AMERICAN GAS ASSOCIATION & INTERSTATE NATURAL GAS ASSOCIATION

Update on Selected Cases and Rulings

Sal Montalbano

June 29, 2010

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Update on Selected Cases and RulingsCapitalization 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.

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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.

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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.

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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.

• .

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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

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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

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Update on Selected Cases and RulingsTax 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”

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Update on Selected Cases and RulingsLILO/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.

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Update on Selected Cases and RulingsCodification 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.

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Update on Selected Cases and RulingsTransaction 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.

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Update on Selected Cases and RulingsTransaction 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.

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Update on Selected Cases and RulingsResearch 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.

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Update on Selected Cases and RulingsResearch 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.

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Update on Selected Cases and RulingsCapital 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.

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Update on Selected Cases and RulingsCasualty 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.

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Update on Selected Cases and RulingsEnergy 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.

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Update on Selected Cases and RulingsInflation 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.

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Update on Selected Cases and RulingsPurchased 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).

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Update on Selected Cases and RulingsChange 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.

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Update on Selected Cases and RulingsAccrual 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.

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Update on Selected Cases and RulingsFICA 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.

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Update on Selected Cases and RulingsInterest 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.

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Update on Selected Cases and RulingsSection 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.

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Update on Selected Cases and RulingsIntegrated 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

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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.

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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

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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.

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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.

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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.

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Update on Selected Cases and RulingsAsset 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.

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Update on Selected Cases and RulingsExtended 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.

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Update on Selected Cases and RulingsNormalization

• 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.

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Update on Selected Cases and Rulings

Q&A