, and amounts paid to adapt 
property to a new or different use. They also address the treatment of 
those capitalized expenditures, for example, as a charge to capital 
account or basis. These rules are incorporated into and expanded upon 
in Sec.  1.263(a)-3 of the proposed regulations. The proposed 
regulations also revise Sec.  1.162-4 of the current regulations 
(allowing a deduction for the cost of incidental repairs) to provide 
rules consistent with Sec.  1.263(a)-3 of the proposed regulations 
(requiring capitalization of amounts paid to improve property).
    The proposed regulations do not address amounts paid to acquire or 
create intangible interests in land, such as easements, life estates, 
mineral interests, timber rights, zoning variances, or other intangible 
interests in land. The IRS and Treasury Department request comments on 
whether these and similar amounts, or certain of these amounts, should 
be addressed in the final regulations and, if so, what rules should be 
provided. The proposed regulations also do not address the treatment of 
software development costs.

II. General Principle of Capitalization

A. Overview
    The proposed regulations require capitalization of amounts paid to 
acquire, produce, or improve tangible real and personal property, 
including amounts paid to facilitate the acquisition of tangible 
property. The proposed regulations do not address amounts paid to 
facilitate an acquisition of a trade or business because those amounts 
are addressed in Sec.  1.263(a)-5 of the current regulations.
    The proposed regulations clarify that they do not change the 
treatment of any amount that is specifically provided for under any 
provision of the Code or regulations other than section 162(a) or 
section 212 and the regulations under those sections. This rule applies 
regardless of whether that specific provision is more or less favorable 
to the taxpayer than the treatment in the proposed regulations. Thus, 
where another section of the Code or regulations prescribes a specific 
treatment of an amount, the provisions of that section apply and not 
the rules contained in the proposed regulations. This rule is the same 
as that contained in Sec. Sec.  1.263(a)-4(b)(4) and 1.263(a)-5(j) of 
the current regulations. The proposed regulations, for example, do not 
preclude taxpayers from deducting the cost of certain depreciable 
business assets under section 179. On the other hand, the proposed 
regulations do not exempt taxpayers from applying the uniform 
capitalization rules under section 263A when applicable, nor do they 
exempt taxpayers from complying with the timing rules regarding 
incurring a liability under section 461 (including economic 
performance).
    The rule clarifying that the proposed regulations do not change the 
treatment of any other amount that is specifically provided for under 
any other provision of the Code or regulations provides an exception 
for the treatment of any amount that is specifically provided for under 
section 162(a) or section 212 or the regulations under those sections. 
Thus, the proposed regulations override any conflicting provisions in 
the regulations under sections 162(a) and 212. For this reason, the 
proposed regulations amend the current rule for deductible repairs 
under Sec.  1.162-4 to provide that amounts paid for repairs and 
maintenance to tangible property are deductible if the amounts paid are 
not required to be capitalized under Sec.  1.263(a)-3 of the proposed 
regulations. The proposed regulations, however, do not amend or remove 
any other provisions of the current regulations under section 162(a), 
including Sec. Sec.  1.162-6 (regarding professional expenses) and 
1.162-12 (regarding certain expenses of farmers). Section 1.162-6 
permits a deduction for amounts paid for books, furniture, and 
professional instruments and equipment, the useful life of which is 
short, while Sec.  1.162-12 permits a deduction for the cost of 
ordinary tools of short life or small cost. The rules in current 
Sec. Sec.  1.162-6 and 1.162-12 are consistent with the rules in the 
proposed regulations and are not revised.
B. Amounts Paid To Sell Property
    The proposed regulations provide that, except in the case of 
dealers in property, commissions and other transaction costs paid to 
facilitate the sale of property generally must be capitalized and 
treated as a reduction in the amount realized. Dealers in property 
include taxpayers that maintain and sell inventories and taxpayers that 
produce property for sale in the ordinary course of business, for 
example, the home construction business. The language in this section 
is slightly broader than the current language of Sec.  1.263(a)-2(e), 
which refers only to commissions paid in selling securities. However, 
the language in the proposed regulations is consistent with case law 
that generally treats all transaction costs paid in connection with the 
sale of any property as capitalized and offset against the amount 
realized. See, Wilson v. Commissioner, 49 T.C. 406, 414 (1968); rev'd 
on other grounds, 412 F.2d 314 (6th Cir. 1969) (``The rule is 
thoroughly engrained that commissions and similar charges must be 
treated as capital expenditures which reduce the selling price when 
gain or loss is computed on the transaction''); Frick v. Commissioner, 
T.C. Memo 1983-733, aff'd without opinion, 774 F.2d 1168 (7th Cir. 
1985) (``Fees paid in connection with the disposition of real property 
are capital expenditures and are deductible from the selling price in 
determining gain or loss on the ultimate disposition''); Hindes v. 
United States, 246 F. Supp. 147, 150 (W.D. Tex. 1965); affd. in part, 
revd. in part on other grounds, 371 F.2d 650 (5th Cir. 1967) (``Fees 
and expenses paid in connection with the acquisition or disposition of 
property, real or personal, are capital expenditures, and, in the case 
of a taxpayer not engaged in the business of buying and selling real 
estate, are deductible from the selling price in determining gain or 
loss on the ultimate disposition''). The sales cost rule in the 
proposed regulations, however, applies only to transaction costs and 
does not include other amounts that might be paid for the purpose of 
selling property, such as amounts paid to repair or improve the 
property in preparation for a sale. The treatment of those amounts is 
governed by the general rules under Sec.  1.263(a)-3 of the proposed 
regulations relating to improvements.

III. Amounts Paid To Acquire or Produce Tangible Property

A. In General
    The current regulations under section 263(a) require capitalization 
of amounts paid for the acquisition, construction, or erection of 
buildings, machinery and equipment, furniture and fixtures, and similar 
property having a useful life substantially beyond the taxable year. 
See Sec.  1.263(a)-2(a) of the current regulations. The proposed 
regulations are consistent with this rule, but treat amounts paid to 
construct or erect property as production costs. Specifically, the 
proposed regulations require capitalization of amounts paid for 
property having a useful life substantially beyond the taxable year, 
including land and land improvements, buildings, machinery and 
equipment, and furniture and fixtures, and a unit of property (as 
determined under Sec.  1.263(a)-3(d)(2)), having a useful life 
substantially beyond the taxable year. See Sec.  1.263(a)-2(d) of the 
proposed

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regulations. Thus, Sec.  1.263(a)-2 of the proposed regulations 
requires capitalization of amounts paid for property that is not itself 
a unit of property, such as property (not treated as a material or 
supply under Sec.  1.162-3) that is intended to be used as a component 
in the repair or improvement of a unit of property. Additionally, the 
current regulations at Sec.  1.263(a)-1(b) list inventory costs as 
capital expenditures under Sec.  1.263(a)-1(a). Therefore, Sec.  
1.263(a)-2 of the proposed regulations also requires capitalization of 
amounts paid to acquire real or personal property for resale and to 
produce real or personal property for sale.
    The proposed regulations provide that the terms amounts paid and 
payment mean, in the case of a taxpayer using an accrual method of 
accounting, a liability incurred (within the meaning of Sec.  1.446-
1(c)(1)(ii)). The definitions of real and tangible personal property 
are intended to be the same as the definitions used for depreciation 
purposes as derived from the language in the regulations at Sec.  1.48-
1. Thus, for purposes of the proposed regulations, tangible personal 
property means any tangible property except land and improvements 
thereto, such as buildings or other inherently permanent structures 
(including items that are structural components of buildings or 
structures). See, Whiteco Indus., Inc. v. Commissioner, 65 T.C. 664 
(1975) (applying six factors in determining whether property is an 
inherently permanent structure). Under the proposed regulations, the 
definitions of building and structural components are the definitions 
provided in Sec.  1.48-1(e). The IRS and Treasury Department considered 
other definitions of real and tangible personal property, including the 
definitions in the regulations under section 263A(f), but believe that 
the definitions used for depreciation purposes are the definitions most 
consistent with the purposes of the proposed regulations.
    The definition of produce in Sec.  1.263(a)-2(b)(4) of the proposed 
regulations is intended to be the same as the definition used for 
purposes of section 263A(g)(1) and Sec.  1.263A-2(a)(1)(i), except that 
improvements are separately defined in Sec.  1.263(a)-3 of the proposed 
regulations. The costs that are required to be capitalized to property 
produced or to any improvement are the costs that must be capitalized 
under section 263A. Thus, for example, all direct materials and direct 
labor, and all indirect costs that directly benefit or are incurred by 
reason of production/improvement activities are required to be 
capitalized to the property being produced or improved.
    The proposed regulations require taxpayers to capitalize an amount 
paid to defend or perfect title to tangible property. This rule is 
consistent with the current regulations at Sec.  1.263(a)-2(c) and 
parallels the rule in Sec.  1.263(a)-4(d)(9) with regard to intangible 
property. The proposed regulations also require capitalization of 
amounts paid to facilitate the acquisition of real or personal 
property. The IRS and Treasury Department request comments on whether 
any specific guidance is needed with regard to employee compensation 
and overhead costs that facilitate the acquisition of tangible property 
and, if so, what that guidance should provide. The proposed regulations 
do not address transaction costs related to the production or 
improvement of tangible property because those costs are subject to 
capitalization under section 263A.
B. Materials and Supplies
    As noted in section II.A. above, the proposed regulations generally 
do not change the treatment of any amount that is specifically provided 
for under any provision of the Code or regulations other than section 
162(a) or section 212 and the regulations under those sections. 
However, with regard to section 162(a), the proposed regulations 
provide an exception for amounts paid for materials and supplies that 
are properly treated as deductions or deferred expenses, as 
appropriate, under Sec.  1.162-3. Thus, the proposed regulations do not 
change the treatment of materials and supplies under Sec.  1.162-3, 
including property that is treated as a material and supply that is not 
incidental under Rev. Proc. 2002-28 (2002-1 C.B. 815) (regarding the 
use of the cash method by certain qualifying small business taxpayers), 
Rev. Proc. 2002-12 (2002-1 C.B. 374) (regarding smallwares), and Rev. 
Proc. 2001-10 (2001-1 C.B 272) (regarding inventory of certain 
qualifying taxpayers).
C. 12-Month Rule
    The current regulations under sections 263(a), 446, and 461 require 
taxpayers to capitalize amounts paid to acquire property having a 
useful life substantially beyond the taxable year. See Sec. Sec.  
1.263(a)-2(a), 1.446-1(c)(1)(ii), and 1.461-1(a)(2)(i) of the current 
regulations. Section 1.263(a)-2(d) of the proposed regulations retains 
this general rule. Some courts have adopted a 12-month rule for 
determining whether property has a useful life substantially beyond the 
taxable year. See Mennuto v. Commissioner, 56 T.C. 910 (1971), acq. 
(1973-2 C.B. 2); Zelco, Inc. v. Commissioner, 331 F.2d 418 (1st Cir. 
1964); International Shoe Co. v. Commissioner, 38 B.T.A. 81 (1938). 
Under the 12-month rule adopted by some courts, a taxpayer may deduct 
currently an amount paid for a benefit or paid for property having a 
useful life that does not extend beyond one year. This rule was adopted 
in the regulations relating to intangibles. See Sec.  1.263(a)-4(f). 
The proposed regulations provide a similar 12-month rule for amounts 
paid to acquire or produce certain tangible property.
    The proposed regulations generally provide that an amount 
(including transaction costs) paid for the acquisition or production of 
a unit of property with an economic useful life of 12 months or less is 
not a capital expenditure. The unit of property and economic useful 
life determinations are made under the rules described in Sec.  
1.263(a)-3 for improved property. The 12-month rule generally applies 
unless the taxpayer elects not to apply the 12-month rule, which 
election may be made with regard to each unit of property that the 
taxpayer acquires or produces. An election not to apply the 12-month 
rule may not be revoked. Taxpayers that have elected to use the 
original tire capitalization method of accounting for the cost of 
certain tires under Rev. Proc. 2002-27 (2002-1 C.B. 802), must use that 
method for the original and replacement tires of all their qualifying 
vehicles. See section 5.01 of Rev. Proc. 2002-27. Therefore, taxpayers 
that use that method cannot use the 12-month rule provided under the 
proposed regulations to deduct amounts paid to acquire original or 
replacement tires.
    The proposed regulations clarify the interaction of the 12-month 
rule with the timing rules contained in section 461 of the Code. 
Nothing in the proposed regulations is intended to change the 
application of section 461, including the application of the economic 
performance rules in section 461(h). This coordination rule is the same 
as that provided in the regulations under section 263(a) relating to 
intangibles. See Sec.  1.263(a)-4(f). In the case of a taxpayer using 
an accrual method of accounting, section 461 requires that an item be 
incurred before it is taken into account through capitalization or 
deduction. For example, under Sec.  1.461-1(a)(2), a liability 
generally is not incurred until the taxable year in which all the 
events have occurred that establish the fact of the liability, the 
amount of the liability can be determined with reasonable accuracy, and 
economic performance

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has occurred with respect to the liability. Thus, the 12-month rule 
provided by the proposed regulations does not permit an accrual method 
taxpayer to deduct an amount paid for tangible property if the amount 
has not been incurred under section 461 (for example, if the taxpayer 
does not have a fixed liability to acquire the property). The proposed 
regulations contain examples illustrating the interaction of the 12-
month rule with section 461.
    The proposed regulations provide that, upon a sale or other 
disposition, property to which a taxpayer applies the 12-month rule is 
not treated as a capital asset under section 1221 or as property used 
in the trade or business under section 1231. Thus, 12-month property is 
not of a character subject to depreciation and any amount realized upon 
disposition of 12-month property is ordinary income to the taxpayer.
    The IRS and Treasury Department do not believe that it is 
appropriate to apply the 12-month rule to certain types of property. 
Thus, the proposed regulations provide that the 12-month rule does not 
apply to property that is or will be included in property produced for 
sale or property acquired for resale, improvements to a unit of 
property, land, or a component of a unit of property.
D. De Minimis Rule
    In Notice 2004-6, the IRS and Treasury Department requested 
comments on whether the regulations should provide a de minimis rule. 
Because the notice refers to the application of section 263(a) to 
amounts paid to repair, improve, or rehabilitate tangible property, 
most commentators focused on a de minimis rule for the cost of repairs 
rather than the cost to acquire property. However, one commentator 
requested that the regulations specifically provide a de minimis rule 
for acquisition costs, but allow taxpayers to continue to use their 
current method if they have reached a working agreement with their IRS 
examining agent regarding a de minimis rule.
    The IRS and Treasury Department recognize that for regulatory or 
financial accounting purposes, taxpayers often have a policy for 
deducting an amount paid below a certain dollar threshold for the 
acquisition of tangible property (de minimis rule). For Federal income 
tax purposes, the taxpayer generally would be required to capitalize 
the amount paid if the property has a useful life substantially beyond 
the taxable year. However, in this context some courts have permitted 
the use of a de minimis rule for Federal income tax purposes. See Union 
Pacific R.R. Co. v. United States, 524 F.2d 1343 (Ct. Cl. 1975) 
(permitting the use of the taxpayer's $500 de minimis rule, which was 
in accordance with the Interstate Commerce Commission (ICC) minimum 
rule and generally accepted accounting principles); Cincinnati, N.O. & 
Tex. Pac. Ry. v. United States, 424 F.2d 563 (Ct. Cl. 1970) (same). But 
see Alacare Home Health Services, Inc. v. Commissioner, T.C. Memo 2001-
149 (disallowing the taxpayer's use of a $500 de minimis rule because 
it distorted income).
    The proposed regulations do not include a de minimis rule for 
acquisition costs. However, the IRS and Treasury Department recognize 
that taxpayers often reach an agreement with IRS examining agents that, 
as an administrative matter, based on risk analysis and/or materiality, 
the IRS examining agents do not select certain items for review such as 
the acquisition of tangible assets with a small cost. This often is 
referred to by taxpayers and IRS examining agents as a de minimis rule. 
The absence of a de minimis rule in the proposed regulations is not 
intended to change this practice.
    The IRS and Treasury Department considered including a de minimis 
rule in the proposed regulations. The de minimis rule considered would 
have provided that taxpayers are not required to capitalize certain de 
minimis amounts paid for the acquisition or production of a unit of 
property. Under the rule considered, if a taxpayer had written 
accounting procedures in place treating as an expense on its applicable 
financial statement (AFS) amounts paid for property costing less than a 
certain dollar amount, and treated the amounts paid during the taxable 
year as an expense on its AFS in accordance with those written 
accounting procedures, the taxpayer would not have been required to 
capitalize those amounts if they did not exceed a certain dollar 
threshold. A taxpayer that did not meet these criteria (for example, a 
taxpayer that did not have an AFS) would not have been required to 
capitalize amounts paid for a unit of property that did not exceed the 
established dollar threshold. Because taxpayers without an AFS 
generally are smaller than taxpayers with an AFS, the dollar threshold 
for the de minimis rule that would have applied to them would have been 
lower than the threshold for taxpayers with an AFS (although the de 
minimis rule for taxpayers with an AFS also would have been limited to 
the amount treated as an expense on their AFS). The de minimis rule 
considered by the IRS and Treasury Department would not have applied to 
inventory property, improvements, land, or a component of a unit of 
property.
    The de minimis rule considered also would have provided that 
property to which a taxpayer applies the de minimis rule is treated 
upon sale or disposition similar to section 179 property. Thus, de 
minimis property would have been property of a character subject to 
depreciation and amounts paid that were not capitalized under the de 
minimis rule would have been treated as amortization subject to 
recapture under section 1245. Thus, gain on disposition of the property 
would have been ordinary income to the taxpayer to the extent of the 
amount treated as amortization for purposes of section 1245.
    The IRS and Treasury Department decided to not include a de minimis 
rule in the proposed regulations but instead to request comments on 
whether such a rule should be included in the final regulations or 
whether to continue to rely on the current administrative practice of 
IRS examining agents. Therefore, the IRS and Treasury Department 
request comments on whether a de minimis rule for acquisition costs 
should be included in the final regulations, and, if so, whether the de 
minimis rule should be the rule described above and what dollar 
thresholds are appropriate.
    The IRS and Treasury Department also request comments on the scope 
of costs that should be included in a de minimis rule if one is 
provided in the final regulations and on the character of de minimis 
rule property. For example, the de minimis rule considered by the IRS 
and Treasury Department would have applied to the aggregate of amounts 
paid for the acquisition or production (including any amounts paid to 
facilitate the acquisition or production) of a unit of property and 
including amounts paid for improvements prior to the unit of property 
being placed in service. If a de minimis rule should be provided in the 
final regulations, the IRS and Treasury Department request comments on 
what, if any, type of rule should be provided to prevent a distortion 
of income when taxpayers acquire a large number of assets, each of 
which individually is within the de minimis rule (for example, the 
purchase by a taxpayer of 2,000 personal computers).
    If a de minimis rule for acquisition costs should be provided in 
the final regulations, the IRS and Treasury Department request comments 
on whether the rule should permit IRS examining agents and taxpayers to 
agree to the use of higher de minimis thresholds on the basis of 
materiality

[[Page 48594]]

and risk analysis and, if so, under what circumstances a higher 
threshold should be allowed. The IRS and Treasury Department also 
request comments on whether, if a de minimis rule should be provided in 
the final regulations, changes to begin using a de minimis rule or 
changes to a higher dollar amount within a de minimis rule should be 
treated as changes in a method of accounting.
E. Recovery of Costs When Property Is Used in a Repair
    As noted in section III.A. of this preamble, Sec.  1.263(a)-2 of 
the proposed regulations generally requires capitalization of amounts 
paid for the acquisition or production of property having a useful life 
substantially beyond the taxable year. Thus, Sec.  1.263(a)-2(d) of the 
proposed regulations applies to property that is not itself a unit of 
property, such as property (not treated as a material or supply under 
Sec.  1.162-3) that is intended to be used as a component in the repair 
or improvement of a unit of property. It must be determined whether the 
subsequent use of the component property results in an improvement to 
the unit of property under Sec.  1.263(a)-3 or an otherwise deductible 
repair or maintenance cost under Sec.  1.162-4. Even if the subsequent 
use of the component is an otherwise deductible expense under Sec.  
1.162-4, the amount paid nonetheless may be required to be capitalized. 
For example, it must be determined whether the amount paid for the 
component property is required to be capitalized under section 263A as 
an indirect cost that directly benefits or is incurred by reason of 
property produced or acquired for resale. The proposed regulations 
illustrate this concept in an example of a manufacturer that replaces 
one window in a building. The taxpayer initially must capitalize under 
Sec.  1.263(a)-2(d) amounts paid to acquire the window. The replacement 
of the window subsequently is determined to be a repair to the building 
rather than an improvement. Amounts paid for the repair (or an 
allocable portion thereof) must then be capitalized under section 263A 
to the inventory that the taxpayer produces to the extent that the 
repair directly benefits or is incurred by reason of the taxpayer's 
production activities.

IV. Amounts Paid To Improve Tangible Property

A. In General
    In response to Notice 2004-6, the IRS and Treasury Department 
received several comments on the issues that should be addressed in the 
proposed regulations to provide guidance on amounts paid to repair, 
improve, and rehabilitate tangible property. These comments have been 
taken into account in drafting Sec.  1.263(a)-3 of the proposed 
regulations. That section addresses amounts paid to improve tangible 
property and includes the following provisions: (1) Rules for 
determining the appropriate unit of property to which the improvement 
provisions apply; (2) general rules for improvements; (3) rules for 
determining whether an amount paid materially increases the value of 
the unit of property; (4) rules for determining whether an amount paid 
restores the unit of property; and (5) an optional repair allowance 
method.
B. Unit of Property Rules
1. In General
    A threshold issue in applying the improvement rules under Sec.  
1.263(a)-3 of the proposed regulations is determining the appropriate 
unit of property to which the rules should be applied. For example, to 
determine whether an amount paid materially increases the value of 
property, it is necessary to know what property is at issue. The 
smaller the unit of property, the more likely it is that amounts paid 
in connection with that unit of property will materially increase the 
value of, or restore, the property. Taxpayers and the IRS frequently 
disagree on the unit of property to which the capitalization rules 
should be applied. Thus, the unit of property rules in the proposed 
regulations are intended to provide guidance in determining whether an 
amount paid improves the unit of property under Sec.  1.263(a)-3. The 
unit of property rules also apply for purposes of Sec.  1.263(a)-1 of 
the proposed regulations (which references the rules in Sec. Sec.  
1.263(a)-2 and 1.263(a)-3 of the proposed regulations) and Sec.  
1.263(a)-2 of the proposed regulations (for example, with regard to the 
12-month rule). The unit of property rules in the proposed regulations 
apply only for purposes of section 263(a) and Sec. Sec.  1.263(a)-1, 
1.263(a)-2, and 1.263(a)-3 of the proposed regulations, and not any 
other Code or regulation section. For example, no inference is intended 
that these unit of property rules have any application for section 
263A(f) interest capitalization purposes.
    The current regulations under section 263(a) do not provide any 
guidance on determining the appropriate unit of property. Some courts 
have addressed the unit of property issue under section 263(a), but 
their holdings are based on the particular facts of each case and do 
not contain rules that are generally applicable for purposes of section 
263(a). See, FedEx Corp. v. United States, 291 F. Supp. 2d 699 (W.D. 
Tenn. 2003), aff'd, 412 F.3d 617 (6th Cir. 2005) (concluding that an 
aircraft, and not the aircraft engine, was the appropriate unit of 
property); Smith v. Commissioner, 300 F.3d 1023 (9th Cir. 2002) 
(concluding that an aluminum reduction cell, rather than entire cell 
line, was the appropriate unit of property); Ingram Industries, Inc. v. 
Commissioner, T.C. Memo 2000-323 (concluding that a towboat, and not 
the towboat engine, was the appropriate unit of property); LaSalle 
Trucking Co. v. Commissioner, T.C. Memo 1963-274 (concluding that truck 
engines, tanks, and cabs were each separate units of property).
    In FedEx, the court ruled on whether an aircraft engine or the 
entire aircraft was the appropriate unit of property for determining 
whether the costs of engine shop visits (ESVs) must be treated as 
capital expenditures. Relying on the opinions in Ingram and Smith, the 
court concluded that the following four factors were relevant in 
determining the appropriate unit of property: (1) Whether the taxpayer 
and the industry treat the component part as a part of a larger unit of 
property for regulatory, market, management, or accounting purposes; 
(2) whether the economic useful life of the component part is 
coextensive with the economic useful life of the larger unit of 
property; (3) whether the larger unit of property and the smaller unit 
of property can function without each other; and (4) whether the 
component part can be and is maintained while affixed to the larger 
unit of property. Applying these factors to aircraft engines, the court 
concluded that the engines should not be considered a unit of property 
separate and apart from the airplane.
    In Notice 2004-6, the IRS and Treasury Department requested 
comments on the relevance of various unit of property factors derived 
from FedEx and other cases that addressed the unit of property issue. 
The factors listed in Notice 2004-6 included: (1) Whether the property 
is manufactured, marketed, or purchased separately; (2) whether the 
property is treated as a separate unit by a regulatory agency, in 
industry practice, or by the taxpayer in its books and records; (3) 
whether the property is designed to be easily removed from a larger 
assembly, is regularly or periodically replaced, or is one of a 
fungible set of interchangeable or rotable assets; (4) whether the 
property must be removed from a larger assembly to be fixed or 
improved; (5)

[[Page 48595]]

whether the property has a different economic life than the larger 
assembly; (6) whether the property is subject to a separate warranty; 
(7) whether the property serves a discrete purpose or functions 
independently from a larger assembly; or (8) whether the property 
serves a dual purpose function.
    The IRS and Treasury Department received nine comments on the unit 
of property issue, four of which specifically recommended that the 
proposed regulations adopt the factors used by the court in FedEx. 
These factors essentially are contained in factors 1, 2, 4, 5, and 7 of 
Notice 2004-6. Several of the factors listed in Notice 2004-6 have been 
incorporated into the proposed regulations. However, the IRS and 
Treasury Department determined that some factors were not relevant for 
certain types of property. For example, the factors listed in Notice 
2004-6 primarily derive from case law that addresses tangible personal 
property; therefore, the factors were not as helpful in determining the 
appropriate unit of property for real property, such as land. Further, 
some types of property lend themselves to specific unit of property 
rules, such as buildings and property owned by taxpayers in a regulated 
industry. The IRS and Treasury Department believe that the 
administrative burden associated with determining the appropriate unit 
of property can be reduced for both the IRS and taxpayers by 
identifying specific rules reflecting an approach appropriate for the 
taxpayer's industry and the type of property at issue. Therefore, the 
proposed regulations provide different unit of property rules for four 
categories of property, rather than prescribing one rule for all types 
of property.
    The unit of property rules in the proposed regulations apply to all 
real and personal property other than network assets. For purposes of 
the unit of property rules, 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. Network 
assets include, for example, trunk and feeder lines, pole lines, and 
buried conduit. They do not include property that would be included as 
a structural component of a building under Sec.  1.263(a)-3(d)(2)(iv) 
of the proposed regulations, nor do they include separate property that 
is adjacent to, but not part of a network asset, such as bridges, 
culverts, or tunnels. The proposed regulations do not affect current 
guidance that addresses the unit of property or capitalization rules 
for network assets, such as Rev. Proc. 2001-46 (2001-2 C.B. 263) (track 
maintenance allowance method for Class I railroads); Rev. Proc. 2002-65 
(2002-2 C.B. 700) (track maintenance allowance method for Class II and 
III railroads); and Rev. Proc. 2003-63 (2003-2 C.B. 304) (safe harbor 
unit of property rule for cable television distribution systems). The 
IRS and Treasury Department request comments on the relevant rules for 
determining the appropriate unit of property for network assets. 
Additionally, the IRS and Treasury Department request comments on 
whether to include rules for network assets in final regulations, or 
whether to develop for network assets industry-specific guidance that 
is similar to the above referenced revenue procedures.
    With the exception of network assets, the four categories of 
property in the proposed regulations are intended to cover all real and 
personal property. In addition to the four categories of property, the 
unit of property rules provide for an initial unit of property 
determination, which, except with regard to buildings and structural 
components, is made prior to categorizing the property. The initial 
unit of property determination is based on the functional 
interdependence test in Sec.  1.263A-10(a)(2), relating to the 
capitalization of interest. The initial unit of property determination 
is intended to be a common-sense approach to defining the largest 
possible unit of property as a starting point for analyzing the rules 
under one of the four relevant unit of property categories. After the 
initial unit of property is determined, the additional unit of property 
rules are intended to result in a determination that either confirms 
the initial unit of property as the unit of property, or that separates 
one or more components of the initial unit of property into separate 
units of property.
    Some commentators suggested that the functional interdependence 
test under Sec.  1.263A-10(a)(2) regarding interest capitalization 
should be the sole test for determining the appropriate unit of 
property. The IRS and Treasury Department believe that the functional 
interdependence test is a relevant, but not dispositive factor. The 
purpose of that test under Sec.  1.263A-10(a)(2) is to calculate the 
appropriate unit of property for determining the accumulated production 
expenditures at the beginning and end of the production period. The 
preamble that accompanied the promulgation of Sec.  1.263A-10 discusses 
the reasoning for adopting a broad formulation of the unit of property 
definition and states that ``this concept of single property may differ 
from the concept of single or separate property that taxpayers use for 
other purposes (e.g., for computing amounts of depreciation deductions 
or separately tracking the bases of assets).'' TD 8584 (59 FR 67,187; 
1995-1 C.B. 20, 25; Dec. 29, 1994).
    In contrast to the unit of property rules in Sec.  1.263A-10(a)(2), 
the purpose of the unit of property rules under section 263(a) is to 
provide a starting point for determining whether an amount paid 
materially increases the value of, or restores, the unit of property. 
Thus, Sec.  1.263A-10(a)(2) has a different purpose than the proposed 
regulations under section 263(a). Further, in determining the 
appropriate unit of property for purposes of section 263(a), the 
functional interdependence test does not always produce appropriate 
results. For example, a taxpayer might argue that application of that 
test results in an entire complex of structures and machinery, such as 
an entire power plant, being treated as a single unit of property. The 
IRS and Treasury Department do not believe that result is correct for 
purposes of section 263(a).
    After the initial unit of property determination is made, the unit 
of property analysis continues with determining the appropriate 
category of property and applying the rules in that category. The 
proposed regulations provide specific rules for four categories of 
property: (1) Property owned by taxpayers in a regulated industry; (2) 
buildings and structural components; (3) other personal property; and 
(4) other real property. The unit of property determination made under 
the applicable category is then subject to an additional rule in Sec.  
1.263(a)-3(d)(2)(vii) regarding treatment for other Federal income tax 
purposes. The rules for each of the four categories are explained 
below.
2. Category I: Taxpayers in Regulated Industries
    The first unit of property category in the proposed regulations is 
property owned by taxpayers in a regulated industry. The proposed 
regulations provide that if the taxpayer is in an industry for which a 
Federal regulator has a uniform system of accounts (USOA) identifying a 
particular unit of property, the taxpayer must use the same unit of 
property for Federal income tax purposes, regardless of whether the 
taxpayer is subject to the regulatory accounting rules of the Federal 
regulator and regardless of whether the property is particular to that 
industry. This rule derives from one of the factors cited by the court 
in FedEx

[[Page 48596]]

for determining the appropriate unit of property--whether the taxpayer 
and the industry treat the component part as part of the larger unit of 
property for regulatory, market, management, or accounting purposes. 
Thus, this rule ties into the regulatory accounting element of the 
FedEx factor, as well as the general concept of industry practice. The 
IRS and Treasury Department are aware of three Federal regulators that 
provide a USOA: (1) The Federal Energy Regulatory Commission (FERC); 
(2) the Federal Communications Commission (FCC); and (3) the Surface 
Transportation Board (STB). Accordingly, this unit of property category 
applies to taxpayers such as power companies, telecommunications 
companies, and railroads.
    The IRS and Treasury Department determined that the regulatory 
accounting rule should be applied similarly to all taxpayers in 
industries for which a Federal regulator provides a USOA, regardless of 
whether the taxpayer is subject to the regulatory accounting rules of 
the Federal regulator. This rule is consistent with the general 
standard of using industry practice to determine the appropriate unit 
of property. Further, it results in all taxpayers within a specific 
industry being treated the same for Federal income tax purposes, 
without regard to whether a particular taxpayer is subject to the 
accounting rules of the Federal regulator. The rule is limited to the 
regulator's USOA and does not apply to other Federal regulatory rules, 
such as rules concerning safety or health. The proposed regulations 
apply only to USOA provided by Federal regulators and do not apply to 
USOA issued by any state or local agencies. Rules of state and local 
agencies may be different than Federal regulatory rules and can vary 
widely within an industry depending on the taxpayer's location.
    Four of the commentators on this aspect of Notice 2004-6 
recommended adopting the four factors cited in FedEx, from which the 
regulated industry rule was derived. None of the commentators 
specifically objected to a regulatory accounting rule, although one 
commentator suggested that where cost recovery is determined for non-
tax purposes by a Federal or state agency, the regulations should 
provide a special election that may be made on an annual basis under 
which the taxpayer may use the same unit of property for tax purposes 
as it must use for regulatory purposes. The IRS and Treasury Department 
believe the unit of property inquiry should result in one clear 
determination that will be used consistently by the taxpayer unless the 
underlying facts change and, therefore, do not believe an annual 
election is appropriate.
3. Category II: Buildings and Structural Components
    In general, a building and its structural components must be 
treated as one unit of property. This rule is based on the definitions 
of building and structural component in the regulations under section 
48. The repair allowance regulations under the Class Life Asset 
Depreciation Range (CLADR) system also provide that a building and its 
structural components generally are a single unit of property. See 
Sec.  1.167(a)-11(d)(2)(vi). The IRS and Treasury Department believe 
that these definitions are useful in determining the appropriate unit 
of property for buildings and structural components. One commentator 
specifically requested that the proposed regulations use the definition 
of building under Sec.  1.48-1(e) to determine a unit of property. The 
proposed regulations rely on the definition of building under Sec.  
1.48-1(e). Property located inside a building that is not a structural 
component of the building must be analyzed under one of the other three 
unit of property categories; for example, machinery and equipment 
inside a factory must be analyzed under Category III (the other 
personal property category).
    This Category II is the only category to which the initial unit of 
property determination does not apply. Applying the functional 
interdependence test to a building would raise issues in cases where 
certain floors or portions of a building are placed in service 
independently of another. The IRS and Treasury Department believe that, 
unless the additional rule in Sec.  1.263(a)-3(d)(2)(vii) of the 
proposed regulations (regarding treatment for other Federal income tax 
purposes) applies to require a component of a building to be treated as 
a separate unit of property, the building and its structural components 
should be the unit of property. The IRS and Treasury Department 
recognize, however, that it is not always appropriate to treat the 
entire building as the unit of property. For example, a taxpayer who 
owns a unit in a condominium building, whether the unit is used for 
personal or investment purposes, should not treat the entire building 
as the unit of property. Therefore, the IRS and Treasury request 
comments on how the unit of property rules should apply to 
condominiums, cooperatives, and similar types of property.
4. Category III: Other Personal Property
    The unit of property determination for personal property not 
included in Category I (taxpayers in a regulated industry) is a facts 
and circumstances test, based on four exclusive factors, none of which 
is dispositive or weighs more heavily than the others.
a. Factor 1: Marketplace Treatment Factor
    The first exclusive factor is whether the component is (1) marketed 
separately to or acquired or leased separately by the taxpayer (from a 
party other than the seller/lessor of the property of which the 
component is a part) at the time it is initially acquired or leased; 
(2) subject to a separate warranty contract (from a party other than 
the seller/lessor of the property of which the component is a part); 
(3) subject to a separate maintenance manual or written maintenance 
policy; (4) appraised separately; or (5) sold or leased separately by 
the taxpayer to another party. This factor contains a number of items 
intended to determine the treatment in the marketplace of the component 
as a separate unit of property.
    Whether the component is acquired separately was a factor addressed 
by the courts in FedEx and Ingram, and is also part of the CLADR repair 
allowance regulations under section 167 and the unit of property 
determination for interest capitalization in Sec.  1.263A-10. In FedEx, 
the court discussed this issue in the context of whether the taxpayer 
and the industry treat the component part as part of the larger unit of 
property for regulatory, market, management, or accounting purposes. In 
finding that the aircraft engines were not purchased separately, the 
court relied on the fact that the engines and aircraft were designed to 
be compatible and were generally acquired by the taxpayer at the same 
time. The court disregarded the fact that the taxpayer purchased the 
engines and airframes from different sellers when the aircraft were 
initially acquired. The IRS and Treasury Department believe that the 
acquisition of a component from a different seller at the time the 
larger property is acquired should be a relevant factor, and that the 
same rule should apply if the taxpayer leases the component from a 
different party than the seller of the larger property.
    The IRS and Treasury Department recognize that this factor may 
produce different results depending on whether the property is new or 
used. When a taxpayer acquires or leases used property, it is possible 
that items that

[[Page 48597]]

were separate units of property when purchased new will be treated as 
one unit of property because the initial purchaser has assembled the 
units into one functional item that it sells or leases. The IRS and 
Treasury Department considered whether it was appropriate to have a 
factor that could treat new and used property differently, and decided 
that the difference reasonably reflects the substance of the 
transactions--where the taxpayer acquires or leases a component from a 
different party from whom it acquires or leases the larger property, 
the taxpayer typically is conducting different, but related, 
transactions with separately negotiated terms.
    Whether the component is subject to a separate warranty contract, 
maintenance manual, or written maintenance policy was cited as a factor 
in FedEx and is adopted as part of the marketplace treatment factor in 
the proposed regulations. The warranty contract factor applies only to 
a warranty that is provided by a party other than the seller/lessor of 
the larger property. It is not intended to apply to a warranty provided 
by the sellor/lessor that may contain separate warranties (for example, 
for different time periods) on various components of the larger 
property. Whether the property is manufactured separately was a 
possible factor cited in Notice 2004-6. The proposed regulations do not 
specifically adopt this factor because components that are subject to a 
separate warranty or maintenance procedures also are likely to be 
manufactured separately. The FedEx case used as a factor whether the 
component was appraised or valued separately and the CLADR repair 
allowance regulations under section 167 addressed whether the component 
was sold separately to another party. The proposed regulations adopt 
these tests as part of the marketplace factor.
    The IRS and Treasury Department believe that it is important that 
all the criteria in this factor be taken into account together when 
weighing this factor with the other three factors. Some criteria may be 
stronger indicators warranting treatment of the component as a separate 
unit of property than others. The IRS and Treasury Department 
acknowledge that several of the criteria within this factor do not work 
well for property produced by the taxpayer, and request comments 
regarding how and whether a marketplace factor should apply to self-
constructed property.
b. Factor 2: Industry Practice and Financial Accounting Factor
    The second exclusive factor in this Category III is whether the 
component is treated as a separate unit of property in industry 
practice or by the taxpayer in its books and records. This factor was 
cited by the court in FedEx. The IRS and Treasury Department believe 
that the taxpayer's treatment of the component as separate in its books 
and records is a relevant factor in determining whether the component 
should be treated as a separate unit of property in the proposed 
regulations. In particular, if the taxpayer's books and records assign 
different economic useful lives to the component and the larger 
property, this factor would weigh heavily toward treating the component 
as a separate unit of property.
    The IRS and Treasury Department considered whether to use as a 
factor whether the component has a different economic useful life than 
the property of which it is a part. This factor was cited by the courts 
in Smith, Ingram, and FedEx. However, for this factor to be useful, the 
regulations would need to define economic useful life. The proposed 
regulations at Sec.  1.263(a)-3(f) (with regard to restoration of a 
unit of property) provide a definition of economic useful life, which 
has different meanings depending on whether a taxpayer has an AFS. If 
the unit of property rules adopted this definition, the economic useful 
life test under this factor would produce different results depending 
on whether the taxpayer has an AFS. These different results are not 
justified in this context. Further, a taxpayer's treatment of the 
component in its books and records under this Factor 2 includes any 
useful life determinations of the component and the property of which 
the component is a part in the books and records. Therefore, the 
economic useful life factor was not specifically adopted as a separate 
factor.
c. Factor 3: Rotable Part Factor
    The third exclusive factor in the other personal property category 
is whether the taxpayer treats the component as a rotable part. A 
rotable part is defined as a part that is removeable from property, 
repaired or improved, and either immediately reinstalled on other 
property or stored for later installation. This factor was cited by the 
courts in Smith and LaSalle. The court in FedEx ignored this factor, 
but considered as a separate concept whether the component can be and 
is maintained while affixed to the larger unit. The IRS and Treasury 
Department considered this separate concept as well, but believe that 
the rotable part factor incorporates this concept from FedEx. As the 
examples in the proposed regulations illustrate, this factor focuses on 
the particular taxpayer's treatment of the property as a rotable part 
in determining whether the rotable is a separate unit of property. 
Therefore, for example, if the rotable part is a separate unit of 
property to the taxpayer and the taxpayer incorporates the rotable into 
other property for resale, the rotable part will not necessarily be a 
separate unit of property to the purchaser.
    Two commentators stated that the treatment of a component as a 
rotable part is of limited or no relevance. While treatment of minor 
parts as rotable would not weigh heavily toward separate unit of 
property treatment, the IRS and Treasury Department believe that the 
treatment of major components as rotable is a relevant factor in 
determining whether a component is a separate unit of property, 
particularly when the economic useful life of the larger property is 
limited by the expected useful life of the rotable part. Many taxpayers 
do not maintain an inventory of rotable spares for their major 
components. Although it is understood that the purpose for maintaining 
an inventory of rotables is to minimize the time that the larger 
property is out of service, treatment of a major component as a rotable 
has consequences that tend to be indicative of a separate unit of 
property. For example, in the case of a taxpayer that does not maintain 
an inventory of rotable spare parts, if a major component of the larger 
property breaks down, then the entire larger property must be taken out 
of service while the major component is being repaired. This is 
indicative of the larger property and the component collectively being 
treated as one unit of property. Conversely, a taxpayer that does 
maintain an inventory of rotable spare parts for a major component is 
able to continue to use the larger property without regard to the time 
required to repair the broken down component. In this instance, the IRS 
and Treasury Department believe that continued use of the larger 
property is indicative of separate unit of property treatment for the 
rotable part. In addition, rotables being depreciated as rotable spare 
parts is indicative of separate treatment because the components are 
depreciated separately from the larger property.
    In the request for comments, Notice 2004-6 combined several other 
factors with the rotables factor, including whether a component is 
designed to be easily removed from a larger assembly,

[[Page 48598]]

is regularly or periodically replaced, or is one of a fungible set of 
interchangeable assets. These factors are broader than the rotables 
factor in the proposed regulations and would sweep in many minor 
components that rarely, if ever, would be appropriately considered a 
separate unit of property. Further, these factors are duplicative of 
the rotables part factor, because a rotable generally meets all of 
these factors. The IRS and Treasury Department believe that these 
factors are not more helpful in determining whether a component is a 
separate unit of property than the rotables factor described in the 
proposed regulations. Therefore, the proposed regulations do not 
include these other factors.
d. Factor 4: Function Factor
    The fourth and final factor in Category III is whether the property 
of which the component is a part generally functions for its intended 
use without the component property. This factor was cited by the court 
in FedEx and is similar to the discrete purpose test under the CLADR 
repair allowance regulations. It is also similar to the functional 
interdependence test under Sec.  1.263A-10(a)(2) and the rules in these 
proposed regulations regarding the initial unit of property 
determination. As noted in the discussion of the initial unit of 
property determination, the IRS and Treasury Department agree with 
commentators that the functional interdependence test is a relevant, 
although not dispositive, factor in the unit of property analysis. 
Although the proposed regulations use the functional interdependence 
test to determine the initial unit of property, the functional 
interdependence test in that context is merely a starting point in 
determining the appropriate unit of property, rather than a specific 
factor to be considered. Providing this version of the functional 
interdependence test as a specific factor gives appropriate weight to 
that test in the unit of property analysis for other personal property.
5. Category IV: Other Real Property
    The unit of property determination for real property not included 
in Category I or II is based on a facts and circumstances test. The 
property subject to this category is primarily land and land 
improvements owned or leased by taxpayers not in a regulated industry. 
This category does not list specific factors because land and land 
improvements are such unique assets that specific factors cannot 
uniformly provide appropriate results. Thus, the unit of property 
determination for property in this category may be based on some, all, 
or none of the factors listed in Category III for personal property, or 
may be based on other factors. The IRS and Treasury Department request 
comments on whether additional guidance is needed for this category of 
property and, if so, what unit of property guidance would be 
appropriate.
6. Additional Rule for Unit of Property
    After determining the initial unit of property and applying the 
unit of property rules under the appropriate category, the additional 
rule in Sec.  1.263(a)-3(d)(2)(vii) must be applied. Under this rule, 
if a taxpayer properly treats a component as a separate unit of 
property for any Federal income tax purpose, the taxpayer must treat 
the component as a separate unit of property for purposes of Sec.  
1.263(a)-3. The purpose of this rule is to prevent taxpayers from 
taking inconsistent positions by arguing that a component of property 
is a unit of property for one tax purpose and that it is not a separate 
unit of property for capitalization purposes. For example