IRS Issues New Safe Harbor Rules for Natural Gas Repairs: What Rate-Regulated Utilities Need to Know

The IRS has issued a new revenue procedure, Rev. Proc. 2023-15, providing a safe harbor method of accounting for natural gas transmission and distribution property repairs, maintenance, replacements, and improvements. This new method allows taxpayers to classify these costs as either capital or deductible expenditures, providing clear and bright-line rules to reduce the burden of compliance.

The determination of whether expenditures must be capitalized is complex, particularly for large networks of interconnected assets like natural gas transmission and distribution property, and has led to disputes between taxpayers and the IRS. Now that new guidelines have been issues to clarify, taxpayers that do not adopt the new method may face greater scrutiny from the IRS.

Scope and Purpose

Rev. Proc. 2023-15 aims to reduce uncertainty and disputes between taxpayers and the IRS regarding whether expenditures must be capitalized under section 263(a) or may be treated as ordinary and necessary business expenses for which a deduction is allowable under section 162(a). The procedure defines units of property and provides simplified rules for determining whether the costs of replacing or repairing components of the property must be capitalized or can be treated as ordinary and necessary business expenses.

As a general rule, expenditures that result in a betterment or restoration of the property, or that adapt the property to new or different use, must be capitalized, whereas taxpayers may generally deduct repair and maintenance expenditures that do not result in a betterment, restoration, or adaptation in use of the property. Furthermore, expenditures properly allocable to property produced by the taxpayer are generally required to be capitalized under section 263(a).

Due to ongoing disputes about the fact-intensive determination of whether expenditures related to natural gas transmission and distribution are required to be capitalized, the IRS selected the issue for its Industry Issue Resolution (IIR) program. The IRS uses the IIR program to develop guidance for complicated tax issues that business taxpayers can use to reduce the time and expense of resolving frequent issues. Many IIRs have been settled with revenue procedures providing safe harbors specific to the utility industry, including steam or electric power generation property (Rev. Proc. 2013-24) and electric transmission and distribution property (Rev. Proc. 2011-42 and Rev. Proc. 2011-43).

The result of the IIR program demonstrates a collaborative effort and a fair application of rules in a an otherwise complex area. Taxpayers in the natural gas industry are likely to welcome the approach for applying section 263(a), which is fairly comprehensive.

Key Changes from Previous Guidelines

Section 4.01 of Rev. Proc. 2023-15 outlines the “natural gas transmission and distribution property safe harbor method of accounting” (NGSH Method) for determining whether costs are required to be capitalized under section 263(a) or section 263A, or may be treated as ordinary and necessary business expenses for which a deduction is allowable under section 162(a). Section 3.03 provides clear guidance on which costs “maintain, repair, replace, or improve” natural gas transmission or distribution property, and identifies exclusions of costs for which the NGSH does not apply.

Under the NGSH Method, a taxpayer first classifies its natural gas transmission and distribution property as either linear (e.g., pipes, fittings, valves) or non-linear (e.g., compressors, regulators, meters), with distinct safe harbor rules applicable each categorization of property.

Linear Safe Harbor

Under the NGSH Method the taxpayer must apply the Linear Safe Harbor to all of its transmission and distribution assets designated as linear property, which is effectively defined as any transmission and distribution property that does not satisfy the definition of non-linear property.

The revenue procedure defines units of transmission property and stipulates a bright-line test: namely, that replacement costs of transmission property must only be capitalized if more than ten percent of the length of the transmission property unit is being replaced.

The Linear Safe Harbor delineates distribution property between distribution mains and distribution service lines, and provides distinct rules for determining whether distribution main replacement costs should be capitalized and whether repair, maintenance, replacement, or improvement costs for distribution service lines must be capitalized.

Non-Linear Safe Harbor

Unlike the mandatory application of the Linear Safe Harbor, taxpayers can choose to apply or to not apply the Non-Linear Safe Harbor to their non-linear property, which is defined as compressor station property, gas storage facility property, measuring and regulating station property, or meters or regulators.

Again, the revenue procedure defines units of property for transmission and distribution assets and specifies that the cost of replacing a unit or major component of non-linear property must be capitalized, along with the cost of any repairs, maintenance, or replacements that directly benefit or are incurred by reason of the replacement of the non-linear property.

Per Se Capital Expenditures

The revenue procedure further identifies certain direct and indirect costs as per se capital expenditures for any taxpayer using the NGSH Method. These costs include those incurred for property necessary to add new customers or to increase capacity for existing or potential customers. Additionally, costs incurred for repairing or replacing damaged property or adapting property for a new use are also included.

An expenditure for linear property is considered material if it increases capacity by more than 5% to one or more existing or potential customers. However, if the taxpayer can prove that the addition or replacement of linear property was for safety reasons, to standardize the system, or to comply with regulatory requirements unrelated to increasing capacity, they are not required to capitalize these costs.

Distribution Service Lines

To the extent a taxpayer can identify distribution service line costs with reasonable accuracy, costs must be capitalized if they are per se capital expenditures or if they are associated with distribution main replacements of more than four miles. Any distribution service line costs that do not meet this threshold are not required to be capitalized.

If costs cannot be determined with a reasonable degree of accuracy, the revenue procedure provides steps by which the total distribution line costs can be determined by leveraging an applicable capitalization ratio.

Implications for Rate-Regulated Utilities

The revenue procedure provides simplified conventions to provide clarity to taxpayers via the NGSH Method. The IRS appears to be encouraging taxpayers to adopt their approved approach for the treatment of repair expenses by lessening the compliance burden with taxpayer-favorable rules. Notable guidelines are that replacement or improvement costs may be entirely deducted if project costs do not exceed specified thresholds.

In addition to the explicit tax-benefits provided by the revenue procedure, eligible taxpayers may also find encouragement from the implication that the those that choose not to adopt the NGSH Method will likely face greater IRS scrutiny. Not only does Rev. Proc. 2023-15 provide guidance to natural gas companies for complying with capitalization regulations, it also provides a roadmap for the IRS to determine what treatment is considered reasonable.

It is worth noting that the format of the NGSH Method closely resembles the safe harbor provided with regard to electric transmission and distribution property in Rev. Proc. 2011-43, particularly with regard to the distinctions between linear and non-linear property. Because of this, the rulings under Rev. Proc. 2011-43 may be informative for taxpayers planning to adopt the NGSH Method, and this suggests that the IRS views the types of property similarly.

Taxpayers will be able to choose between sets of terms for making the accounting method change in either the first year after the revenue procedure, the first three years, or the fourth or later years. The IRS does make efforts to encourage early adoption, but flexible transition rules allow taxpayers time to consider how best to apply the NGSH Method.

How Lucasys Can Help

Lucasys professionals have decades of experience helping utilities adopt prior revenue procedures related to tax repairs. We can help bridge the gap between tax and property accounting to ensure that units of property are properly identified and classified, and that bright-line rules for linear property are properly configured. Furthermore, the Lucasys team has deep experience helping compute and integrate 481(a) adjustments into the utilities’ tax and fixed asset records. Contact us to schedule a free consultation.