AMERICAN GAS ASSOCIATION & INTERSTATE NATURAL GAS ASSOCIATION

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AMERICAN GAS ASSOCIATION &
INTERSTATE NATURAL GAS ASSOCIATION

Update on Selected Cases and Rulings

Sal Montalbano

June 29, 2010


2

Update on Selected Cases and Rulings

Capitalization under
§
263A


Robinson Knife Manufacturing Co., Inc. & Subs v.
Commissioner, 105 AFTR 2d 2010
-
1467, March 19, 2010.



Held
: A manufacturer’s royalty payments are currently deductible and
not subject to capitalization under
§
263A if they are (1) calculated as
a percentage of sales revenue from inventory and (2) are incurred only
upon the sale of that inventory.



Rationale
: The taxpayer could have manufactured exactly the same
quantity and type of products without owing any royalties, so long as
none of its inventory was ever sold bearing the licensed trademark.
Therefore, the royalties were not ‘incurred by reason of’ production
activities and did not ‘directly benefit’ such activities. However,
manufacturing
-
based royalties (those paid based on each item
manufactured) remain subject to capitalization under section 263A.



The court’s rationale would apply to all sales
-
based royalties, not just
those for the use of trademarks.


3

Update on Selected Cases and Rulings


Capitalization under
§
263A


Chief Counsel Advice 200946035, November 13, 2009.



Ruled
: An engineering department that incurs service costs allocable
to production activities and also incurs
§
174

research and
experimental expenditures constitutes a mixed service department and
as such costs should be allocated among production and non
-
production activities.



Rationale
: To satisfy the mixed service cost definition under Reg
§
1.263A
-
1(e)(4)(ii)(C) expenditures must relate to both production
and non
-
production activities.
The fact that a cost is deductible does
not automatically mean it is allocable to a non
-
production activity.
For example, a service department that incurs production costs and
also a
§
179 deduction would not qualify as a mixed service
department since this expense does not involve the department
engaging in any separate activity.
§
174

expenditures do involve a
department engaging in research endeavors which would constitute a
separate non
-
production activity and thus would qualify as a mixed
service cost.


4

Update on Selected Cases and Rulings


Capitalization under
§
263A


ILM 201013035, May 23, 2010



Concluded
: The IRS is not precluded by Notice 2007
-
29 from
examining removed inventory costs to determine the potential
application of section 263A capitalization rules.



Rationale
: The taxpayer had used negative amounts in its section
263A calculations under the simplified production method. Although
the interim guidance in Notice 2007
-
29 stated that the IRS will not
challenge the inclusion of such negative amounts, it did not change
the statutory rules or regulations on inventory capitalization. Since the
IRS was not challenging the
means
of removing costs from inventory,
but rather the
appropriateness

of removal as a general matter, the IRS
may examine and adjust inventory costs.



No opinion was expressed on whether the specific costs in question
are in fact required to be capitalized under section 263A or if the costs
may be properly removed from inventory and treated as deductible.

5

Update on Selected Cases and Rulings


Capitalization under
§
263A


Mixed Service Costs IDD #5, September 15, 2009



Classifies certain MSC allocation methods according to their relative
significance to taxpayer compliance.


Field is directed not to challenge methods identified as
less significant

to compliance:


Consistent head count ratio


Production cost ratio with limited reduction for purchased power


Methods considered
more significant

to compliance:


Generation departments in the MSC pool


Additional costs of working in an energized environment treated as costs
of maintaining electric service


Overly broad or inappropriate cost drivers


Imputation of production costs based on hypothetical events


MSC allocation remains a Tier I issue for post
-
August 5, 2005 years.



.

6

Update on Selected Cases and Rulings


Capitalization under
§
263A


Update on IDD# 5



SSCM


Last few cases working their way through Appeals



New methods adopted in 2005: Many different methods by various
taxpayers



IDD #5


Issued Sept 2009


Large number of method changes filed in December and
January (90
-
day window)


Utility and many non
-
utility taxpayers


7

Update on Selected Cases and Rulings


Capitalization under
§
263A


Update on IDD# 5



No consents granted nor 21
-
day letters yet received to 2009 and
2010 changes



IRS


Several cases settled under IDD #5


Current concerns appear to be:


Interplay with repairs deduction


Application to LDC (Cost of purchased gas)


Current exams appear to be proceeding on schedule


IMT assigned to review all settlements for consistency with
IDD #5


8

Update on Selected Cases and Rulings

Tax Accrual Workpapers


Textron Inc. et al. v. United States, No. 09
-
750, May 23, 2010.



On May 23, 2010, the United States Supreme Court denied a petition
for certiorari to reconsider the First Circuit Court of Appeals decision
that had allowed the IRS access to a company’s tax accrual
workpapers despite objections that the work product doctrine applied.



The First Circuit,
en banc,
had held that the work product privilege
only extends to documents prepared for use in litigation, rather than to
documents created to comply with financial reporting rules.



Practitioners were generally surprised by the denial.



The importance of the denial may be lessened by the recent IRS
decision to require taxpayers to self report uncertain tax positions.






Part I

Uncertain Tax Positions for the Current Tax Year

IRS Announcement 2010
-
9

Draft “Schedule UTP”

Part II

Uncertain Tax Positions for Prior Tax Years

IRS Announcement 2010
-
9

Draft “Schedule UTP”

Part III

Concise Description of Uncertain Tax Positions

IRS Announcement 2010
-
9

Draft “Schedule UTP”

12

Update on Selected Cases and Rulings

LILO/SILO Cases


Wells Fargo & Co. v. United States, Fed. Cl. No. 06
-
628T,
January 8, 2010.



Held
: Wells Fargo & Co. was not entitled to a refund for $115 million
in taxes it paid after the disallowance of deductions stemming from its
participation in 26 SILO transactions.



Rationale
: The transactions, which generally involved rail cars and
buses, lacked economic substance, were intended only to reduce
federal taxes, and did not grant Wells Fargo the benefits and burdens
of ownership of the property at issue. The court distinguished the case
of
Consolidated Edison Company of New York Inc. v. United Stated,
on the grounds that there the LILO transaction at issue had a
legitimate business purpose.


13

Update on Selected Cases and Rulings

Codification of Economic Substance


Health Care and Education Affordability Reconciliation
Act of 2010, March 30, 2010.



Codified the economic substance doctrine in new section 7701(o)
of the Code.


In case of any transaction to which the economic substance
doctrine is relevant, the transaction will be treated as having
economic substance only if:


It changes in a meaningful way (apart from federal income tax effects) the
taxpayer’s economic position;
and


The taxpayer has a substantial purpose (other than to obtain federal income tax
benefits) for entering into the transaction.


It imposes a strict liability penalty (with no reasonable cause
exception) for transactions lacking economic substance.






14

Update on Selected Cases and Rulings

Transaction Costs


Private Letter Ruling 200953014, January 1, 2010.



Ruled
: (1) Costs associated with transaction
-
related services arranged
by one or more parties to a merger may be taken into account by the
taxpayer when (a) the Taxpayer demonstrates that the services were
rendered to the taxpayer, and/or on behalf of the taxpayer; and (b) the
fees associated with such services were paid for by the taxpayer,
and/or reimbursed by the taxpayer.



(2) Due diligence costs that are incurred before the “bright
-
line” date
and not inherently facilitative may be deducted under
§
162.



(3) Capitalized costs paid by the taxpayer in financing the transaction
are allocated to the underlying debt instrument and deductible over
the term of each debt instrument under Regulations
§
1.446
-
5.


15

Update on Selected Cases and Rulings

Transaction Costs


Technical Advice Memorandum 201002036, January 15, 2010.



Ruled
: General spreadsheets developed by an accounting firm in
conjunction with employees of service providers, along with other
corroborating documentation provided by the taxpayer qualify as
“other records,” for purposes of substantiating the non
-
facilitative
portion of a success
-
based fee.



Rationale
: Any document can serve to establish the deductible portion
of a success
-
based fee, even when the document was not produced by
the service provider but was based on interviews of the service
provider’s employees. The IRS stated: “What is important is whether
the documents presented, taken as a whole, provide the information
required by Regulations
§
1.263(a)
-
5(f)(1)
-
(4).”



Whether they actually supported the allocation was left to LMSB.


16

Update on Selected Cases and Rulings

Research and Foreign Tax Credit Carry Backs


R.H. Donnelley Corp. v. United States, U.S. D.C. Eastern Dist.,
NC, Western Div. No. 5:08
-
CV
-
501
-
BO, January 29, 2010.




Held
: Taxpayer was not entitled to a refund based on the carry back of
unused research and foreign tax credits from a closed year, where the
correct but uncharged tax liability for the closed year exceeded the
amount of the credits, leaving none to be carried back.



Rationale
: Although the IRS cannot collect an uncharged tax liability
for a closed year, in determining whether the taxpayer is entitled to a
refund, it can recompute the proper tax liability for a closed year to
determine whether unused credits are available to be carried back.


17

Update on Selected Cases and Rulings

Research Credit


T.G. Missouri Corp. v. Commissioner, T.C. No. 8333
-
06, 133
T.C. No. 13, November 12, 2009.




Held
: Production molds sold to customers are not assets of a character
subject to the allowance for depreciation under
§
41(b)(2)(c) and
§
174(c) and, therefore, the taxpayer properly included the costs of
the molds as cost of supplies in computing its research credit.



Rationale
: It is reasonable to interpret the language of
§
41(b)(2)(c)
and
§
174(c) as a reference to property that is not properly classified as
depreciable property on the books and records of the taxpayer. The
term cannot mean that there is a generic character of property that
exists without any reference to a particular taxpayer and such
taxpayer’s use of the property.


18

Update on Selected Cases and Rulings

Capital Versus Ordinary Losses


Chief Counsel Advice 201002035, January 15, 2010.




Ruled
: A foreign, state
-
owned commercial entity’s refusal to agree to
terms for connecting a power plant project to the grid did not amount
to a seizure within the meaning of
§
1231(a)(4), and therefore a US
taxpayer’s loss on it partnership interest in the project was not an
ordinary loss.



Rationale
: The state
-
owned commercial entity was a commercial
entity without regulatory power but with responsibility for electric
power in the relevant region. Its refusal to enter into an
interconnection agreement was based on its economic self
-
interest.
Thus, the taxpayer’s loss resulted from market forces, business
setbacks, and parties acting in commercial capacities, not
governmental actions.


19

Update on Selected Cases and Rulings

Casualty Losses


Single Identifiable Property


Technical Advice Memorandum 201014052, November 23, 2009.



Ruled
: A telecommunications taxpayer’s wire center was subdivided
into three single identifiable properties (SIPs) by reference to which
section 165 casualty losses were determined. These were:



The central office building itself;


Central office equipment; and


Outside plant.



Rationale
: These SIPs were consistent with how the taxpayer
classified its assets for regulatory, financial, and tax accounting
purposes, were consistent with the section 165 Regulations, and were
reasonable in relation to the nature and scope of the casualties the
taxpayer experienced.


20

Update on Selected Cases and Rulings

Energy Credits


Private Letter Ruling 200947027, November 20, 2009.



Ruled
: A reflective roof surface installed in connection with a rooftop
photovoltaic solar generation system constitutes energy property
under IRC
§
48.



Rationale
: Since the reflective roof surface enables the generation of
significant amounts of electricity from reflected sunlight, it constitutes
equipment that uses solar energy to generate electricity only when
installed in connection with the photovoltaic solar generation system.
When installed in connection with such a system, the reflective roof
surface also satisfies the definition of energy property under Reg.
§
1.48
-
9(d)(1) and
§
1.48
-
9(d)(3), because it is part of the equipment
and materials that use solar energy to directly generate electricity.


21

Update on Selected Cases and Rulings

Inflation Adjustment Factors

Notice 2010
-
37, May 3, 2010.



Publishes the 2010 inflation adjustment factors and reference prices under for the
production tax credit (“PTC”) and other credits under Code section 45.



Because the reference prices did not exceed the relevant thresholds, the phase
-
out
of the credits is not applicable.



With the inflation adjustment, the PTC is 2.2 cents per kilowatt hour for wind,
closed
-
loop biomass, geothermal and solar energy. It is 1.1 cent per kilowatt hour
for open
-
loop biomass and qualified hydro projects.

22

Update on Selected Cases and Rulings

Purchased State Tax Credits




LTR 200951024
,
September 10, 2009.



Ruled
: A public gas and electric utility’s basis in a state tax credit it
buys will be the cost of the credit. Gain or loss will be realized on any
difference between the basis and the amount of liability satisfied in
applying it when the utility company applies the credit to its state tax
liability.



Rationale
: Payment for the purchase of a transferable tax credit is not
a payment of tax or a payment in lieu of tax for purposes of
§
164(a).
The transferee has purchased a valuable right, the basis of which is
the cost incurred. The use of the credit to satisfy the transferee's state
tax liability is a transfer of property to the state in satisfaction of the
liability. Therefore, when the transferee uses the credit to satisfy a
state tax liability, the transferee will have gain or loss under
§

1001 on
the use of the credit and will be treated as having made a payment of
state tax, for purposes of
§
164(a).

23

Update on Selected Cases and Rulings

Change of Accounting Method


Deferral of
Advance Payments


Chief Counsel Advice 201011009, March 19, 2010.



Ruled
: A taxpayer that previously elected to defer advanced payments
under Rev. Proc. 2004
-
34 is required to obtain consent under
§
446(e)
if the taxpayer subsequently changes its book method for the deferred
advance payments



Rationale
:
§
1.446
-
1(e)(2)(i) states that a taxpayer that changes its
book method of accounting must secure the Commissioner’s consent
before applying its new book method of accounting for tax purposes
even if the new method is the proper method of accounting.
Furthermore, as the method of accounting for advanced payments is a
timing item, a change in that method may result in the omission of
income or double inclusion of income. Such omission or double
inclusion can be avoided under
§
481(a) only if the change is
attributable to a change in method of accounting.

24

Update on Selected Cases and Rulings

Accrual of Bonuses


Chief Counsel Advice 200949040, July 28, 2009.



Advised
: A taxpayer’s liability to pay bonuses to its non
-
executive
employees under a plan that requires employees to be employed by
the taxpayer on the date the bonuses are paid is not fixed until the
contingency is satisfied


when the employee is still employed on the
dated of payment and receives the bonus.



Rationale
:
Even though the bonuses may be based on the company’s
performance in year 1, economic performance does not occur and the
liability is not fixed until the date the bonuses are paid because
service must continue until that date. The IRS rejected the taxpayer’s
argument that its liability was fixed because any amount of the bonus
not paid to employees had to be paid to charity. Section 170(a)(2)
does not govern the timing of the accrual of the bonus, because the
taxpayer did not make any payments to charity.

25

Update on Selected Cases and Rulings

FICA Tax on Severance in Bankruptcy


United States v. Quality Stores Inc. (In re Quality Stores Inc.),
W.D. Mich., No. 1:09
-
cv
-
44, 2/23/10.



Held
: A bankruptcy debtor is not liable for FICA tax on severance
payments to employees upon their termination based on downsizing.



Rationale
: The severance payments met the definition of
“supplemental unemployment compensation benefits” in
§
3402(o)(2).
§
3402(o) implies that any payment meeting this definition should not
be considered wages since the language “shall be treated as if it were
a payment of wages by an employer to an employee for a payroll
period” would be unnecessary otherwise.


26

Update on Selected Cases and Rulings

Interest Rate Netting


Energy East Corp. v. United States; No. 1:07
-
cv
-
00812, March
11, 2010



Held
: Interest rate netting is not available to a parent corporation
regarding its tax underpayment and its subsidiaries' tax overpayments
if they were separate unrelated entities at the time the underpayment
and overpayments occurred and do not qualify as the same taxpayer
under
§
6621(d).



Rationale
: According to
§
6621(d), interest rates may be netted only
on "equivalent underpayments and overpayments by the same
taxpayer”. The group did not fit the definition of “same taxpayer”
prior to the acquisition and formation of a consolidated group. Since
the underpayments and overpayments were made prior to the
acquisition of the subsidiaries, the group would not be considered the
same taxpayer and would not qualify for interest rate netting.

27

Update on Selected Cases and Rulings

Section 199 DPGR



Legal Memorandum 200946037, October 26, 2009.



Ruled
:
§
1.199
-
4(b)(2)(ii)(B) does not require or permit corporations
to allocate part of the cost of goods sold of an inventory item to non
-
DPGR when the gross receipts from the sale of that item are treated as
DPGR.



Rationale
: Because the cost of goods sold are properly capitalizable to
current year production under
§
263A, they are related to gross
receipts generated from the sale of goods in the current year. As a
result, they must be included in determining the cost of goods sold
allocable to DPGR for the tax year in which the costs are incurred and
must be allocated to DPGR using a reasonable method in accordance
with Reg.
§
1.199
-
4(b)(2)(i). The most reasonable method of
allocation under these facts is the specific identification method which
results in the entire amount of the costs at issue being allocated to
DPGR.


28

Update on Selected Cases and Rulings

Integrated Property
-

Depreciation




LTR 200949019
,
August 31, 2009.



Ruled
: A real estate developer may treat a business and commercial
complex consisting of two buildings and a parking garage as a single
building for purposes of determining whether the integrated unit is
residential or nonresidential property under
§
168(e)(2).



Rationale
: Under
§
1.1250
-
1(a)(2)(ii) if two or more buildings or
structures on a single or contiguous tract or parcel of land are
operated as an integrated unit (evidenced by actual operation,
management, financing, and accounting), they may be treated as a
single item. In this case:


Buildings are located on contiguous parcels of real property and will be
placed in service in the same 12
-
month period


Project will be operated under single security services contract


Apartment amenities on one building rooftop serve all buildings


One company retains overall management responsibilities of buildings


One overall plan of financing for development of project and financing is
secured by deeds of trust on entire project


Single budget, single set of books, consolidated income statement and
balance sheet, single Federal tax return reflecting aggregate operations

29

Update on Selected Cases and Rulings

§
118 Nonshareholder Contributions to Capital


Revenue Procedure 2010
-
20, March 10, 2010.




Safe Harbor
:
The IRS will not challenge a corporation’s
treatment of a smart grid investment grant (SGIG) made by the
DOE to the corporation as a nonshareholder contribution to the
capital of the corporation under section 118(a) of the Code if
the corporation properly reduces the basis of its property under
section 362(c)(2) and the Regulations thereunder.




Caveat
: The safe harbor does not apply to noncorporate
taxpayers, or to smart grid technology research, development,
and demonstration grants (SGDGs).



Effective March 10, 2010.




30

Update on Selected Cases and Rulings


§
118 Nonshareholder Contributions to Capital




LTR 201003005, October 22, 2009



Ruled
: (1)government payments to assist in the construction of a
plant are nonshareholder contributions to capital under
§
118(a) and
are excludable from gross income under
§
61 and (2) the basis of
capital assets acquired with the money contributed by government
shall be reduced by the amount of the contribution in accordance with
the provisions of section 362(c) and the regulations thereunder



Five Characteristics of Nonshareholder Contribution to Capital set
forth in
Chicago, Burlington & Quincy Railroad Case
:


Payment must become a permanent part of the transferee's working
capital structure.


Payment may not be compensation for a specific, quantifiable service
provided for the transferor by the transferee.


Payment must be bargained for.


Asset transferred must foreseeably benefit the transferee in an amount
commensurate with its value.


Asset ordinarily will be employed in or contribute to the production of
additional income and its value assured in that respect


31

Update on Selected Cases and Rulings

§
118 Nonshareholder Contributions to Capital




LTR 200952014, September 18, 2009.



Ruled
: Certain payments and transfers of property from a
government agency to a utility to place overhead electrical lines and
related equipment underground do not constitute contributions in aid
of construction under
§
118(b), but are contributions to capital under
§
118(a) and thus excludable from gross income under
§
61.



Rationale
:



(1) Contribution did not relate to provision of services by utility or for
the benefit of the contributor, but rather related to the benefit of the
public at large, and thus was not a CIAC.



(2) The contribution had the five characteristics of a nonshareholder
contribution to capital set forth in
Chicago, Burlington & Quincy
Railroad Company
case.


32

Update on Selected Cases and Rulings


§
118 Nonshareholder Contributions to Capital




LTR 201005002, October 16, 2009.



Ruled
: The contribution of an intertie by a producer to the taxpayer
will not be a CIAC under section 118(b) and will be excludible from
gross income as a nonshareholder contribution to capital under section
118(a).




Rationale
:



The safe harbor requirements of Notice 88
-
129, as amended and
modified by Notice 90
-
60 and 2001
-
82 were met.



The transfer of the intertie possessed the characteristics of a
nonshareholder contribution to capital set forth in the
Chicago,
Burlington & Quincy Railroad Company
case.


33

Update on Selected Cases and Rulings


§
118 Nonshareholder Contributions to Capital


LMSB
-
04
-
0209
-
003, January 7, 2010.



IRS has moved
§
118 abuse sub
-
issue involving universal service
funds (USFs) from a Tier 1 issue to monitoring status.



Legal position concluded that USF proceeds received by
telecommunication providers from federal and state universal service
programs represent payments for services constituting taxable income
under
§
61 and not non
-
shareholder contributions to capital excludable
from income under
§
118(a).



USF issue remains a coordinated issue, and sub
-
issues involving state
and local tax incentives, bioenergy subsidies, and environmental
remediation remain in active Tier 1 status.


34

Update on Selected Cases and Rulings

Asset Class of Support Vessels


Private Letter Ruling 201001018, January 14, 2010.



Ruled
: For purposes of
§
168, offshore support vessels that are
primarily used to transport supplies, equipment, and personnel in
offshore oil and gas operations are classified in asset class 13.0
Offshore Drilling (5 yr recovery period for
§
168(a) and 7.5 yrs for
§
168(g)) instead of asset class 00.28 Vessels, Barges, Tugs, and
similar Water Transportation Equipment (10 yr recovery period for
§
168(a) and 18 yrs for
§
168(g)).



Rationale
: Based on a detailed analysis of the history and the plain
language of the description of asset class 13, the support vessels
classified by Rev Proc 66
-
18, 1966
-
1 CB 646 in the Marine Contract
Construction class are currently included in asset class 13.

35

Update on Selected Cases and Rulings

Extended NOL Carryback


Rev. Proc. 2009
-
52, 2009
-
49 IRB 744,
November 20,
2009
.


Applies to taxpayers that incurred an applicable NOL or an applicable
loss from operations for a taxable year ending after December 31,
2007, and beginning before January 1, 2010


Prescribes when and how to elect under
§
172(b)(1)(H) to carry back
NOLs for a period of 3, 4, or 5 years for (1) taxpayers that have not
claimed a deduction for an applicable NOL; (2) taxpayers that
previously claimed a deduction for an applicable NOL; and (3)
taxpayers that previously filed an election under
§
172(b)(3) or
§
810(b)(3) to forgo the NOL carryback period.


May file election by attaching a statement to federal return for the
taxable year in which the applicable NOL arises or by attaching an
election statement to the appropriate form the taxpayer files applying the
NOL carryback period the taxpayer elects.


Must file election on or before the return due date (including extensions)
for the taxpayer's last taxable year beginning in 2009.


36

Update on Selected Cases and Rulings

Normalization


Private Letter Ruling 200945006, July 28, 2009.



Ruled
:



(1) A direct flow
-
through by Taxpayer to customers of the ADITC balance on
natural gas assets subsequent to the sale of those assets to Buyer is a normalization
violation;



(2) A transfer from Taxpayer to Buyer of Taxpayer’s unamortized ADITC balance
in a taxable sale of assets and the use thereof by Buyer to reduce its cost of service
is a normalization violation;




(3) Taxpayer’s remittance to Buyer of amounts in lieu of and equal to the amount of
Taxpayer’s annual ADITC amortization if the sale of assets had not occurred for
the purpose of flowing through those amounts to the ratepayers of Buyer as ordered
by the Commission is a normalization violation; and



(4) If a normalization violation occurs, the result is the disallowance or recapture of
all unamortized ITCs of Taxpayer with respect to public utility property.


37

Update on Selected Cases and Rulings













Q&A