Re-proposed Repair Regulations: Implications for Gas Utilities TAX Carol Conjura , KPMG LLP, Washington National Tax Susan Grais, Ernst & Young LLP, Washington National Tax June 29, 2010

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Presenters Carol Conjura, KPMG LLP: 202-533-3040 Susan Grais, Ernst & Young LLP: 202-327-8782

Agenda Repairs Overview of re-proposed regulations Technical Update Tier 1 Status and Implications Retirements Unit of Property

Overview of Re-proposed Rules

Capital vs. Repair Analysis Is the expenditure for new construction, acquisition, expansion, or replacement of entire unit of property? Is the expenditure for new construction, acquisition, expansion, or replacement of entire unit of property? YES Capitalize Capitalize NO New or Different Use? New or Different Use? YES NO NO YES Betterment? Betterment? Routine Maintenance? Routine Maintenance YES NO YES Expense Restoration? Restoration? Expense NO 6

What is the Unit of Property? Buildings and Structural Components Generally one unit of property, except leasehold improvements Retail outlets and C stores General rule for all other property Functional Interdependence Exceptions Plant property Group of components that performs a discrete and major function Compare 2006 proposal, which used the Uniform System of Accounts Network assets [reserved] (pipelines, storage facilities) Additional rule Separate financial statement lives Different and proper MACRS class or method Have any proposals been considered for defining the unit of property for network assets

What is a Betterment? Amounts paid result in a betterment to the unit of property only if they: Correct a material condition or defect that existed prior to taxpayer’s acquisition or arose during production Result in material addition to the unit of property Result in material increase in capacity, productivity, efficiency, strength, or quality to the unit of property or its output Focus is on qualitative, not quantitative change in fair market value Materiality not defined Unavailability of replacement parts Compare with status of property prior to last normal repair, or prior to a particular event

What is a Restoration? Replace a component deducted as loss Replace a component and basis adjusted for sale or exchange Repair after a casualty if basis adjusted Return the property to operating condition if in a state of disrepair and no longer functional for its intended use Rebuild the property to like-new condition after the end of economic life Replace a major component or substantial structural part after the end of the property’s MACRS recovery period Replace a combination of parts that comprise 50% or more of property’s replacement cost Replace a combination of parts that comprise 50% or more of property’s physical structure Can you explain how the ruling in Rev. Rul. 2000-7 is impacted by the re-proposed regulations? i.e., why does it not change the result in the ruling.

Repairs after a Casualty Chief Counsel Memo AM 2006-006 Taxpayer cannot take both a casualty loss and repair deduction as a result of a single casualty Applies proposed regulations, even though prospective Inconsistent with CCM 199903030, permitting deduction for both casualty loss and restoration expenses Designated as Tier II LMSB exam issue Impact of TAM 200902011 Unit of property for casualty loss purposes (SIP) Electric transmission unit of property is each transmission line, substation. Electric distribution unit of property is each circuit and substation

Casualty Loss Example 1 2 3 SIP Adjusted Basis $10,000 $ -0- $5,000 FMV Decline 5,000 10,000 Repair Cost Deduction 1111

Relocation Costs Costs of relocating pipelines and other facilities Do not result in a betterment or restoration Consistent with Badger Pipeline v. Commissioner, T.C. Memo 1997-457 12

Removal Costs Rev. Rul. 2000-7 If retirement and removal of an asset occurs in connection with the installation or production of a replacement asset, removal costs are deductible Applies to single asset or mass asset accounts Not applicable to removal of a component of a depreciable asset If replacement is a repair--removal costs are deductible If replacement is an improvement—removal costs are capital Compare re-proposed regulations which treat replacement of component as capital if gain or loss recognized on removal 13

Environmental Remediation Re-proposed regulations are consistent with Rev. Rul. 94-38 Soil and groundwater cleanup associated with existing business operations are not required to be capitalized Costs of water treatment facility are capital But see Rev. Rul. 2005-42: Otherwise deductible environmental remediation costs must be capitalized under section 263A if incident to production of property 14

Environmental Remediation (cont’d) Pre-existing material condition or defect Remediation of pre-acquisition contamination treated as a betterment Latent hazardous conditions not treated as a pre-existing material condition or defect Compare Kerr-McGee v. US, 77 Fed. Cl. (2007) Application to otherwise periodic maintenance following an acquisition is uncertain Extension of section 198 Election to expense otherwise capital remediation

Spare Parts Under current law, may be classified as supplies or fixed assets, depending on facts Expendable parts are generally treated as supplies Deferred expense, deductible when consumed Emergency standby parts and repairable parts are generally treated as fixed assets Depreciation begins when acquired and ready for use Rotable spare parts Current law: deductible when placed in service Re-proposed regulations: deductible when disposed of 16

Supplies Definition of supply Not a unit of property Unit of property with economic useful life of 12 months or less Unit of property with acquisition or production cost of $100 or less Identified in published guidance Election to capitalize and depreciate if supply is a unit of property or a component of a unit of property that is not a supply

Optional Regulatory Accounting Method Simplified method for regulated taxpayers FERC FCC STB Must follow regulatory method of accounting for tax purposes Must use for all tangible property subject to regulatory accounting rules 18

Routine Maintenance Safe Harbor Includes recurring activities to keep a unit of property in ordinarily efficient operating condition Activities are routine if: Reasonably expected to occur more than once in an asset’s MACRS class life Gas production—Every 7 years or more frequently Gas transportation—Every 11 years or more frequently Not applicable if property restored under tests 1-4 i.e., if replacements are componentized or after a casualty, or dysfunctional state 19

Minimum Capitalization Rule Taxpayer may use financial statement minimum capitalization policy Requirements/restrictions Not applicable to repair and improvement costs Applicable Financial Statement; written accounting procedures; no income distortion Safe harbor for no distortion--total aggregate amount of expenses does not exceed the lesser of 0.1% of gross receipts 2.0% of total depreciation and amortization expense Annual, unit-by-unit, election to capitalize and depreciate 20

Section 263A Impact Re-proposed regulations obsolete the general plan of rehabilitation doctrine See situation 3 of Rev. Rul. 2001-4, requiring otherwise deductible repairs to be capitalized if incurred at same time as capital improvements Pursuant to section 263A, only repairs that directly benefit or are incurred by reason of an improvement are required to be capitalized For example, if a utility incurred costs to expand the capacity of a processing plant, contemporaneous repairs to the existing structure would remain deductible 21

Section 263A Impact (cont’d) Repairs in connection with inventory production must be capitalized to current production Section 481 adjustment for repairs change relates to prior production activities Impact depends on inventory cost flow assumption May relate to prior LIFO layer