An Overview of the Proposed Bonus Depreciation Regulations under Section 168(k) August 21, 2018 Federal Bar Association 2018 (US) LLP All Rights Reserved. This communication is for general informational purposes only and is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making decisions of a legal nature with respect to the issues discussed herein. The recipient is encouraged to consult independent counsel before making any decisions or taking any action concerning the matters in this communication. This communication does not create an attorney-client relationship between (US) LLP and the recipient. (US) LLP is part of a global legal practice, operating through various separate and distinct legal entities, under. For a full description of the structure and a list of offices, please visit www.eversheds-sutherland.com.
Agenda History of Bonus Depreciation TCJA Amendments to Section 168(k) How the Proposed Regulations Address Issues Arising under Section 168(k) Legislative Inconsistencies Regarding QIP Recovery Period Used Property Eligible for Bonus Depreciation Effect of Binding Contracts on Acquisition Date Determinations The Impact of the Proposed Regulations on Amendments to Section 168(k) Regarding Certain Corporate Issues Section 168(k) and Partnership Issues: Interaction with Sections 743(b), 734(b), and 704(c) Film, Theatrical and Television Productions: The Impact of Combined Section 168(k) and Section 181 2
History of Bonus Depreciation
History of Bonus Depreciation First introduced in 1981 to provide accelerated depreciation as a tax incentive designed to encourage economic growth. Depreciation rules and section 179 s full expensing provisions for investments under $1 million, allowed for near-immediate cost recovery of certain property for certain taxpayers. 1986 tax reform lengthened class recovery periods and increased the rate of depreciation. In 2002, section 168(k) s bonus depreciation was born. The Job Creation and Worker Assistance Act s bonus depreciation allowance was intended as stimulus to address the 2001 recession and the economic aftermath of September 11, 2001. 4
History of Bonus Depreciation Since 2002, Congress has passed at least 10 laws enhancing or extending depreciation allowances The Tax Relief, Unemployment Compensation Reauthorization, and Job Creation Act of 2010 bumped the bonus depreciation allowance up to 100% in 2011 Subsequently the rate fell to 50% in 2012 and remained there until the 2017 amendments to section 168(k) in the TCJA. 5
TCJA Amendments to Section 168(k)
TCJA Amendments to Section 168(k) Reinstated the 100% first-year bonus depreciation rate Allowing taxpayers to fully expense certain qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023. For qualified property placed in service after 2022, the bonus depreciation rate decreases by 20% each calendar year until the provision expires in 2027. Extends the placed-in-service and phase-down terms by one year for aircraft and other property with longer production periods. Property acquired before September 28, 2017, and placed in service after September 27, 2017 remains subject to the pre-tcja depreciation and phase-down rules. Taxpayers have the option to elect out of the immediate expensing provision for certain classes of property. For qualified property placed in service during the first taxable year ending after September 27, 2017, they can elect to apply the traditional 50% rate. 7
TCJA Amendments to Section 168(k) Qualified property Generally, tangible depreciable property with a recovery period of 20 years or less whose original use began with the taxpayer. TCJA expanded the definition of qualified property in two ways: First, expanded the definition to included film, television and theatre productions These items were previously addressed by section 181. Second, modified the original use requirement to apply to certain used property in addition to new property. Used property may qualify for bonus depreciation if the taxpayer acquired the used property in an arm s-length transaction from an unrelated party and did not use the property before obtaining it, consistent with the requirements of sections 179(d)(2)-(3). TCJA also narrowed the definition of qualified property Excludes certain property used by businesses with floor plan financing indebtedness and by specified public and other utilities that is placed in service after December 31, 2017. 8
TCJA Amendments to Section 168(k) Qualified Improvement Property Consolidated several types of real property with accelerated recovery classes into one. Under prior law, non-residential real property and residential rental property had MACRS recovery periods of 39 and 27.5 years. Qualified leasehold improvement, restaurant and retail improvement property, however, enjoyed an accelerated 15-year recovery period. Prior section 168(k) defined qualified property as including qualified improvement property (QIP). Attempted to provide uniform tax treatment for these different types of real property by eliminating the separate definitions of qualified leasehold improvement, qualified restaurant and qualified retail improvement property from section 168(e)(3). Consolidates the three property types into a redefined QIP category, and moves the new QIP from section 168(k) into section 168(e)(6). As revised, Congress did not assign QIP the previously applicable 15-year MACRS recovery period, thus precluding such property from being eligible for expensing, absent a statutory technical correction. After 2017, QIP means, any improvement to an interior portion of a building which is nonresidential real property if such improvement is placed in service after the date such building was first placed in service. 9
TCJA Amendments to Section 168(k) TCJA also made certain changes to other Code sections that will affect a company s ability to utilize cost-saving provisions fully. For example, the TCJA repealed the corporate alternative minimum tax (AMT), but the former section 168(k)(4) allowed corporate taxpayers to accelerate AMT credit carry-forwards instead of taking bonus depreciation. This change may affect a firm s ability to use all of its remaining credits. During the accelerated drafting and signing of the TCJA before 2017 year-end, a number of issues arose from the amendments made to section 168(k). As previously mentioned, the Treasury and the IRS have attempted to remedy a number of these issues in the proposed regulations. 10
How the Proposed Regulations Address Issues Arising under Section 168(k) Legislative Inconsistencies Regarding QIP Recovery Period
Legislative Inconsistencies Regarding QIP Recovery Period Due to the elimination of separate definitions of qualified leasehold improvement, qualified restaurant and qualified retail improvement property, the consolidation of the three property types into a redefined QIP category, and the failure to assign a 15-year recovery period, QIP now depreciated using a straight-line method over the standard 39 years. The Joint Explanatory Statement accompanying the TCJA s Conference Report clearly stated that QIP placed in service after December 31, 2017, would be eligible for 15-year Modified Accelerated Cost Recovery System (MACRS) depreciation. Treasury and the IRS have indicated publicly that the issue will not be resolved administratively arguing that the matter should be resolved through technical corrections. It is possible for the Treasury and the IRS to ameliorate the confusion with an administrative safe harbor, which allows either bonus depreciation or a 15-year recovery. Such treatment would be consistent with the unambiguous intent of Congress. 12
Legislative Inconsistencies Regarding QIP Recovery Period Proposed regulations do not take this approach. Preamble to the proposed regulations failed to explicitly address the QIP issue quagmire or to articulate why the Treasury and the IRS chose not to resolve the issue. The proposed regulations do clarify that at least for the 2017 return filing season, taxpayers may apply the full expensing provisions to QIP. The preamble specifically states that because of the effective date of the TCJA (property placed in service after December 31, 2017), the proposed regulations provide that MACRS property with a recovery period of 20 years or less (and, therefore, eligible for full expensing) includes QIP that is acquired by the taxpayer after September 27, 2017, construction of which commenced after September 27, 2017, and placed in service by the taxpayer after September 27, 2017, and before January 1, 2018. 13
Legislative Inconsistencies Regarding QIP Recovery Period Proposed regulations also provide taxpayers with the ability to elect out of the additional first year depreciation deduction (or to elect to deduct 50%, instead of 100%, of additional first year depreciation for qualified property). The drafting of section 168(k)(10) also resulted in an unanticipated adverse consequence to taxpayers potentially considering electing 50% as opposed to 100% bonus depreciation for certain classes of assets. As amended by the TCJA, section 168(k)(10) does not state that the election may be made with respect to any class of property. For this reason, the proposed regulations specify that the election under section 168(k)(10) must apply to all qualified property thereby limiting a taxpayer s ability to pick and choose which classes of property for which it may elect 50% as opposed to 100% additional first year depreciation. 14
How the Proposed Regulations Address Issues Arising under Section 168(k) Used Property Eligible for Bonus Depreciation
Used Property Eligible for Bonus Depreciation Section 168(k) now makes bonus depreciation available for used property. Proposed regulations follow the statutory requirements and specify that used property may satisfy the definition of qualified property eligible for bonus depreciation as long as the taxpayer did not use the property at any time prior to [its] acquisition. Additionally, the statute requires that a taxpayer acquire the used property by purchasing it in an arm s-length transaction from an unrelated party. Cannot be acquired from a related party or be property whose basis will be determined by reference to the adjusted basis of such property in the hands of the transferor (i.e., carry-over basis). Although the statute sets forth general rules of application for used property, ambiguity persists with more specific issues such as leased property, previously owned property and treatment by consolidated groups. 16
Used Property Eligible for Bonus Depreciation Property is treated as used by the taxpayer or a predecessor at any time before its acquisition only if the taxpayer or the predecessor had a depreciable interest in the property prior to the acquisition, regardless of whether the taxpayer or predecessor claimed such depreciation deductions. Thus, if a taxpayer is leasing property and does not obtain a depreciable interest in such property, upon subsequent purchase, the property would satisfy the definition of used property and be eligible for full expensing. The proposed regulations also allow previously leased property to qualify for full expensing irrespective of improvements made by the lessee for which it had a depreciable interest; upon subsequent purchase of the property, the amount eligible for full expensing would be the unadjusted basis of the property, less the unadjusted depreciable basis attributed to the improvements. 17
Used Property Eligible for Bonus Depreciation The proposed regulations also allow taxpayers to bifurcate portions of property for depreciable interest purposes. For example, if a taxpayer initially acquires a depreciable interest in a portion of property and subsequently acquires an additional depreciable interest in the same property, the proposed regulations provide that such additional depreciable interest is not treated as previously owned by the taxpayer. The proposed regulations essentially treat a consolidated group as a single taxpayer. Additional first year depreciation is not available to individual members of a consolidated group when property is disposed of by one member of a consolidated group and then subsequently acquired by another member of the group. For transactions between related parties, the preamble indicates that the ordering of steps or the use of an unrelated intermediary in a series of related transactions should not control. 18
Used Property Eligible for Bonus Depreciation Consolidated groups (cont.) In the case of a series of related transactions, the proposed regulations provide that the transfer of property will be treated as transferred from the original transferor to the ultimate transferee, with the relation between the original transferor and the ultimate transferee being tested immediately after the last transaction in the series. 19
How the Proposed Regulations Address Issues Arising under Section 168(k) Effect of Binding Contracts on Acquisition Date Determinations
Effect of Binding Contracts on Acquisition Date Determinations The Acquisition Date Previously, acquisition occurred when the taxpayer pays or incurs the cost of the property. Under the proposed regulations, when a taxpayer acquires property pursuant to a written binding contract, the acquisition date is the date of the contract. In other words, property is not treated as acquired after the date on which a written binding contact is executed for such acquisition, even if the taxpayer does not receive the property on that date. The statute fails to define written binding contract, which is generally controlled by commercial law. As a result, when property becomes subject to a legally binding contract, the date of such contract may alter the acquisition date of the property for purposes of bonus depreciation. Taxpayers and practitioners questioned how the binding contract provisions would be applied, especially with respect to selfconstructed property and its components. 21
Effect of Binding Contracts on Acquisition Date Determinations Prior guidance treated a taxpayer that manufactured, produced or constructed property for itself as acquiring the property: When the taxpayer began production of that asset, or When the cost of production exceeded a safe harbor threshold i.e., when the taxpayer began work of a significant nature, or incurred expenses greater than 10% of the total cost. The new section 168(k)(2)(E) maintains that the acquisition requirement will be satisfied if manufacturing begins before the qualified property placed-in-service period ends (i.e., January 1, 2027). Prior to the release of the proposed regulations, it was uncertain whether the previous rules for determining when production begins would continue to apply. 22
Effect of Binding Contracts on Acquisition Date Determinations Prior guidance also provided an exception to the standard acquisition rule for certain components of selfconstructed property. Rev. Proc. 2011-26 allowed bonus depreciation for components acquired within the applicable placed-in-service period, even when the larger self-constructed property to which such components attached were acquired prior to the effective date and therefore ineligible for bonus depreciation. Thus, a taxpayer could elect to fully expense the eligible components that met the qualified property requirements even though the larger project commenced prior to the bonus depreciation effective date. 23
Effect of Binding Contracts on Acquisition Date Determinations The proposed regulations specify that the property must be acquired by the taxpayer pursuant to a written binding contract entered into by the taxpayer after September 27, 2017, confirming the statutory rule. Previously, property manufactured, constructed or produced under a binding contract that would have been self-constructed property if manufactured, constructed or produced by the taxpayer was treated as self-constructed property. The conversion of property previously treated as self-constructed property under the new binding contract rule will come as a surprise to many. As previously noted, the acquisition date is the date when the contract is entered into, even if the contract includes a series of other dates, (e.g., completion, delivery, etc.). For self-constructed property, the proposed regulations provide that the acquisition rules of the statute are met if the taxpayer begins manufacturing, constructing or producing the property after September 27, 2017. 24
How the Proposed Regulations Address Issues Arising under Section 168(k) The Impact (or Lack Thereof) of the Proposed Regulations on Amendments to Section 168(k) Regarding Certain Corporate Issues
The Impact (or Lack Thereof) of the Proposed Regulations on Amendments to Section 168(k) Regarding Certain Corporate Issues Two key corporate issues that arise from the TCJA amendments to section 168(k) include: (1) the effect that claiming bonus depreciation for used property will have on transactions involving section 338 and section 336(e) elections; and (2) the discrepancy in effective dates between section 168(k) and section 163(j) concerning property excluded from the definition of qualified property. Section 338 Prior to the TCJA, section 168(k) bonus depreciation was not available for a stock purchase treated as an asset acquisition as a result of a section 338 election or a stock disposition treated as an asset transfer as a result of a section 336(e) election. Such transactions would not have satisfied the original use requirement. 26
The Impact (or Lack Thereof) of the Proposed Regulations on Amendments to Section 168(k) Regarding Certain Corporate Issues Section 338 (cont.) In a section 338 transaction, the target corporation holds and uses its assets before the transaction, the former target is deemed to transfer the assets, and the New Co Target is deemed to acquire those assets and then continue to hold and use such assets. Similarly, in a section 336(e) transaction, assets are deemed to have been acquired by a New Co Target when the election is made. When the original use requirement in section 168(k) was modified by the TCJA, bonus depreciation became available for a stock transaction treated as an asset transaction because of a section 338 or a section 336(e) election. 27
The Impact (or Lack Thereof) of the Proposed Regulations on Amendments to Section 168(k) Regarding Certain Corporate Issues Section 338 (cont.) To qualify for bonus depreciation in this context, several requirements must be met: (1) the transaction must be taxable as provided in section 179(d)(2); (2) the parties (transferee and transferor) cannot be related as provided in section 179(d)(3); and (3) the transferee cannot have used the property at any time prior to the acquisition. Due to the similarities between section 338 elections and section 336(e) elections, the proposed regulations also modified Treas. Reg. 1.179-4(c)(2), which addresses the treatment of a section 338 election, to include property deemed to have been acquired by a new target corporation as a result of a section 336(e) election. The preamble to the proposed regulations notes that while both the Treasury and the IRS interpreted the former regulation as applying to both a section 338 and a section 336(e) election, to remove any doubt, the language was modified. 28
The Impact (or Lack Thereof) of the Proposed Regulations on Amendments to Section 168(k) Regarding Certain Corporate Issues Section 163(j) Treasury and the IRS did not to address the discrepancy in effective dates between section 168(k)(9) and section 163(j). Section 168(k)(9) excludes from the definition of qualified property certain property used in trades or businesses exempt from the interest limitations under section 163(j), namely property used in the trade or business of furnishing energy by regulated companies. The definition of qualified property also excludes property used in a trade or business that has floor plan financing indebtedness, if section 163(j) s interest limitations do not apply to the indebtedness. 29
The Impact (or Lack Thereof) of the Proposed Regulations on Amendments to Section 168(k) Regarding Certain Corporate Issues Section 163(j) During the expedited drafting process of the TCJA, an oversight occurred, thereby providing the effective date for section 168(k) (generally, September 27, 2017) to fall before the effective date for section 163(j) (beginning after December 31, 2017). Because of the January 1, 2018 effective date for section 163(j), the Treasury and the IRS concluded that property acquired by utilities after September 27, 2017, construction of which commenced after that date, and placed in service before January 1, 2018, would be eligible for expensing. Given that utilities, many of whom have sizable accumulated net operating losses attributable to bonus depreciation, essentially traded ineligibility for expensing for not being subject to the interest limitations of Section 163(j), this result was unexpected. To the extent the utilities wish to forgo the additional expensing, they will need to file elections out of expensing for such property. Treasury also failed to address the definition of trade or business used to define ineligible property. 30
How the Proposed Regulations Address Issues Arising under Section 168(k) Section 168(k) and Partnership Issues: Interaction with Sections 743(b), 734(b), and 704(c)
Section 168(k) and Partnership Issues: Interaction with Sections 743(b), 734(b), and 704(c) Under prior section 168(k) partnership basis adjustments were ineligible for bonus depreciation because the adjustments were made with respect to previously used partnership property and thus failed to satisfy the original use requirement. As noted above, the TCJA amended section 168(k) to allow bonus depreciation for certain used property in addition to new property, which raises the issue of whether these partnership basis adjustments are now eligible for bonus depreciation. Under the proposed regulations, partnership basis adjustments under section 743(b), which generally are permitted in connection with a person s acquisition of a partnership interest from a partner, may be considered used property that is eligible for bonus depreciation, depending on the facts and circumstances. Apply aggregate view of partnership taxation 32
Section 168(k) and Partnership Issues: Interaction with Sections 743(b), 734(b), and 704(c) In contrast, the proposed regulations take the position that partnership basis adjustments under section 734(b), which generally are permitted in connection with partnership distributions to a partner (including distributions in complete or partial liquidation of the partner s partnership interest) are not eligible for bonus depreciation. Unlike a section 743(b) adjustment, a section 734(b) adjustment is on a non-partner specific basis. The proposed regulations apply an entity view (under which the partnership is considered an entity separate from its partners). Based on the entity view, the proposed regulations conclude that the partnership basis adjustment under section 734(b) cannot meet the used property requirements of section 168(k)(2)(E)(ii) because the partnership used the property prior to the event giving rise to the section 734(b) adjustment. 33
Section 168(k) and Partnership Issues: Interaction with Sections 743(b), 734(b), and 704(c) Similarly, the proposed regulations take the position that remedial allocations under section 704(c) with respect to depreciable property, which is contributed to the partnership or revalued on the partnership s books in connection with a partnership contribution or distribution, can result in depreciation deductions that are similar to depreciation deductions allowed with respect to partnership basis adjustments, and are not eligible for bonus depreciation. Thus, under the approach of the proposed regulations, partnership transactions that are economically similar may be treated differently for purposes of the bonus depreciation rules of section 168(k), depending on the structure utilized. 34
How the Proposed Regulations Address Issues Arising under Section 168(k) Film, Theatrical and Television Productions: The Impact of Combined Section 168(k) and Section 181
Film, Theatrical and Television Productions: The Impact of Combined Section 168(k) and Section 181 Section 168(k) expanded qualified property to include film, television and live theatrical productions, as those terms are defined in section 181. Section 181 allowed companies to immediately expense up to either $15 or $20 million of certain qualified film, theatrical and television production costs, depending on the geographic location in which the costs of production were incurred. At first, the effect of the interaction of these two provisions seemed straightforward, since section 181 s incentives would have expired at the end of 2016; therefore, section 168(k) would essentially replace section 181. However, the Bipartisan Budget Act of 2018, enacted in February of this year, extended section 181(g) s sunset provision to December 31, 2017. Thus, qualified productions commencing between September 27 and December 31, 2017, are subject to both provisions. As such, there was a question about whether the proposed regulations would impose an ordering rule or limit available bonus depreciation to amounts above such as deductible amounts. 36
Film, Theatrical and Television Productions: The Impact of Combined Section 168(k) and Section 181 Additionally, section 181 expenses were deductible based on when and where they were incurred, not when they were placed in service. Section 168(k)(2) makes clear that only productions placed in service after September 27, 2017, will be eligible for bonus depreciation. Since section 168(k)(2)(H) states that productions are placed in service on the date of initial release, broadcast or stage performance, companies will have to pay special attention to when they released the production to determine whether any costs above the expense cap will be deductible. The proposed regulations provide that a qualified film, television or live theatrical production is treated as placed in service at the time of the first commercial exhibition of a production to an audience. With certain exceptions for limited exhibitions. 37
Film, Theatrical and Television Productions: The Impact of Combined Section 168(k) and Section 181 The proposed regulations provide that a qualified film or television production is treated as acquired on the date principal photography commences, and a qualified live theatrical production is treated as acquired on the date when all of the necessary elements for producing the live theatrical production are secured. 38
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