Christmas comes early for taxpayer seeking to include construction service costs as part of bonus depreciation eligible investment upon property acquisition | Eversheds Sutherland (US) LLP

In FAA 20234801F (FAA), the IRS determined that construction service costs relating to a third party turn-key contract were considered to be incurred upon transfer of the tangible property to the taxpayer, without taking into account the timing of when the services included in the contract were provided. As a result, the taxpayer was able to take a deduction for bonus depreciation under Section 168(k) as the qualified property was deemed to be placed in service after September 27, 2017, having satisfied the requirements for the 10% safe harbor provided by Treas. Reg. 1.168(k)-2(b)(5)(iv)(B)(2). Although often unfavorable, taxpayers should find this FAA supportive to the extent their business involves turn-key EPC contracts for which investments may be eligible for bonus depreciation.

Facts
In the FAA, the taxpayer engaged a third-party contractor under an engineering, procurement, and construction (EPC) contract to construct a facility for use in the taxpayer’s trade or business. The EPC contract at issue is a “turn-key contract,” which requires the contractor to conduct all activities necessary to ensure that the facility is fully functional and operable at specified milestones. These activities include design, construction, inspection, testing, and integrating the facility at the worksite, along with supplying workforce, obtaining permits, and training personnel. The objective of the contract is to supply the taxpayer with a property that is fully operational and in a condition, which is ready to use.

The facility was constructed in three phases. During each phase of the contract, care, custody, and control of the facilities pass to the taxpayer on the day following the day that the taxpayer countersigns a substantial completion certificate. At this time, risk of physical loss and damage transfers to the taxpayer, along with title to the portion of the equipment upon specific achievements. Progress invoices are issued monthly.

Upon completion of Phase One, the taxpayer and contractor executed a substantial completion certificate and placed the facilities into service. The taxpayer subsequently claimed 100% additional first-year depreciation deduction for the portion of the facility associated with the initial phase.

Law Requirements to claim bonus depreciation
Subsequent to the Tax Cuts and Jobs Act, Section 168(k) provided for an additional first-year depreciation deduction for qualified property acquired and placed in service after September 27, 2017, pursuant to rules provided in Treas. Reg. §1.168(k)-2. Under Treas. Reg. § 1.168(k)-2(b)(5), this acquisition requirement is satisfied if property is acquired pursuant to a written binding contract entered into by the taxpayer after September 27, 2017. The regulations further clarify that property that is manufactured, constructed, or produced for the taxpayer by another person under a written binding contract that is entered into prior to the manufacture, construction, or production of the property for use by the taxpayer in its trade or business is not acquired pursuant to a written binding contract but is considered self-constructed property for purposes of the acquisition rules under Treas. Reg. §1.168(k)- 2(b)(5)(ii). If considered self-constructed property under this provision, the acquisition requirement is satisfied if a taxpayer enters into a written binding contract before September 28, 2017, but the manufacture, construction, or production of the property begins after September 27, 2017.

For purposes of determining when the manufacture, construction or production of property begins, Treas. Reg. §1.168(k)-2(b)(5)(iv)(B)(1) provides such occurs when physical work of a significant nature begins. The regulations provide taxpayers with the discretion to determine when this event occurs, in particular, providing that physical work of a significant nature will be considered to begin at the time the taxpayer incurs or pays more than 10% of the total cost of the property (10% safe harbor).

Timing considerations for accrual method taxpayers
Treas. Reg. §1.461-1(a)(2) provides that under an accrual method of accounting, a liability is generally incurred in 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 has occurred with respect to the liability (All Events Test). The term “liability” includes any item allowable as a deduction, cost, or expense for income tax purposes. Treas. Reg. §1.446-1(c)(1)(ii)(B).

Section 461(h) provides the economic performance rules for the All Events Test, particularly that if the liability of the taxpayer arises out of providing of services or property to the taxpayer by another person, economic performance occurs as the services or property is provided.

While Treas. Reg. § 1.461-4(d)(6)(iii) states that a taxpayer is permitted to treat property as provided to the taxpayer when the property is delivered or accepted, or when title to the property passes, with respect to the receipt of services, Treas. Reg. § 1.461-2(d)(6)(iv) provides that if different services or items of property are required to be provided to a taxpayer under a single contract or agreement, economic performance generally occurs over the time each service is provided and as each item of property is provided. However, if a service or item of property is incidental to other services or property under the contract, the taxpayer is not required to allocate any portion of the total contract price to the incidental service or property. Services or property are “incidental” if the cost of the services or property is treated on the taxpayer’s books and records as part of the cost of the other services or property provided under the contract; and the aggregate cost of the services or property does not exceed 10% of the total contract price.

Notwithstanding the regulations, the Service has issue several rulings in the past in the context of Section 168(k) and costs involved for different services or property under a single contract, and concluded that the costs of services that are integral to the provision of property that is the subject of a turn-key construction contract are costs of the property and are not separately allocated to services. See PLR 201313012, PLR 201214003, PLR 20121004.

Analysis
In the FAA, the Service had to determine whether the manufacture, construction, or production of the relevant property began after September 27, 2017, in order for the taxpayer to qualify to claim bonus depreciation. Because the property at issue was constructed subject to a turn-key EPC contract, a decision had to be made whether the contract was for property, or for both property and services. If the EPC contract was solely for property, the taxpayer could rely on an earlier date for achievement of economic performance and thus take advantage of the bonus depreciation available in the taxable year at issue by applying the 10% safe harbor and incurring 10% of the total cost of the property in that taxable year.

Under the accrual method of accounting, the All Events Test requires an expense to be fixed, determinable, and for economic performance to have occurred. With respect to the first two prongs, the Service determined the costs became fixed and determinable in connection with the monthly invoices as the work progressed, but such costs were not considered incurred until economic performance occurred. The Service further concluded that economic performance was achieved upon acceptance of the property by the taxpayer and its signature of the substantial completion certificate. While an argument could be made that economic performance for the contract did not occur until the services were provided, because the services were found to be only incidental to the main objective, which is to provide taxpayer with a turn-key property, the contract was treated solely for property for purposes
of Section 461(h). Rather than considered separate from the property, the Service determined the construction services to be “merely a means to [an] end,” which was to provide a facility that was fully operational.


Eversheds Sutherland observation: Taxpayers should find this FAA helpful, particularly if their business involves turn-key EPC contracts for which investments may be eligible for bonus depreciation. Because the Service determined the turn-key project was a contract for property, rather than property and services, construction service costs relating to the contract were considered to be incurred upon transfer of the tangible property to the taxpayer, without taking into account the timing of the provision of services included in the contract. This enabled the taxpayer to claim bonus depreciation earlier than had the contract been bifurcated between property and services, which would have delayed the taxpayer’s ability to claim and expense until economic performance occurred with respect to the services. Because the taxpayer was permitted to incur the costs of the property upon acceptance of the facility, the 10% safe harbor provided by Treas. Reg. 1.168(k)-2(b)(5)(iv)(B)(2) was met, and the qualified property was deemed to be placed in service after September 27, 2017, thus qualifying for bonus depreciation under section 168(k). To the extent taxpayers have contracts providing for both property and services, this FAA would be helpful to review to assist in the determination of when the related contract expenses may be claimed.

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