Internal Revenue Bulletin 2006-39 (PDF rendition): IRS Revenue Procedures

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.

Bulletin No. 200
6-39
September 25, 20
06
HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.
INCOME TAX
Rev. Rul. 2006–46, page 511.
Conservation Security Program (CSP).This ruling holds
that the Conservation Security Program is substantially similar
to the type of programs described in section 126(a)(1) through
(8) of the Code within the meaning of section 126(a)(9). As a
result, all or a portion of cost-share payments received under
the CSP is eligible for exclusion from gross income to the extent
permitted by section 126.
Rev. Rul.
2006–47, page 511.
Fringe be
nefits aircraft valuation formula.The Standard
Industry
Fare Level (SIFL) cents-per-mile rates and terminal
charge in
effect for the second half of 2006 are set forth for
purposes
of determining the value of noncommercial flights
on employ
er-provided aircraft under section 1.61–21(g) of the
regulat
ions.
Rev. Rul. 2006–48, page 516.
LIFO; price indexes; department stores.The July 2006
Bureau of Labor Statistics price indexes are accepted for use
by department stores employing the retail inventory and last-in,
first-out inventory methods for valuing inventories for tax years
ended on, or with reference to, July 31, 2006.
T.D. 9281, page 517.
REG–120509–06, page 570.
Final, temporary, and proposed regulations under sections 882
and 884 of the Code state that foreign corporations engaged
in a trade or business within the United States are subject to tax
on their income that is treated as effectively connected with the
trade or business. Expenses related to that income are alloca-
ble and deductible against the effectively connected income to
determine the foreign corporation’s net U.S. taxable income.
Special rules apply to the allocable amount of interest expense
allowed in determining the net U.S. taxable income. Additional
rules for foreign banking corporations are also applicable. Cer-
tain clarifications and conforming updates are also made to the
1996 final regulations under section 1.882–5.
T.D. 9282, page 512.
Final regulations under sections 162(k) and 404(k) of the Code
provide that a payment in redemption of employer securities
held by an employee stock ownership plan (ESOP) is not de-
ductible.
REG–168745–03, page 532.
Proposed regulations under section 263 of the Code explain
how section 263(a) applies to amounts paid to acquire, pro-
duce, or improve tangible property. The proposed regula-
tions clarify what amounts must be capitalized, rather than de-
ducted currently, and how those capitalized amounts should be
treated. A public hearing is scheduled for December 19, 2006.
Notice 2006–82, page 529.
Extension of replacement period for livestock sold on
account of drought.This notice explains the circumstances
under which the 4-year replacement period under section
1033(e)(2) of the Code is extended for livestock sold on
account of drought. The noticeinforms taxpayers that the
Service will publish an annual list of counties that experienced
exceptional, extreme, or severe drought conditions, which a
taxpayer can use to determine if an extension is available.
(Continued on the next page)
A
nnouncements of Disbarments and Suspensions begin on page 572.
Finding Lists begin on page ii.
Index for July through September begins on page iv.

EMPLOYEE PLANS
T.D. 9282, page 512.
Final regulations under sections 162(k) and 404(k) of the Code
provide that a payment in redemption of employer securities
held by an employee stock ownership plan (ESOP) is not de-
ductible.
ADMINISTRATIVE
REG–145154–05, page 567.
Proposed regulations under 31 USC 9701 implement new user
fees for the Special Enrollment Examination (SEE) for enrolled
agents, the application for enrollment of enrolled agents, and
the renewal of such enrollment. The user fee that the IRS cur-
rently charges applicants in order to take the SEE is being mod-
ified to reflect the change in the IRS costs of administering the
exam program as a result of the contracting out of the exam.
The regulations establish an $11 per applicant user fee for the
SEE and separate $125 user fees for the enrollment and re-
newal of enrollment process. A public hearing is scheduled for
September 29, 2006.
Rev. Proc. 2006–38, page 530.
Low-income housing credit.This procedure publishes the
amounts of unused housing credit carryovers allocated to qual-
ified states under section 42(h)(3)(D) of the Code for calendar
year 2006.
September 25, 20062006–39 I.R.B.

The IRS Mission
Provide America’s taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
Introduction
The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
Superintendent of Documents on a subscription basis. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis.
It is the policy of the Service to publish in the Bulletin all sub-
stantive rulings necessary to promote a uniform application of
the tax laws, including all rulings that supersede, revoke, mod-
ify, or amend any of those previously published in the Bulletin.
All published rulings apply retroactively unless otherwise indi-
cated. Procedures relating solely to matters of internal man-
agement are not published; however, statements of internal
practices and procedures that affect the rights and duties of
taxpayers are published.
Revenue rulings represent the conclusions of the Service on the
application of the law to the pivotal facts stated in the revenue
ruling. In those based on positions taken in rulings to taxpayers
or technical advice to Service field offices, identifying details
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be considered,
and Service personnel and others concerned are cautioned
against reaching the same conclusions in other cases unless
the facts and circumstances are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—19
86 Code.
This part i
ncludes rulings and decisions based on provisions of
the Intern
al Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows: Subpart A,
Tax Conventions and Other Related Items, and Subpart B, Leg-
islation and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the Department of the Treasury’s Office of the Assistant Sec-
retary (Enforcement).
Part IV
.—Items of General Interest.
This par
t includes notices of proposed rulemakings, disbar-
ment an
d suspension lists, and announcements.
The last Bulletin for each month includes a cumulative index
for the matters published during the preceding months. These
monthly indexes are cumulated on a semiannual basis, and are
published in the last Bulletin of each semiannual period.
The c
ontents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents, U.S.Government Printing Office, Washington, DC 20402.
2006–39 I.R.B.September 25, 2006

Place missing child here.
September 25, 20062006–39 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 42.—Low-Income
Housing Credit
26 CFR 1.42–14: Allocation rules for post-1989
State housing credit ceiling amounts.
Guidance is provided to state housing credit agen-
cies of qualified states that request an allocation
of unused housing credit carryover under section
42(h)(3)(D) of the Internal Revenue Code. See Rev.
Proc. 2006-38, page 530.
Section 61.—Gross Income
Defined
26 CFR 1.61–21: Taxation of fringe benefits.
Fringe benefits aircraft valuation for-
mula.The Standard Industry Fare Level
(SIFL) cents-per-mile rates and terminal
charge in effect for the second half of 2006
are set forth for purposes of determining
the value of noncommercial flights on
employer-provided aircraft under section
1.61–21(g) of the regulations.
Rev. Rul. 2006–47
For purposes of the taxation of fringe
benefits under section 61 of the Inter-
nal Revenue Code, section 1.61–21(g) of
the Income Tax Regulations provides a
rule for valuing noncommercial flights
on employer-provided aircraft. Section
1.61–21(g)(5) provides an aircraft valua-
tion formula to determine the value of such
flights. The value of a flight is determined
under the base aircraft valuation formula
(also known as the Standard Industry Fare
Level formula or SIFL) by multiplying
the SIFL cents-per-mile rates applicable
for the period during which the flight was
taken by the appropriate aircraft multiple
provided in section 1.61–21(g)(7) and then
adding the applicable terminal charge. The
SIFL cents-per-mile rates in the formula
and the terminal charge are calculated by
the Department of Transportation and are
reviewed semi-annually.
The following chart sets forth the termi-
nal charges and SIFL mileage rates:
Period During Which
the Flight Is Taken
Terminal
Charge
SIFL Mileage
Rates
7/1/06 - 12/31/06
$37.85
Up to 500 miles
= $.2071 per mile
501–1500 miles
= $.1579 per mile
Over 1500 miles
= $.1518 per mile
DRAFTING INFORMATION
The
principal author of this revenue
rul
ing is Kathleen Edmondson of the
Of
fice of Division Counsel/Associate
Ch
ief Counsel (Tax Exempt/Govern-
me
nt Entities). For further information
re
garding this revenue ruling, contact
Ms
. Edmondson at (202) 622–0047 (not a
to
ll-free call).
Section 126.—Certain
Cost-Sharing Payments
Conservation Security Program
(CSP).This ruling holds that the Con-
servation Security Program is substan-
tially similar to the type of programs
describedinsection126(a)(1)through(8)
of the Code within the meaning of section
126(a)(9). As a result, all or a portion of
cost-share payments received under the
CSP is eligible for exclusion from gross
income to the extent permitted by section
126.
Rev. Rul. 2006–46
ISSUE
Is the Conservation Security Program
(CSP) within the scope of § 126(a)(9) so
that cost-share payments received under
theCSPareeligibleforexclusionfrom
gross income to the extent permitted by
§126?
FACTS
The CSP, authorized under the provi-
sions of §§ 1238–1238C of the Food Secu-
rity Act of 1985, Pub. L. No. 99–198, 99
Stat. 1354, as amended by the Farm Se-
curity and Rural Investment Act of 2002,
Pub. L. No. 107–171, 116 Stat. 134, 16
U.S.C. §§ 3838–3838c, is a voluntary pro-
gram that supports ongoing conservation
stewardship of agricultural lands by pro-
viding financial assistance to agricultural
producers who maintain and enhance nat-
ural resources. The CSP is administered
by the U.S. Department of Agriculture
(USDA). An agricultural producer who
wishes to participate in the CSP must enter
into a long-term conservation security con-
tract with the USDA’s Natural Resources
Conservation Service (NRCS). The CSP is
available to agricultural producers owning
private agricultural land (including crop-
land, grassland, prairie land, improved
pasture land, rangeland, land under the
jurisdiction of an Indian tribe, or forested
land that is an incidental part of an agri-
cultural operation). The NRCS, using
the USDA’s Commodity Credit Corpo-
ration, provides contract payments that
may include (1) an annual stewardship
component for the existing base level con-
servation treatment; (2) an annual existing
practice component for maintaining exist-
ing conservation practices; (3) a one-time
2006–39 I.R.B.511September 25, 2006

new practice component for additional
needed practices; and (4) an enhancement
component for exceptional conservation
effort and additional conservation prac-
tices or activities that provide increased
resource benefits beyond the prescribed
level. Payments for practices included
in the existing practice and new practice
components are limited, under 16 U.S.C.
§ 3838c, to 75 percent (or, in the case of a
beginning farmer or rancher, 90 percent)
of the average county costs of the practices
for the 2001 crop year. Payments under
the stewardship component are not limited
to the taxpayer’s costs but are instead a
percentage of the rental rate applicable to
the land, as determined by the NRCS. Pay-
ments under the enhancement component
may be based either on an activity’s cost
or on its expected conservation benefits.
The Secretary of Agriculture has deter-
mined that payments under the CSP are
primarily for the purpose of conserving
soil and water resources or protecting and
restoring the environment. In addition, the
Secretary of Agriculture has informed the
Treasury Department that USDA believes
the CSP is a small watershed program.
LAW AND ANALYSIS
Under § 126(a), gross income does not
include the excludable portion of pay-
ments received under certain conservation
programs set forth in § 126(a)(1) through
(8). Section 126(a)(9) provides that a
small watershed program administered by
the Secretary of Agriculture also is eligi-
ble for § 126 treatment if the Secretary of
the Treasury determines that the program
is substantially similar to the type of pro-
grams described in § 126(a)(1) through
(8). See § 16A.126–1(d) of the Temporary
Income Regulations Relating To The Par-
tial Exclusion For Certain Cost-Sharing
Payments for rules permitting the Com-
missioner to make these determinations
and announce them in the Internal Rev-
enue Bulletin and for the definition of
“small watershed.”
If the Commissioner has determined
that a program is substantially similar
to the types of programs described in
§ 126(a)(1) through (8), taxpayers re-
ceiving cost-share payments under that
program must determine what portion
of the cost-share payments is excludable
from gross income under § 126. Under
§ 126(b), the excludable portion of a pay-
ment is limited to the portion that (1) is
determined by the Secretary of Agricul-
ture to be made primarily for the purpose
of conserving soil and water resources,
protecting or restoring the environment,
improving forests, or providing a habitat
for wildlife, (2) does not substantially
increase the income derived from the
property, and (3) is not properly associ-
ated with a deductible expense. Payments
in the nature of rent or compensation for
services do not qualify for the exclusion.
See § 126(b) and § 16A.126–1, relating to
the partial exclusion of certain cost-share
payments, to determine what portion of the
cost-share payments is excludable from
gross income under § 126.
HOLDING
The Internal Revenue Service accepts
USDA’s conclusion that the CSP is a small
watershed program. Accordingly, the CSP
will be treated for purposes of § 126 as a
small watershed program administered by
the Secretary of Agriculture. In addition,
the Commissioner has determined that the
CSP is substantially similar to the type of
programs described in § 126(a)(1) through
(8).
Payments for practices included in the
existing practice and new practice com-
ponents are limited to a percentage of the
average county costsof the practices and
qualify as cost-sharepayments. Thecost-
share payments received under the exist-
ing practice and new practice components
of the CSP are eligible for exclusion from
gross income to the extent permitted by
§ 126.
Payments under the stewardship com-
ponent are based on the rental rate applica-
ble to the land and are not cost-share pay-
ments that are excludable from gross in-
come.
Payments under the enhancement com-
ponent qualify as cost-share payments if
they are based on an activity’s cost rather
than on its expected conservation benefits.
The cost-share payments received under
the enhancement component are eligible
for exclusion from gross income to the ex-
tent permitted by § 126. Payments under
the enhancement component based on the
activity’s expected conservation benefits
rather than on its cost are not cost-share
payments and are not excludable from
gross income.
See § 126(b) and § 16A.126–1 to de-
termine the extent to which cost-share
payments under the existing practice, new
practice, and enhancement components
are excludable from gross income under
§126.
DRAFTING INFORMATION
The principal author of this revenue rul-
ing is Jennifer C. Bernardini of the Office
of Associate Chief Counsel (Passthroughs
& Special Industries). For further informa-
tion regarding this revenue ruling, contact
Jennifer C. Bernardini at (202) 622–3120
(not a toll-free call).
Section 162.—Trade or
Business Expenses
26 CFR 1.162(k)–1: Disallowance of deduction for
reacquisition payments.
26 CFR 1.404(k)–3: Disallowance of deduction for
reacquisition payments.
T.D. 9282
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Part 1
Dividends Paid Deduction for
StockHeldinEmployeeStock
Ownership Plan
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains
final regulations under sections 162(k)
and 404(k) of the Internal Revenue Code
(Code) providing that a payment in re-
demption of employer securities held by
an employee stock ownership plan (ESOP)
is not deductible. These regulations gen-
erally affect administrators of, employers
maintaining, participants in, and benefi-
ciaries of ESOPs. In addition, they will
affect corporations that make distributions
in redemption of stock held in an ESOP.
DATES:Effective Date:These regulations
are effective on August 30, 2006.
September 25, 20065122006–39 I.R.B.

Applicability Dates:These regulations
apply with respect to payments to reac-
quire stock that are made on or after and
amounts paid or incurred on or after Au-
gust 30, 2006. See §§1.162(k)–1(c) and
1.404(k)–3, Q&A–2.
FOR FURTHER INFORMATION
CONTACT: John T. Ricotta at (202)
622–6060 with respect to section 404(k)
or Jean R. Brenner at (202) 622–7790 with
respect to section 162(k) (not toll-free
numbers).
SUPPLEMENTARY INFORMATION:
Background
This document contains final regu-
lations (26 CFR Part 1) under sections
162(k) and 404(k) of the Code.
Section 162(k)(1) generally provides
that no deduction otherwise allowable un-
der chapter 1 of the Code is allowed for
any amount paid or incurred by a corpora-
tion in connection with the reacquisition of
its stock or the stock of any related person
(as defined in section 465(b)(3)(C)). The
legislative history of section 162(k) states
that the phrase “in connection with” is
“intended to be construed broadly.” H.R.
Conf. Rep. No. 99–841, at 168 (1986).
Section 404(k)(1) provides a deduction
for an applicable dividend paid in cash by
a C corporation with respect to applica-
ble employer securities held by an ESOP,
as defined in section 4975(e)(7). Section
404(k)(2) generally provides that the term
applicable dividendmeans any dividend
which, in accordance with the plan provi-
sions,iseitherpaidincashtoplanpartic-
ipants or beneficiaries or paid to the plan
and distributed in cash to participants or
beneficiaries not later than 90 days after
the close of the plan year in which paid.
An applicable dividend also includes a div-
idend which, at the election of participants
or their beneficiaries, is payable as pro-
vided in the preceding sentence or paid to
the plan and reinvested in qualifying em-
ployer securities. Finally, an applicable
dividend also includes a dividend that is
used to make payments on a loan described
in section 404(a)(9), the proceeds of which
were used to acquire the employer secu-
rities (whether or not allocated to partici-
pants) with respect to which the dividend is
paid. Under section 404(k)(4), the deduc-
tion is allowable in the taxable year of the
corporation in which the dividend is paid
or distributed to the participant or benefi-
ciary.
Prior to 2002, section 404(k)(5)(A) pro-
vided that the Secretary may disallow the
deduction under section 404(k) for any
dividend if the Secretary determines that
such dividend constitutes, in substance, an
evasion of taxation. Section 662(b) of the
Economic Growth and Tax Relief Recon-
ciliation Act of 2001 (115 Stat. 38, 2001)
amended section 404(k)(5)(A) to provide
that the Secretary may disallow a deduc-
tion under section 404(k) for any divi-
dend the Secretary determines constitutes,
in substance, an avoidance or evasion of
taxation.
Rev. Rul. 2001–6, 2001–1 C.B.
491 (see §601.601(d)(2) of this chapter),
states that distributions to participants of
amounts paid by an employer to reacquire
shares of its stock from the employer’s
ESOP (redemption proceeds) are made
in connection with the reacquisition of
the employer’s stock and that section
162(k)(1) therefore bars the deduction
under these circumstances regardless of
whether the distributions to participants
would otherwise be deductible under sec-
tion 404(k). The revenue ruling also states
that the treatment of redemption proceeds
as “applicable dividends” under section
404(k) would produce such anomalous
results that the section cannot reasonably
be construed as encompassing such pay-
ments. The revenue ruling states that the
application of section 404(k) to redemp-
tion proceeds not only would allow em-
ployers to claim deductions for payments
that do not represent true economic costs,
but also, as further explained below, would
vitiate important rights and protections for
recipients of ESOP distributions. Finally,
the ruling states that a deduction would
be disallowed under section 404(k)(5)(A)
because a deduction under these circum-
stances would constitute, in substance, an
evasion of taxation.
These positions were reiterated in
Notice 2002–2, Q&A–11, 2002–2 C.B.
285 (See §601.601(d)(2) of this chapter),
which states that, in accordance with Rev.
Rul. 2001–6, payments in redemption of
stockheldbyanESOPthatareusedto
make distributions to terminating ESOP
participants constitute an evasion of tax-
ation under section 404(k)(5)(A) and are
not applicable dividends under section
404(k)(1). Moreover, the notice states that
any deduction for such payments in re-
demption of stock is barred under section
162(k).
Notice 2002–2 (Q&A–7) also discusses
the tax treatment of section 404(k) divi-
dend distributions, stating that dividends
paid in cash to a participant (rather than
reinvested at the option of the partici-
pant under section 404(k)(2)(A)(iii)) are
taxable without regard to the return of
basis provisions under section 72, and are
not subject to the consent requirements
of section 411(a)(11) or the distribution
restrictions of section 401(k)(2)(B). In ad-
dition, the notice provides that dividends
paid to participants under section 404(k)
are not eligible rollover distributions under
section 402(c), even if the dividends are
distributed at the same time as amounts
that do constitute an eligible rollover dis-
tribution (or are reported on Form 1099-R
(Distributions From Pensions, Annuities,
Retirement or Profit-Sharing Plans, IRAs,
Insurance Contracts, etc.) in accordance
with Announcement 85–168).
1
See also
§ 1.402(c)–2, Q&A–4(e), under which
dividends paid on employer securities un-
der section 404(k) are not eligible rollover
distributions under section 402(c).
InBoise Cascade Corporation v.
United States, 329 F.3d 751 (9
th
Cir.
2003), the Court of Appeals for the Ninth
Circuit held that payments made by the
issuer of stock to redeem its stock held
by its ESOP were deductible as dividends
paid under section 404(k), and that the
deduction was not precluded by section
162(k). The IRS issued Chief Coun-
sel Notice 2004–038 (October 1, 2004)
(available atwww.irs.gov/foiathrough the
electronic reading room) to indicate that it
disagreed with the Court’s interpretation
and would continue to assert in any matter
in controversy outside the Ninth Circuit
that sections 162(k) and 404(k) disallow
a deduction for payments to reacquire
employer securities held by an ESOP. For
any matter in controversy within the Ninth
1
Announcement 85–168, 1985–48 I.R.B. 40, states that section 404(k) distributions are reportable as dividends on a recipient’s tax return and that such distributions are fully taxable without
regard to return of basis.
2006–39 I.R.B.513September 25, 2006

Circuit, agents or district counsel attorneys
are to consult the National Office.
A notice of proposed rulemaking con-
taining proposed regulations under sec-
tions 162(k) and 404(k) was issued on Au-
gust 25, 2005 (REG–133578–05, 2005–39
I.R.B. 610 [70 FR 49897]) to address two
issues: 1) which corporation is entitled
to the deduction for applicable dividends
under section 404(k) where the payor
and employer are different entities; and
2) whether a payment in redemption of
employer securities held by an ESOP is
deductible. The issue in the proposed
regulations concerning which corporation
is entitled to the deduction for applicable
dividends under section 404(k) is expected
to be addressed in future regulations.
The notice of proposed rulemaking in-
cluded proposed regulations under section
404(k) that would provide that payments
made to reacquire stock held by an ESOP
are not deductible under section 404(k)
because such payments would not con-
stitute applicable dividends under section
404(k)(2) and a deduction for such pay-
ments would constitute, in substance, an
avoidance or evasion of taxation within
the meaning of section 404(k)(5) because
itwouldallowacorporationtoclaim
two deductions for the same economic
cost. It also included proposed regula-
tions under section 162(k) providing that
section 162(k), subject to certain excep-
tions, would disallow any deduction for
amounts paid or incurred by a corporation
in connection with the reacquisition of its
stock or the stock of any related person
(as defined in section 465(b)(3)(C)). Fi-
nally, the proposed regulations provided
that amounts paid or incurred in connec-
tion with the reacquisition of stock include
amounts paid by a corporation to reacquire
its stock from an ESOP that are then dis-
tributed by the ESOP to its participants (or
their beneficiaries) or otherwise used in a
manner described in section 404(k)(2)(A).
A public hearing on the proposed reg-
ulations was held on January 18, 2006.
After consideration of the comments
received, these final regulations adopt
without material change the provisions
of the proposed regulations concerning
payments in redemption of employer se-
curitiesheldbyanESOP.
Explanation of Provisions
With respect to the treatment of pay-
ments in redemption of employer securi-
ties, these final regulations adopt the rule
of the proposed regulations under which
payments made to reacquire stock held by
an ESOP are not deductible under section
404(k) because such payments do not con-
stitute applicable dividends under section
404(k)(2) and a deduction for such pay-
ments would constitute, in substance, an
avoidance or evasion of taxation within the
meaning of section 404(k)(5). These final
regulations also adopt the rule of the pro-
posed regulations that explicitly provides
that section 162(k) disallows any deduc-
tion, including any deduction under sec-
tion 404(k), for amounts paid or incurred
by a corporation in connection with the
reacquisition of its stock or the stock of
any related person (as defined in section
465(b)(3)(C)). In addition, these final reg-
ulations adopt the rule of the proposed reg-
ulations providing that amounts paid or in-
curred in connection with the reacquisition
of stock include amounts paid by a corpo-
ration to reacquire its stock from an ESOP
that are then distributed by the ESOP to its
participants (or their beneficiaries) or oth-
erwise used in a manner described in sec-
tion 404(k)(2)(A).
These provisions aroused little opposi-
tion and only two comments were received
regarding the treatment of payments made
to reacquire stock. A trade association rep-
resenting companies that sponsor ESOPs
supported the position of the proposed
regulations that a repurchase of shares of
ESOP stock from ESOP participants in
a stock redemption does not qualify as a
deductible dividend under section 404(k).
The other commentator disagreed with
the position in the proposed regulations,
arguing that redemptions of stock held by
an ESOP that are recharacterized as divi-
dends under section 302 nevertheless are
proper dividends that should be treated the
same as ordinary dividends paid with re-
specttostockheldbyanESOP.Thecom-
mentator argued that, by enacting section
404(k), Congress intended to allow a dou-
ble deduction for contributions to purchase
employer stock because the value of stock
purchased with employer contributions
includes the present value of expected
future dividends. Thus, the commentator
argued, a deduction for redemptive pro-
ceeds should not be characterized as an
avoidance or evasion of taxation within
the meaning of section 404(k)(5). Finally,
the commentator argued that, because the
legislative history to section 162(k) does
not specifically refer to section 404(k)
dividends and section 162(k) was enacted
only two years after section 404(k), sec-
tion 162(k) does not preclude a deduction
for a redemptive dividend under section
404(k).
These arguments are unpersuasive. Al-
though the present value of expected fu-
ture dividends is an element of the value
of shares of stock at any point in time, and
Congress did authorize a current deduc-
tion for the value of stock contributions
to qualified plans, as well as a later de-
duction for certain dividends paid on those
shares under section 404(k), these deduc-
tions are carefully limited to dividends ac-
tually paid in certain specified ways while
thestockisheldbytheESOP.Thereis
no evidence that Congress intended to au-
thorize yet another deduction for the full
value of the shares upon their redemption.
To allow a deduction for redemption pro-
ceeds would be to allow a second deduc-
tion that includes the present value of div-
idends that are paid out after the date of
distribution from the ESOP, contrary to the
intent of the statute. Moreover, the amount
of the deduction with respect to a redemp-
tion could be many times the amount that
would be deducted for that year for a con-
ventional dividend. (In fact, permitting a
second deduction for the full value of the
shares would allow a corporation to claim
one deduction for a share of stock con-
tributed to an ESOP and allocated to an
employee early in a tax year and another
deduction if the share is redeemed to make
a distribution to the employee later in the
same tax year.) There is a no indication
that such a result was intended and there is
no obvious purpose that would be served
by such a result.
Congress recognized that an arrange-
ment that might be argued to come within
the literal language of section 404(k) might
nevertheless be inconsistent with its pur-
pose. Congress therefore granted authority
to the Secretary, in section 404(k)(5)(A),
to disallow a deduction for any dividend
that the Secretary finds to be, in substance,
an evasion of taxation. The statute was
clarified, for years beginning in 2002, to
explicitly broaden that authority to permit
September 25, 20065142006–39 I.R.B.

the Service to disallow any deduction that
is an avoidance or evasion of taxation. A
deduction for redemption proceeds is both
excessive in amount and inconsistent with
the purpose of section 404(k), so that this is
clearly an appropriate case for the author-
ity under section 404(k)(5)(A) to be exer-
cised.
2
The IRS and Treasury Department
also continue to believe, as provided in
Rev. Rul. 2001–6, that a deduction for
redemption of benefit distributions is
appropriately disallowed under section
404(k)(5)(A) because a deduction under
these circumstances would constitute, in
substance, anevasionof taxation. As
stated in Rev. Rul. 2001–6, the treatment
of redemption proceeds as “applicable
dividends” under section 404(k) would
produce such anomalous results that the
section cannot reasonably be construed
as encompassing such payments. As one
example, if a redemption of a benefit
distribution were an applicable dividend
under section 404(k), there would be no
reason why such a redemption could only
occur once with respect to a participant, so
that multiple redemptions (or theoretically
even an unlimited number of redemp-
tions
3
) might be possible, a result that is
clearly not consistent with the intent of
section 404(k).
Further, as described in Rev. Rul.
2001–6, the application of section 404(k)
to redemption amounts also would viti-
ate important rights and protections for
recipients of ESOP distributions. These
important rights and protections include
the right to apply the return of basis pro-
visions under section 72 (whereas an
applicable dividend under section 404(k)
is includible in gross income without re-
gard to return of basis under section 72),
and the protection against involuntary
cash-outs (section 411(a)(11)). See sec-
tion 72(e)(5)(D), and Q&A–7 of Notice
2002–2, 2002–1 C.B. 285. Similarly, if
redemption amounts distributed as a nor-
mal benefit distribution were treated as an
applicable dividend under section 404(k),
then a participant would not have the right
to elect a direct or indirect rollover with
respect to redemption proceeds that are
distributed from the ESOP, and any notice
provided to the employee as required by
section402(f)wouldhavetoidentifythe
loss of this valuable right to the partici-
pant. See §1.402(c)–2, Q&A–4(e).
Congress also provided for other spe-
cial treatment for applicable dividends un-
der section 404(k) that would be incon-
sistent with redemption of a normal bene-
fit distribution beingtreated as an applica-
ble dividend under section 404(k). Section
72(t)(2)(A)(vi) provides for an exception
to the 10 percent additional income tax for
early distributions for dividends paid with
respect to stock of a corporation which are
described in section 404(k). Further, sec-
tion 404(k)(5)(B) provides that a plan will
not violate the requirements of sections
401, 409, or 4975(e)(7) or be engaging in a
prohibited transaction merely by reason of
distributing an applicable dividend under
section 404(k). Thus, for example, a distri-
bution of an applicable dividend under sec-
tion 404(k) is not subject to the prohibition
against in-service distributions of amounts
attributable to elective deferrals under sec-
tion 401(k)(2). Clearly, these broad ex-
ceptions under section 72(t)(2)(A)(vi) and
404(k)(5)(B) were not intended to apply to
normal benefit distributions from ESOPs,
essentially at the election of the employer
or distributee.
Finally, even if the IRS declined
to exercise its authority under section
404(k)(5)(A), the plain language of sec-
tion 162(k) precludes the deduction for
payments by a corporation to redeem its
stock including deductions otherwise al-
lowed under section 404(k). As described
under theBackgroundsection of this pre-
amble, section 162(k) provides that “no
deduction otherwise allowable shall be
allowedunder this chapterfor any amount
paid or incurred by a corporation in con-
nection with the reacquisition of its stock”
(emphasis added) and section 404(k) is in
the same chapter as section 162(k). The
commentator’s attempt to avoid the effect
of the plain language of the statute by ref-
erence to a supposed negative inference in
the legislative history is unavailing.
Accordingly, these regulations adopt
the rule in the proposed regulations with-
out material change.
Effective Date
Section 1.162(k)–1 applies with respect
to amounts paid or incurred on or after
August 30, 2006.
Section 1.404(k)–3 applies with respect
to payments to reacquire stock that are
made on or after August 30, 2006. Rev.
Rul. 2001–6 remains in effect for all peri-
ods, including periods before the effective
date of this regulation.
Special Analyses
It has been determined that this Trea-
sury decision is not asignificant regula-
tory action as defined in Executive Order
12866. Therefore, a regulatory assessment
is not required. It also has been deter-
mined that section 553(b) of the Admin-
istrative Procedure Act (5 U.S.C. chapter
5) does not apply to these regulations, and
because the regulations do not impose a
collection of information on small entities,
the Regulatory Flexibility Act (5 U.S.C.
chapter 6) does not apply. Pursuant to sec-
tion 7805(f) of the Code, the proposed reg-
ulations preceding these regulations were
submitted to the Chief Counsel for Advo-
cacy of the Small Business Administration
for comment on its impact on small busi-
ness.
Drafting Information
The principal authors of these reg-
ulations are John T. Ricotta, Office of
Division Counsel/Associate Chief Coun-
sel (Tax Exempt and Government Entities)
and Jennifer D. Sledge, Office of Asso-
ciate Chief Counsel (Corporate). How-
ever, other personnel from the IRS and the
Treasury Department participated in the
development of these regulations.
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR part 1 is amended
as follows:
2
Given the special rules of section 409(h) which generally entitle participants to receive cash for employer securities that are not publicly traded,if Congress had so intended, it would likely
have identified the interaction of these provisions in light of the potentially large additional deductions such a rule would permit. Cf.,Charles Ilfeld Co. v. Hernandez, 292 U.S. 62 (1934).
3
For example, a plan participant might elect to have his or her account balance redeemed to the extent invested in employer securities, and then promptly have the cash reinvested in employer
securities, and then could immediately repeat this redemption/reinvestment process with no theoretical limit.
2006–39 I.R.B.515September 25, 2006

PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding entries in nu-
merical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.162(k)–1 is also issued under
section26U.S.C.162(k).***
Section1.404(k)–3isalsoissued
under sections 26 U.S.C. 162(k) and
404(k)(5)(A). * * *
Par. 2. Section 1.162(k)–1 is added to
read as follows:
§1.162(k)–1 Disallowance of deduction
for reacquisition payments.
(a)In general. Except as provided
in paragraph (b) of this section, no de-
duction otherwise allowable is allowed
under Chapter 1 of the Internal Revenue
Code for any amount paid or incurred
by a corporation in connection with the
reacquisition of its stock or the stock of
any related person (as defined in section
465(b)(3)(C)). Amounts paid or incurred
in connection with the reacquisition of
stock include amounts paid by a corpora-
tion to reacquire its stock from an ESOP
that are used in a manner described in
section 404(k)(2)(A). See §1.404(k)–3.
(b)Exceptions. Paragraph (a) of this
section does not apply to any—
(1) Deduction allowable under section
163(relatingtointerest);
(2) Deduction for amounts that are
properly allocable toindebtedness and
amortized over the term of such indebted-
ness;
(3) Deduction for dividends paid
(within the meaning of section 561); or
(4) Amount paid or incurred in connec-
tion with the redemption of any stock in a
regulated investment company that issues
only stock which is redeemable upon the
demand of the shareholder.
(c)Effective date. This section applies
with respect to amounts paid or incurred on
or after August 30, 2006.
Par. 3. Section 1.404(k)–3 is added to
read as follows:
§1.404(k)–3 Disallowance of deduction
for reacquisition payments.
Q–1: Are payments to reacquire stock
held by an ESOP applicable dividends that
are deductible under section 404(k)(1)?
A–1: (a) Payments to reacquire stock
held by an ESOP, including reacquisition
payments that are used to make benefit dis-
tributions to participants or beneficiaries,
are not deductible under section 404(k) be-
cause—
(1) Those payments do not consti-
tute applicable dividends under section
404(k)(2); and
(2) The treatment of those payments
as applicable dividends would constitute,
in substance, an avoidance or evasion of
taxation within the meaning of section
404(k)(5).
(b) See also §1.162(k)–1 concerning the
disallowance of deductions for amounts
paid or incurred by a corporation in con-
nection with the reacquisition of its stock
from an ESOP.
Q–2: What is the effective date of this
section?
A–2: This section applies with respect
to payments to reacquire stock that are
made on or after August 30, 2006.
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved August 22, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary
oftheTreasury(TaxPolicy).
(Filed by the Office of the Federal Register on August 29,
2006, 8:45 a.m., and published in the issue of the Federal
Register for August 30, 2006, 71 F.R. 51471)
Section 472.—Last-in,
First-out Inventories
26 CFR 1.472–1: Last-in, first-out inventories.
LIFO; price indexes; department
stores.The July 2006 Bureau of Labor
Statistics price indexes are accepted for
use by department stores employing the
retail inventory and last-in, first-out in-
ventory methods for valuing inventories
for tax years ended on, or with reference
to, July 31, 2006.
Rev. Rul. 2006–48
The following Department Store In-
ventory Price Indexes for July 2006 were
issued by the Bureau of Labor Statistics.
The indexes are accepted by the Inter-
nal Revenue Service, under § 1.472–1(k)
of the Income Tax Regulations and Rev.
Proc. 86–46, 1986–2 C.B. 739, for ap-
propriate application to inventories of
department stores employing the retail
inventory and last-in, first-out inventory
methods for tax years ended on, or with
reference to, July 31, 2006.
The Department Store Inventory Price
Indexes are prepared on a national basis
and include (a) 23 major groups of depart-
ments, (b) three special combinations of
the major groups — soft goods, durable
goods, and miscellaneous goods, and (c) a
store total, which covers all departments,
including some not listed separately, ex-
cept for the following: candy, food, liquor,
tobacco, and contract departments.
BUREAU OF LABOR STATISTICS, DEPARTMENT STORE
INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
GroupsJuly 2005July 2006
Percent Change
from July 2005
to July 2006
1
1. PieceGoods .............................................495.0465.0-6.1
2. DomesticsandDraperies..................................517.7488.7-5.6
3. Women’sandChildren’sShoes ............................629.0655.74.2
4. Men’sShoes.............................................867.0875.41.0
5. Infants’Wear ............................................548.0557.71.8
September 25, 20065162006–39 I.R.B.

BUREAU OF LABOR STATISTICS, DEPARTMENT STORE
INVENTORY PRICE INDEXES BY DEPARTMENT GROUPS
(January 1941 = 100, unless otherwise noted)
GroupsJuly 2005July 2006
Percent Change
from July 2005
to July 2006
1
6. Women’sUnderwear......................................541.2546.81.0
7. Women’sHosiery ........................................339.7343.81.2
8. Women’sandGirls’Accessories ...........................580.5544.5-6.2
9. Women’sOuterwearandGirls’Wear .......................321.7327.31.7
10. Men’sClothing ..........................................520.6514.2-1.2
11. Men’sFurnishings........................................552.6550.3-0.4
12. Boys’ClothingandFurnishings............................386.1371.3-3.8
13. Jewelry..................................................870.2898.03.2
14. Notions .................................................809.2822.91.7
15. ToiletArticlesandDrugs..................................997.1995.1-0.2
16. FurnitureandBedding ....................................599.1602.40.6
17. FloorCoverings..........................................609.8614.10.7
18. Housewares..............................................712.2697.1-2.1
19. MajorAppliances.........................................203.5204.20.3
20. RadioandTelevision......................................38.935.8-8.0
21. Recreation and Education
2
.................................77.976.3-2.1
22. Home Improvements
2
.....................................137.6139.61.5
23. Automotive Accessories
2
..................................115.1120.74.9
Groups1–15:SoftGoods .......................................537.3538.30.2
Groups16–20:DurableGoods...................................379.6373.2-1.7
Groups
21–23: Misc. Goods
2
....................................
93.093.40.4
Store Total
3
..............................................481.6480.8-0.2
1
Absence of a minus sign before the percentage change in this column signifies a price increase.
2
Inde
xes on a January 1986 = 100 base.
3
The store total index covers all departments, including some not listed separately, except for the following: candy, food, liquor,
tobacco and contract departments.
DRAFTING INFORMATION
The principal author of this revenue
ruling is Michael Burkom of the Office
of Associate Chief Counsel (Income Tax
and Accounting). For further informa-
tion regarding this revenue ruling, contact
Mr. Burkom at (202) 622–7924 (not a
toll-free call).
Section 882.—Tax on
Income of Foreign
Corporations Connected
Wi
th United States Business
26 CFR 1.882–5: Determination of interest deduc-
tion.
T.D
. 9281
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
De
termination of Interest
Ex
pense Deduction of Foreign
C
orporations
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final and temporary regula-
tions.
SUMMARY: This document contains re-
vised Income Tax Regulations relating to
the determination of the interest expense
deduction of foreign corporations and
applies to foreign corporations engaged
in a trade or business within the United
States. This action is necessary to conform
the rules to subsequent U.S. Income Tax
Treaty agreements and to adopt changes
to facilitate improved administrability for
taxpayers and the IRS.
DATES:Effective Date:These regula-
tions are effective starting the tax year end
for which the original tax return due date
(including extensions) is after August 17,
2006.
Applicability Date:These regulations
are applicable starting the tax year end
2006–39 I.R.B.517September 25, 2006

for which the original tax return due date
(including extensions) is after August 17,
2006.
FOR FURTHER INFORMATION
CONTACT: Gregory Spring or
Paul Epstein, (202) 622–3870 (not a
toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
These temporary regulations are being
issued without prior notice and public pro-
cedure pursuant to the Administrative Pro-
cedure Act (5 U.S.C. 553). For this reason,
the collection of information contained in
these regulations has been reviewed and
pending receipt and evaluation of public
comments, approved by the Office of Man-
agement and Budget under control number
1545–2030. Responses to this collection
of information are mandatory.
An agency may not conduct or sponsor,
and a person is not required to respond
to, a collection of information unless the
collection of information displays a valid
control number.
For further information concerning
these collections of information, and
where to submit comments on the col-
lection of information and the accuracy of
the estimated burden, and suggestions for
reducing this burden, please refer to the
preamble of the cross-referencing notice of
proposed rulemaking (REG–120509–06)
published in this issue of the Bulletin.
Books and records relating to a collec-
tion of information must be retained as
long as their contents may become mate-
rial in the administration of any internal
revenue law. Generally, tax returns and tax
return information are confidential, as re-
quired by 26 U.S.C. 6103.
Background
On December 30, 1980, the Treasury
Department and the IRS published final
regulations T.D. 7749, 1981–1 C.B. 390
[46 FR 16100 (see §601.601(d)(2) of this
chapter)] under section 882(c) of the In-
ternal Revenue Code (Code) regarding
the determination of a foreign corpora-
tion’s interest expense allocable to income
effectively connected with the conduct
of a trade or business within the United
States. On March 8, 1996, the Treasury
Department and the IRS published final
regulations T.D. 8658, 1996–1 C.B. 161
[61 FR 15891 (see §601.601(d)(2) of this
chapter)], and new proposed amendments
INTL–0054–95, 1996–1 C.B. 844 [61
FR 28118) (see §601.601(d)(2) of this
chapter)]. The 1996 amendments imple-
mented certain statutory changes enacted
in the Tax Reform Act of 1986, Public Law
99–514 (100 Stat. 2085), and took account
of developments in international financial
markets. Comments were received on
both the final and proposed 1996 regula-
tions. Since then, two new U.S. income tax
treaties have entered into force that follow
a different approach for determining the
limit on profits attributable to a permanent
establishment in a contracting state and
for determining interest expense allowed
incomputingsuchprofits. OnJuly14,
2005, the Treasury Department and the
IRS published Notice 2005–53, 2005–2
C.B. 32, see §601.601(d)(2)), which de-
scribed those new treaties and announced
the intention to update the final §1.882–5
regulations to take account of changes in
the international banking sector and to
promote both ease of administration and
certainty of application.
These temporary regulations in this
document implement Notice 2005–53,
make effective one part of the 1996 pro-
posed regulations, make miscellaneous
clarifications to the 1996 final regu-
lations, and modify the branch profits
tax liability reduction regulations under
§1.884–1(e)(3).
Explanation of Provisions
The following discussion is divided
into several parts. Section 1 of the fol-
lowing discussionsummarizes Notice
2005–53. Section 2 addresses the coordi-
nation of §1.882–5 with U.S. tax treaties
and discusses other modifications made
by these temporary regulations to the
three-step calculationof interest expense
under §1.882–5. Section 3 addresses
changes made to the branch profits tax
regulations under section 884. Section
4 then addresses miscellaneous technical
modifications made by these temporary
regulations that clarify application of
the existing final regulations. Section 5
describes the effective date of these regu-
lations.
1.Notice 2005–53
Notice 2005–53 provided guidance re-
garding the interaction of §1.882–5 and
U.S. income tax treaties and explained that
since the recent treaties with the United
Kingdom and Japan entered into force,
§1.882–5 no longer provides the exclusive
rules for determining the interest expense
attributable to the business profits of a
U.S. permanent establishment. The no-
tice also provided guidance and requested
comments regarding certain potential
modifications to certain elements of the
three-step calculation of interest expense
under §1.882–5. More specifically, the
notice requested information regarding a
possible increase to the existing 93-per-
cent fixed ratio in Step 2 of the calculation
and announced the intention to allow the
use of a safe-harbor interest rate for deter-
mining excess interest under the “adjusted
U.S.-booked liabilities” method in Step
3. The notice also requested comments
regarding the effect of intangibles on the
Step–1 determination of U.S. assets under
the elective fair market value method and
the Step–2 determination of U.S. liabilities
using the fixed or actual ratio.
2.Modifications to Three-Step
Calculation Under §1.882–5
a.Introduction/background
Section 1.882–5 generally requires a
foreign corporation to use a three-step cal-
culation to determine the amount of inter-
est expense that is allocable under section
882(c) to income effectively connected (or
treated as effectively connected) with the
foreign corporation’s conduct of a trade or
business within the United States.
Step 1 determines the total value of a
foreign corporation’s U.S. assets, which
generally are the assets that produce (or
would produce) income effectively con-
nected with the foreign corporation’s con-
duct of its U.S. trade or business. The
value of the U.S. assets for this purpose
is their adjusted basis, or, if the taxpayer
makes an election, their fair market value.
Step 2 determines the “U.S.-connected
liabilities” of a foreign corporation as the
product of the foreign corporation’s U.S.
assets multiplied either by the actual ratio
of the foreign corporation’s worldwide li-
abilities to worldwide assets, or by a fixed
September 25, 20065182006–39 I.R.B.

ratio. In the case of a bank, the fixed ratio
is 93 percent. If a taxpayer elects to value
its assets at fair market value for purposes
of Step 1, then the taxpayer must value
worldwide assets at fair market value for
purposes of Step 2, as well.
Step 3 determines the allocable amount
of interest expense under either the ad-
justed U.S.-booked liabilities (AUSBL)
method or the separate currency pools
method. Under the AUSBL method, a
foreign bank’s interest expense alloca-
ble to effectively connected income is
determined by comparing “U.S.-booked
liabilities” with U.S.-connected liabilities
and making appropriate adjustments as
necessary. For this purpose, U.S.-booked
liabilities generallyinclude liabilities that
are both entered on books relating to an
activity that produces effectively con-
nected income before the close of the
dayonwhichtheliabilityisincurredand
are directly connected to that activity.
In consequence, U.S.-booked liabilities
are not limited to liabilities reflected on
books within the United States. If a tax-
payer’s U.S.-booked liabilities exceed
its U.S.-connected liabilities, then its
U.S-booked interest expense is propor-
tionately disallowed under a “scale down”
ratio. If a taxpayer’s U.S.-connected lia-
bilities exceed its U.S.-booked liabilities,
then interest expense in addition to the
U.S.-booked interest expense is allocated
in an amount equal to the product of the
excess U.S.-connectedliabilities multi-
plied by the borrowing rate on U.S.-dollar
liabilities that are not U.S.-booked liabil-
ities.
Under the separate currency pools
method, a foreign corporation’s interest
expense allocable toincome effectively
connected with the conduct of a trade or
business within the United States is the
sum of the separate interest deductions for
each of the currencies in which the foreign
corporation has U.S. assets. The separate
interest deductions generally are deter-
mined using a three-step calculation that
multiplies the worldwide borrowing rate
by the U.S.-connectedliabilities relevant
to U.S. assets denominated in each foreign
currency.
Elections under §1.882–5T, as under
the 1996 final regulations, generally are
binding for a minimum of five years unless
specifically provided otherwise. For ex-
ample, consistent with the binding nature
of a domestic corporation’s fair market
value election under section 861, a fair
market value election under §1.882–5T
may be changed only with consent of the
Commissioner.
b.Treaty coordination — modification of
§1.882–5 exclusivity rule
The preamble to the 1996 final regula-
tions states that §1.882–5 was fully consis-
tent with all of the United States’ then-ex-
isting treaty obligations, including Busi-
ness Profits articles, and the 1996 final reg-
ulations state that §1.882–5 provides the
exclusive rules for determining the interest
expense attributable to the business profits
of a U.S. permanent establishment under a
U.S. income tax treaty. However, the Trea-
sury Department Technical Explanation to
Article 7 of the United States-United King-
dom income tax treaty which entered into
force on March 31, 2003, and the Treasury
Department Technical Explanation to Arti-
cle 7 of the United States-Japan income tax
treaty which entered into force on March
30, 2004, note that §1.882–5 may pro-
duce an inappropriate result in some cases.
As a result, the implementing documen-
tation of these treaties provides that the
1995 Organization for Economic Co-Op-
eration and Development (OECD) Trans-
fer Pricing Guidelines will apply by anal-
ogy for the purpose of determining the
business profits attributable to a permanent
establishment. Thus, as noted in Notice
2005–53, the exclusivity provision in the
1996 final regulations is no longer accu-
rate.
These temporary regulations modify
the exclusivity provision by recognizing
that express provision may be made by or
pursuant to an income tax treaty or accom-
panying documents (such as exchange of
notes) that alternative principles will ap-
ply by analogy to determine the business
profits attributable to a permanent estab-
lishment. Such treaty provisions may be
used to determine the limit on the business
profits attributable to a U.S. permanent es-
tablishment, but taxpayers remain eligible
to use §1.882–5, as explained in the Trea-
sury Department Technical Explanations
to Article 7(3) of the United States-United
Kingdom and United States-Japan income
tax treaties. The Treasury Department
and the IRS believe that these treaties
and agreements provide that a taxpayer
must apply either the domestic law or the
alternative rules expressly provided in
the treaty in their entirety, in accordance
with the consistency principle articulated
in Rev. Rul. 84–17, 1984–1 C.B. 308
(see §601.601(d)(2) of this chapter), and
described in the Treasury Department
Technical Explanation to Article 1(2) of
the United States-United Kingdom and
United States-Japan income tax treaties.
The Treasury Department and the IRS
are continuing to consider the specific
application of this consistency principle
including the application of §1.882–5, the
interaction of §1.882–5 with other U.S. in-
come tax treaties (particularly those being
renegotiated in whole or in part), and the
application of the branch profits tax under
alternative rules for determining interest
expense attributable to business profits.
c.Modifications to step one
Consistency Requirement for Fair Market
Value Election
Under the 1996 final regulations, a
taxpayer that uses the fair market value
method for Step 1 must also use the fair
market value method for Step 2. Notice
2005–53 clarified that this consistency
rule applies only when the taxpayer has
elected to use the actual ratio in Step 2,
because assets are not valued when the
fixed ratio is used. Accordingly, under the
final regulations, electing the fair market
value method under Step 1 does not ob-
ligate a taxpayer to elect the actual ratio
under Step 2.
Notice 2005–53 also stated that the
prevalence and significance of intangibles
in the banking industry warrants reevalu-
ating the right to elect both the fair market
value method in Step 1 and the fixed ratio
in Step 2. The Treasury Department and
the IRS are concerned that applying the
fixed ratio to intangibles when a Step 1 fair
market value election is in place would
have the effect of treating existing intan-
gibles as highly leveraged assets when in
fact such items often are more properly
reflected in the taxpayer’s equity accounts
under U.S. tax principles. Comments were
requested.
The single comment received in re-
sponse to this request stated that distor-
tions could result either by failing to take
the value of intangibles into account when
2006–39 I.R.B.519September 25, 2006

revising the fixed ratio for banks or by ap-
plying the fixed ratio to directly purchased
intangibles that are valued at tax basis.
As further discussed in this section in
connection with modifications to Step 2,
these temporary regulations adopt a fixed
ratio that is believed to represent an ap-
proximation of current average banking-
industry balance-sheet ratios estimated un-
der U.S. tax principles. Following due
consideration of the comment, these tem-
porary regulations require that the fair mar-
ket value method may be elected in Step 1
only if a taxpayer is eligible to elect and
in fact uses the actual ratio in Step 2. The
consistency rule continues to require that
the fair market value method, once elected,
must be used in both Step 1 and Step 2.
This consistency rule applies to all foreign
corporations that are subject to §1.882–5.
Conforming-Election Requirement
A taxpayer that has both a valid fair
market value method election for Step
1 and a valid fixed ratio method elec-
tion for Step 2 in effect on the date these
temporary regulations are effective must
conform those elections to the new rules.
Accordingly, such a taxpayer either may
maintain the fixed ratio method for Step
2 and elect the adjusted basis method for
Step 1, or may maintain the fair mar-
ket value method for Step 1 and elect
the actual ratio method for Step 2. Such
conforming elections must be made for
the first year these temporary regulations
are effective, on either an original timely
filed return (including extensions) or an
amended return within 180 days after
the extended due date. If a conforming
election is not made by the extended due
date for filing the amended return, the
Director of Field Operations may make a
binding conforming election on the tax-
payer’s behalf. Conforming elections are
subject to the minimum five-year period
applicable to the adjusted basis method,
fixed ratio and actual ratio method elec-
tions. Elections with respect to Step 1
and Step 2, whether made by the taxpayer
(either under the terms of the regulations
or pursuant to the Commissioner’s grant
of consent within what would otherwise
be a five-year minimum period) or im-
posed by the Commissioner, are separate.
Thus, for example, the Commissioner may
consent to a taxpayer’s request to move
from the fair market value method to the
adjusted basis method for Step 1 without
granting consent to move from the actual
ratio method to the fixed ratio method for
Step 2.
Average Value of Securities Subject to
Section 475 or Section 1256
The 1996 proposed regulations provide
that financial instruments that are subject
to mark-to-market valuation under section
475orsection1256mustbevaluedfor
purposes of §1.882–5 on each “determina-
tion date” (as defined) within the taxable
year. Taxpayers generally assess funding
needs throughout the year, and this rule is
intended to reflect such assessments more
accurately than a single year-end valuation
would do.
These temporary regulations adopt this
rule from the 1996 proposed regulations.
The rule applies solely to determine the av-
erage values of relevant assets for purposes
of computing the average valuation of U.S.
assets in Step 1 of the formula. The rule
does not determine the actual tax basis of
an asset for any other purpose. “Determi-
nation dates” for purposes of the rule are
defined as the most frequent regular inter-
vals for which data are reasonably avail-
able. These temporary regulations pro-
vide that a taxpayer that has elected the ac-
tualratioinStep2mustalsotakeinterim
mark-to-market values into account using
the most frequently available data but in no
event less frequently than actual-ratio tax-
payers are required to do.
d.Modifications to step two
New Fixed Ratio
The 1996 final regulations revised the
fixed ratio for banks downward to 93 per-
cent. Since then, foreign bank taxpayers
have commented that 93 percent is not rep-
resentative of regulated banking industry
capital structures. Foreign bank taxpay-
ers also have commented that use of the
actual ratio in Step 2 presents the poten-
tial for significant tax risk and uncertainty
of results, particularly when adjusting their
books to conform to U.S. tax principles.
It appears that many foreign banks have
adopted the 93-percent fixed ratio despite
indications that many operate on a smaller
equity capital structure.
Notice 2005–53 indicated that the Trea-
sury Department and the IRS were con-
sidering increasing the fixed ratio. In or-
der to improve administration by aligning
the fixed ratio more closely with an ap-
proximation of current average banking in-
dustry balance sheet ratios estimated un-
der U.S. tax principles, these temporary
regulations revise the fixed ratio for for-
eign banks upward to 95 percent. The
new fixed ratio may be adopted by for-
eign banks for the first year in which the
original tax return due date (including ex-
tensions) is after August 17, 2006, or for
any subsequent year. The ratio may be
adopted, for example, for the 2005 calen-
dar year even if the original return was
filed before these regulations were pub-
lished. Taxpayers that want to try to sup-
port any further revision to the fixed ra-
tio would have to submit detailed, specific,
compelling evidence to that effect.
Branch Profits Tax Consequences of
Fixed-Ratio Election
Use of the new 95-percent fixed ratio
in Step 2 conceivably could give rise to
branch profits tax consequences. For ex-
ample, a taxpayer that elects the new fixed
ratio and that had been using either the
93-percent fixed ratio or an actual ratio that
is less than 95 percent could be viewed
under the branch profits tax rules as hav-
ing experienced a decrease in net equity,
thus giving rise to a dividend equivalent
amount. One comment received in re-
sponse to Notice 2005–53 requested that
regulations implementing the notice pro-
vide special immunity from branch profits
tax consequences except to the extent that
a taxpayer benefited from the 1996 reduc-
tion of the fixed ratio from 95 percent to
93 percent.
Such consequences under the branch
profits tax rules should arise only to the
extent a taxpayer uses a 95-percent ra-
tio that is substantially higher than the ra-
tiousedintheprioryear,andthetax-
payer’s asset base has not increased suf-
ficiently in the ordinary course of busi-
ness to cause current and accumulated ef-
fectively connected earnings and profits
to be treated as reinvested. The 1996 fi-
nal regulations identify the actual ratio as
the preferred method, and taxpayers have
always been entitled to elect their actual
ratio. Accordingly, the Treasury Depart-
September 25, 20065202006–39 I.R.B.

ment and the IRS believe that granting the
commenter’s request is unnecessary and in
some cases could produce an inappropri-
ate windfall. In addition, considerable ad-
ministrative difficulties would complicate
efforts to identify and recapture prior tax
benefits that may have resulted from the
increase in net equity when the fixed ra-
tio was reduced in the 1996 final regula-
tions and to track the deferred component
of the computation through the intervening
years up to and including the effective date
of the new fixed ratio. Further, a special
rule of the type requested is inconsistent
with the expectation of reduced effectively
connected income through increased inter-
est expense allocations that result from the
higher ratio. Finally, any branch profits
tax consequences of a new fixed-ratio elec-
tion may be mitigated by applicable tax
treaties and by the expanded availability of
the liability-reduction election under sec-
tion 884, as further discussed in Section 3.
Accordingly, the comment is not adopted.
Elections
Taxpayers that currently have elected
the fixed ratio for Step 2 may use the re-
vised 95-percent ratiofor the first tax year
for which the original tax return due date
(including extensions) is after August 17,
2006. Remaining on the fixed ratio does
not constitute the election of a new five-
year minimum period. For example, a tax-
payer that used the 93-percent fixed ratio
for three years preceding the publication of
these regulations and used the 95-percent
fixed ratio for three more years would be
entitled to elect the actual ratio method in
the following year.
Foreign bank taxpayers that currently
use the actual ratio for Step 2 may make
a binding five-year election to use the new
95-percent fixed ratio for the first year this
amendment is effective, on either an orig-
inal return or on an amended return filed
within 180 days of the extended due date.
An amended return election may not be
made for any year where the extended due
date for a timely filing is after December
31, 2006. If a fixed-ratio election is not
made for the first year these regulations are
effective, a taxpayer using the actual ratio
may make the fixed-ratio election in any
subsequent year, but only on a timely filed
return.
Eligibility
Under the 1996 final regulations, the
93-percent fixed ratio is available to for-
eign banks, which are defined for this
purpose as banks within the meaning of
section 585(a)(2)(B), without regard to the
second sentence thereof. This definition
excludes foreign banking corporations
that are not engaged in a banking business
within the United States. This has the
effect of excluding aforeign corporation
that is engaged in the banking business
outside the United States but terminates
its U.S. banking licenses and continues to
engage in a nonregulated trade or business
within the United States.
The Treasury Department and the IRS
intend that a taxpayer that meets the re-
quirements of section 581 when consid-
ered on a worldwide basis should be eli-
gible to elect the fixed ratio applicable to
banks under §1.882–5 without regard to
whether it remains engaged in a banking
business within the United States. There-
fore, a taxpayer that is regulated as a bank
in its home country, takes deposits, and
makes loans as a substantial part of its
business outside the United States will be
eligible to elect the 95-percent fixed ratio.
e.Modifications to step three
Excess Interest
A foreign bank that uses the AUSBL
method to determine its allocable inter-
est expense may be required to allocate
interest expense in addition to its U.S.-
booked interest expense if U.S.-connected
liabilities exceed U.S.-booked liabilities.
The 1996 final regulations provide that
the interest rate required to be applied to
excess U.S.-connected liabilities is gener-
ally the foreign bank’s average U.S.-dollar
borrowing rate outside the United States.
This rule was a change from the 1981
regulations, which had allowed taxpayers
to use published rates under certain con-
ditions. Taxpayers have commented in-
formally that using actual non-U.S. dollar
borrowing costs in all circumstances im-
poses significant administrative burdens.
The Treasury Department and the IRS
agree that the use of published data rather
than the actual borrowing rate requirement
would simplify administration of the ex-
cess-interest computation both for taxpay-
ers and for the IRS. Notice 2005–53 an-
nounced the intention to permit the use
of the published 30-day average London
Interbank Offering Rate (LIBOR) for tax
years beginning after the date the notice
was published.
In response to Notice 2005–53, two
comments were received. One comment
stated that the proposal to use published
30-day LIBOR rates would make sense if
it has been difficult for banks to calculate
their actual rate of interest and that con-
sideration might be given to making such
a rule available for prior years. The other
comment stated that a small sample of
available information suggested that the
90-day LIBOR rate rather than the 30-day
ratemaybemorerepresentativeofthe
sampled banks and suggested that the IRS
review tax returns with excess interest.
IRS experience in actual cases involv-
ing excess interest supports the adoption of
a 30-day LIBOR rate rather than a 90-day
LIBOR rate. In view of IRS experience
and the absence of contrary data, these
temporary regulations allow an annual
binding election to use a published 30-day
average LIBOR rate beginning with the
first tax year in which an original tax re-
turn is due (including extensions) after
August 17, 2006. Taxpayers may continue
to use their actual U.S.-dollar borrowing
rate in lieu of the 30-day LIBOR rate.
Relevant excess U.S.-connected liabilities
These temporary and proposed regu-
lations provide that the determination of
the actual U.S.-dollar borrowing rate ap-
plicable to excess U.S.-connected liabil-
ities is made with regard only to U.S.-
dollar liabilities that are booked outside
the United States and that do not con-
stitute U.S.-booked liabilities as defined.
The rate applicable to excess U.S.-con-
nected liabilities is intended to reflect the
rate applicable to relevant borrowings and
book interest expense that has not other-
wise been allocated. Because interest with
respect to U.S.-booked liabilities is alloca-
ble under Step 3 of the AUSBL method,
including such interest expense in the de-
termination of the rate applicable to excess
U.S.-connected liabilities could distort the
calculation.
Elections
The 30-day LIBOR election may be
adopted on a year-to-year basis. For the
2006–39 I.R.B.521September 25, 2006

first tax year in which the original tax-re-
turn due date (including extensions) is af-
ter August 17, 2006 and not later than De-
cember 31, 2006, taxpayers may make the
30-day LIBOR election on an original re-
turn, or on an amended return within 180
days of the original extended due date.
For subsequent years, the election must be
made on an original tax return timely filed
(including extensions). The election is
made by attaching a statement to the return
identifying the three-steps of the AUSBL
calculation and the published rate used.
An election to use a 30-day LIBOR rate is
binding for such taxable year and may not
bechangedonanamendedreturnforany
year. Accordingly, a taxpayer is bound by
the published rate used on its original re-
turn. If a taxpayer does not timely file an
income tax return, then the opportunity to
make a timely 30-day LIBOR election will
be forfeited for the tax year. Consistent
with the general rules for untimely elec-
tions, in such circumstances, the Director
of Field Operations may require a taxpayer
to use the actual U.S.-dollar borrowing rate
or apply a published 30-day LIBOR rate
for the year.
3.Liability Reduction Election Under
Branch Profits Tax
In general, the branch profits tax is
imposed under section 884(a) in addition
to the corporate income tax under section
882 and applies only to amounts that are
treated as repatriated from the branch.
These amounts are determined by refer-
ence to a foreign corporation’s effectively
connected earnings and profits for a year
and accumulated effectively connected
earnings and profits, adjusted upward to
reflect decreases in U.S. net equity and
adjusted downward to reflect increases in
U.S. net equity. Adjustments to net equity
generally are made by comparing U.S. net
equity at the end of a taxable year to U.S.
net equity at the beginning of a taxable
year.
The branch profits tax rules impute
equity capital to a branch according to a
formula that treats a portion of reinvested
amounts as having been funded by in-
debtedness. This generally reduces U.S.
net equity and so gives rise to a dividend
equivalent amount. Regulations provide
that a taxpayer may elect to treat reinvested
earnings as equity capital (rather than as
debt-funded capital) by reducing U.S. lia-
bilities as of the determination date. The
amount of liabilities eligible for reduction
under this election is limited to the ex-
cess of U.S. liabilities (which is generally
based on U.S.-connected liabilities, as de-
fined under §1.882–5) over U.S.-booked
liabilities (as defined under §1.882–5) as
of the determination date. An election
to reduce liabilities under §1.884–1 also
reduces the interest deduction available
under §1.882–5.
Taxpayers have expressed uncertainty
regarding the policy served by setting
U.S.-booked liabilities as a floor for liabil-
ity reduction and have requested greater
latitude to treat earnings as reinvested.
For example, taxpayers have noted that
the amount of U.S.-booked liabilities is
not relevant to the §1.882–5 allocation
under the separate currency pools method.
They have noted also that the amount of
U.S.-booked liabilities taken into account
under the AUSBL method is an average
balance for the year that may differ signif-
icantly from a year-end balance.
The Treasury Department and the IRS
believe that it is desirable to more nearly
align the branch profits tax treatment of
distributed earnings with the tax treatment
of a subsidiary’s distributed earnings while
retaining integration with the interest al-
location rules provided in §1.882–5. In
view of taxpayer comments, these tempo-
rary regulations permit a taxpayer to re-
duce U.S. liabilities to the extent neces-
sary to prevent recognition of a dividend
equivalent amount. However, this elec-
tion may not reduce U.S. liabilities below
zero. The other liability-reduction rules of
§1.884–1(e)(3) continue to apply in their
entirety. An example in the final regula-
tions is amended in the temporary regula-
tions to reflect the new limitation rule. The
new liability reduction election is effective
for the first year for which the original tax
return due date (including extensions) is
after August 17, 2006. For tax years for
which the first original tax return due date
(including extensions) is not later than De-
cember 31, 2006, a liability reduction elec-
tionmaybemadeonanamendedreturn
within 180 days after the original extended
due date for filing the original return.
4.Clarifications of 1996 Final
Regulations
Questions have arisen regarding the ap-
plication of certain rules contained in the
1996 final regulations. These temporary
regulations clarify the application of the
1996 final regulations with respect to cer-
tain direct interest allocations, certain re-
quirements applicable to elections gener-
ally under §1.882–5, the definition ofU.S.-
booked liability, and the treatment of cer-
tain currency gain and loss for purposes of
§1.882–5.
a.Direct interest allocations
The direct interest allocation rules un-
der §1.882–5 provide generally that a for-
eign taxpayer with both a U.S. asset and
indebtedness that meet the requirements
of both §1.861–10T(b) and (c) may treat
the asset and the indebtedness as an inte-
grated financial transaction and so may al-
locate interest expense with respect to the
indebtedness directly to income from the
asset. In general, §1.861–10T(b) provides
rules for certain nonrecourse indebtedness,
and §1.861–10T(c) provides rules for cer-
tain integrated financial transactions. Fi-
nancial institutions may allocate interest
directly only to the extent provided by
the nonrecourse indebtedness rules. These
temporary regulations clarify that a finan-
cial institution is not disqualified from di-
rect allocation treatment by satisfying only
the rules provided in §1.861–10T(b) with
respect to particular nonrecourse indebted-
ness transactions. These temporary regu-
lations also clarify that direct allocation is
mandatory for eligible taxpayers if the re-
quirements of either §1.861–10T(b) or (c)
are satisfied.
b.General election requirements
The 1996 final regulations specify
the time, place, and manner for making
elections under each step of the formula.
These temporary regulations clarify that a
taxpayer eligible to change an election as
of right after the minimum five-year pe-
riodmaydosoonlyonanoriginaltimely
filed return. These temporary regulations
also clarify that the election procedures
prohibit relief under §301.9100 for future
elections as well as the elections in the
first year a taxpayer is subject to the rules.
These temporary regulations also clarify
September 25, 20065222006–39 I.R.B.

that after the minimum five-year period,
a taxpayer may change an election on a
timely filed return for any subsequent year.
For example, leaving an election in place
in the sixth year after the election was
made does not constitute a new election
subject to a new 5-year minimum period.
The general election provision is updated
to provide expressly that the elections to
use the fair market value method elec-
tion and the 30-day LIBOR rate election
are subject to their own specific period
requirements instead of the five-year min-
imum period.
c.U.S.-booked liabilities
The definition ofU.S.-booked liability
has changed over time. The 1981 final
regulations defined U.S.-booked liabili-
ties to include only liabilities shown on
the books and records of the U.S. trade
or business. This definition excluded as-
sets that produced effectively connected
income but were booked and maintained
in a foreign branch. The 1996 final regu-
lations modified the definition to include
generally, for non banks, liabilities that are
recorded reasonably contemporaneously
with their acquisition on a set of books
that has a direct relationship to an activity
that gives rise to effectively connected in-
come. For banks, liabilities generally must
be recorded contemporaneously with their
acquisition. These rules do not require
tracing of specific borrowings to specific
effectively connected uses. Whether there
is a direct connection between the liability
and an activity that produces effectively
connected income is determined under all
the facts and circumstances.
These temporary regulations amend the
definition of U.S.-booked liability and pro-
vide an example to clarify that in the case
of a bank, the liability must be recorded on
a set of books before the end of the day
on which it is incurred, and the liability
relates to an activity that produces effec-
tively connected income. The reasonably
contemporaneous booking rule is retained
for non banks and the language clarified
to reassert that the liability must relate to
an activity that produces effectively con-
nected income.
d.Currency gain and loss
A foreign bank’s U.S. branch com-
monly books third-party liabilities de-
nominated in non-dollar currencies and
uses the proceeds to make interbranch
loans. Because interbranch transactions
generally are not recognized for U.S. tax
purposes, the third-party liability is treated
as unhedged. As noted in the pream-
ble to the 1996 final regulations, foreign
currency gain or loss from an unhedged
liability remains subject to the rules of sec-
tion 988. As a result, the U.S. branch may
have currency gain or loss with respect to
the third-party borrowing but may not be
entitled to recognize currency gain or loss
with respect to the offsetting interbranch
transaction. In addition, any scaling down
of interest expense that might otherwise be
required under the AUSBL method does
not apply to foreign currency gain or loss.
Some taxpayers have suggested infor-
mally that, despite the absence of a gen-
eral tracing principle in the interest allo-
cation rules, currency gain and loss from
such third-party liabilities should be trace-
able to currency gains and losses with re-
spect to specific interbranch and noneffec-
tively connected assets. The Treasury De-
partment and the IRS solicit comments re-
garding the allocation, sourcing, and ap-
portionment of currency gain or loss from
unhedged third-party borrowings between
effectively connectedand non-effectively
connected income. Comments are specif-
ically requested regarding the viability of
a tracing principle for this purpose and
the extent to which current booking prac-
tices may provide an administrable basis
for such rules in accordance with existing
authority.
5.Effective Date
The temporary regulations are applica-
ble for the first tax year end for which
the original tax return due date (includ-
ing extensions) is after August 17, 2006.
Accordingly, for calendar-year taxpayers,
the applicability date is for the tax year
ended December 31, 2005. The rules pro-
vide an additional 180 days to make certain
one-time special elections on an amended
return for tax years for which the original
tax return due date is not later than Decem-
ber 31, 2006.
Special Analyses
It has been determined that this Treasury
decision is not a significant regulatory ac-
tion as defined in Executive Order 12866.
Therefore, a regulatory assessment is not
required. It also has been determined that
section 553(b) of the Administrative Pro-
cedure Act (5 U.S.C. chapter 5) does not
apply to these regulations. For applica-
bility of the Regulatory Flexibility Act
(5 U.S.C. chapter 6) please refer to the
cross reference notice of proposed rule-
making published elsewhere in this issue
of the Bulletin. Pursuant to section 7805(f)
of the Code, this regulation has been sub-
mitted to the Chief Counsel for Advocacy
of the Small Business Administration for
comment on its impact on small business.
Drafting Information
The principal authors of these
regulations are Paul S. Epstein and
Gregory A. Spring of the Office of As-
sociate Chief Counsel (International).
*****
Amendments to the Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding entries in nu-
merical order to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.882–5 also issued un-
der 26 U.S.C. 882, 26 U.S.C. 864(e),
26 U.S.C. 988(d), and 26 U.S.C. 7701(l).
***
Section 1.884–1 is also issued under
26 U.S.C. 884. * * *
Par. 2. Section 1.882–0 is amended by:
1. Revising the entries for §1.882–
5(a)(1), (a)(1)(i), (a)(1)(ii), (a)(1)(ii)(A),
(a)(1)(ii)(B), (a)(2), (a)(7), (a)(7)(i),
(a)(7)(ii), (b)(2)(ii)(A), (b)(3), (c)(2)(iv),
(c)(4), (d)(2)(iii)(A), and (d)(5)(ii).
2. Removing the entry for §1.882–
5(b)(2)(iv).
3. Adding entries for §1.882–5T. The
revisions and additions read as follows:
§1.882–0 Table of contents.
*****
§1.882–5 Determination of interest
deduction.
*****
(a)(1) through (a)(2) [Reserved].
2006–39 I.R.B.523September 25, 2006

*****
(a)(7) through (a)(7)(iii) [Reserved].
*****
(b)(2)(ii)(A) [Reserved].
*****
(b)(3) [Reserved].
*****
(c)(2)(iv) [Reserved].
*****
(c)(4) [Reserved].
****
*
(d)(
2)(iii)(A) [Reserved].
*****
(d)(5)(ii) [Reserved].
*****
§1.882–5T Determination of interest
deduction (temporary).
(a) [Reserved].
(1) Overview.
(i) In general.
(ii) Direct allocations.
(A) In general.
(B) Partnership interests.
(2) Coordination with tax treaties.
(3) through (6) [Reserved].
(7) Elections under §1.882–5.
(i) In general.
(ii) Failure to make the proper election.
(iii) Step 2 special election for banks.
(8) through (b)(2)(ii) [Reserved].
(A) In general.
(b)(2)(ii)(B) through (b)(2)(iii)(B) [Re-
served].
(3) Computation of total value of U.S.
assets.
(i) General rule.
(ii) Adjustment to basis of financial in-
struments.
(c) through (c)(2)(iii) [Reserved].
(iv) Determination of value of world-
wide assets.
(c)(2)(v) through (c)(3) [Reserved].
(4) Elective fixed ratio method of deter-
mining U.S. liabilities.
(c)(5) through (d)(2)(iii) [Reserved].
(A) In general.
(B) through (d)(5)(i) [Reserved].
(ii) Interest rate on excess U.S.-con-
nected liabilities.
(A) General rule.
(B) Annual published rate election.
(6) through (f)(2) [Reserved].
Par. 3. Section 1.882–5 is amended by:
1.Revising paragraphs (a)(1)
through (a)(2), (a)(7) through (a)(7)(ii),
(b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4),
(d)(2)(ii)(A)(2),(d)(2)(ii)(A)(3),
(d)(2)(iii)(A), and (d)(5)(ii).
2. Removing paragraph (b)(2)(iv).
3. Adding paragraph (d)(6)Example 5.
The revisions and additions read as fol-
lows:
§1.882–5 Determination of interest
deduction.
(a)(1) through (a)(2) [Reserved].
For further guidance, see entry in
§1.882–5T(a)(1) through (a)(2).
*****
(a)(7)(ii) [Reserved]. For further
guidance, see §1.882–5T(a)(7) through
(a)(7)(ii).
*****
(b)(2)(ii)(A) [Reserved]. For further
guidance, see §1.882–5T(b)(2)(ii)(A).
*****
(b)(3) [Reserved]. For further guid-
ance, see §1.882–5T(b)(3).
*****
(c)(2)(iv) [Reserved]. For further guid-
ance, see §1.882–5T(c)(2)(iv).
*****
(c)(4) [Reserved]. For further guid-
ance, see §1.882–5T(c)(4).
*****
(d)(2)(ii)(A)(2) through (3)[Re-
served]. For further guidance, see
§1.882–5T(d)(2)(ii)(A)(2) through (3).
*****
(d)(2)(iii)(A) [Reserved]. For further
guidance, see §1.882–5T(d)(2)(iii)(A).
*****
(d)(5)(ii) [Reserved]. For further guid-
ance, see §1.882–5T(d)(5)(ii).
*****
(d)(6)Example 5[Reserved]. For fur-
ther guidance, see §1.882–5T(d)(6)Exam-
ple 5.
Par. 4. Section 1.882–5T is added to
read as follows:
§1.882–5T Determination of interest
deduction (temporary).
(a) [Reserved]. For further guidance,
see §1.882–5(a).
(1)Overview—(i)In general.The
amount of interest expense of a foreign
corporation that is allocable under section
882(c) to income which is (or is treated
as) effectively connected with the conduct
of a trade or business within the United
States (ECI) is the sum of the interest al-
locable by the foreign corporation under
the three-step process set forth in para-
graphs (b), (c), and (d) of this section and
the specially allocated interest expense
determined under paragraph (a)(1)(ii) of
this section. The provisions of this section
provide the exclusive rules for allocating
interest expense to the ECI of a foreign
corporation under section 882(c). Un-
der the three-step process, the total value
of the U.S. assets of a foreign corpora-
tion is first determined under paragraph
(b) of this section (Step 1). Next, the
amount of U.S.-connected liabilities is
determined under paragraph (c) of this
section (Step 2). Finally, the amount of
interest paid or accrued on U.S.-booked
liabilities, as determined under paragraph
(d)(2) of this section, is adjusted for inter-
est expense attributable to the difference
between U.S.-connected liabilities and
U.S.-booked liabilities (Step 3). Alterna-
tively, a foreign corporation may elect to
determine its interest rate on U.S.-con-
nected liabilities by reference to its U.S.
assets, using the separate currency pools
method described in paragraph (e) of this
section.
(ii)Direct allocations—(A)In gen-
eral. A foreign corporation that has a
U.S. asset and indebtedness that meet the
requirements of §1.861–10T(b) or (c), as
limited by §1.861–10T(d)(1), shall di-
rectly allocate interest expense from such
indebtedness to income from such asset
in the manner and to the extent provided
in §1.861–10T. For purposes of paragraph
(b)(1) or (c)(2) of this section, a foreign
corporation that allocates its interest ex-
pense under the direct allocation rule of
this paragraph (a)(1)(ii)(A) shall reduce
the basis of the asset that meets the re-
quirements of §1.861–10T(b) or (c) by the
principal amount of the indebtedness that
meets the requirements of §1.861–10T(b)
or (c). The foreign corporation shall also
disregard any indebtedness that meets the
requirements of §1.861–10T(b) or (c) in
determining the amount of the foreign
corporation’s liabilities under paragraphs
(c)(2) and (d)(2) of this section and shall
September 25, 20065242006–39 I.R.B.

not take into account any interest expense
paid or accrued with respect to such a lia-
bility for purposes of paragraph (d) or (e)
of this section.
(B)Partnership interest. A foreign cor-
poration that is a partner in a partnership
that has a U.S. asset and indebtedness that
meet the requirements of §1.861–10T(b)
or (c), as limited by §1.861–10T(d)(1),
shall directly allocate its distributive share
of interest expense from that indebtedness
to its distributive share of income from
that asset in the manner and to the extent
provided in §1.861–10T. A foreign corpo-
ration that allocates its distributive share
of interest expense under the direct allo-
cation rule of this paragraph (a)(1)(ii)(B)
shall disregard any partnership indebt-
edness that meets the requirements of
§1.861–10T(b) or (c) in determining the
amount of its distributive share of part-
nership liabilities for purposes of para-
graphs (b)(1), (c)(2)(vi), and (d)(2)(vii)
or (e)(1)(ii) of this section, and shall not
take into account any partnership interest
expense paid or accrued with respect to
such a liability for purposes of paragraph
(d) or (e) of this section. For purposes of
paragraph (b)(1) of this section, a foreign
corporation that directly allocates its dis-
tributive share of interest expense under
this paragraph (a)(1)(ii)(B) shall—
(1) Reduce the partnership’s basis in
such asset by the amount of such indebt-
edness in allocating its basis in the partner-
ship under §1.884–1(d)(3)(ii); or
(2) Reduce the partnership’s income
from such asset by the partnership’s inter-
est expense from such indebtedness under
§1.884–1(d)(3)(iii).
(2)Coordination with tax treaties.Ex-
cept as expressly provided by or pursuant
to a U.S. income tax treaty or accompa-
nying documents (such as an exchange
of notes), the provisions of this section
provide the exclusive rules for determin-
ing the interest expense attributable to the
business profits of a permanent establish-
ment under a U.S. income tax treaty.
(3) through (a)(6) [Reserved]. For fur-
ther guidance, see §1.882–5(a)(3) through
(a)(6).
(7)Elections under §1.882–5—(i)In
general. A corporation must make each
election provided in this section on the
corporation’s original timely filed Fed-
eral income tax return for the first taxable
year it is subject to the rules of this sec-
tion. An amended return does not qualify
for this purpose, nor shall the provisions
of §301.9100–1 of this chapter and any
guidance promulgated thereunder apply.
Except as provided elsewhere in this sec-
tion, each election under this section,
whether an election for the first taxable
year or a subsequent change of election,
shall be made by the corporation calcu-
lating its interest expense deduction in
accordance with the methods elected. An
elected method (other than the fair market
value method under §1.882–5(b)(2)(ii), or
the annual 30-day London Interbank Of-
fered Rate (LIBOR) election in paragraph
(d)(5)(ii) of this section) must be used for
a minimum period of five years before the
taxpayer may elect a different method. To
change an election before the end of the
requisite five-year period, a taxpayer must
obtain the consent of the Commissioner
or his delegate. The Commissioner or
his delegate will generally consent to a
taxpayer’s request to change its election
only in rare and unusual circumstances.
After the five-year minimum period, an
elected method may be changed for any
subsequent year on the foreign corpora-
tion’s original timely filed tax return for
the first year to which the changed election
applies.
(ii)Failure to make the proper election.
If a taxpayer, for any reason, fails to make
an election provided in this section in a
timely fashion, the Director of Field Oper-
ations may make any or all of the elections
provided in this section on behalf of the
taxpayer, and such elections shall be bind-
ing as if made by the taxpayer.
(iii)Step 2 special election for banks.
For the first tax year for which an origi-
nal income tax return is due (including ex-
tensions) after August 17, 2006 and not
later than December 31, 2006, in which
a taxpayer that is a bank as described in
§1.882–5(c)(4) is subject to the require-
ments of this section, a taxpayer may make
a new election to use the fixed ratio on ei-
ther an original timely filed return, or on
an amended return filed within 180 days
after the original due date (including ex-
tensions). A new fixed ratio election may
be made in any subsequent year subject to
the timely filing and five-year minimum
period requirements of paragraph (a)(7)(i)
of this section. A new fixed ratio election
under this paragraph (a)(7)(iii) is subject
to the adjusted basis or fair market value
conforming election requirements of para-
graph (b)(2)(ii)(A)(2)ofthissectionand
may not be made if a taxpayer elects or
maintains a fair market value election for
purposes of §1.882–5(b). Taxpayers that
already use the fixed ratio method under
an existing election may continue to use
the new fixed ratio at the higher percentage
without having to make a new five-year
election in the first year that the higher per-
centage is effective.
(8) through (b)(2)(ii) [Reserved]. For
further guidance, see §1.882–5(a)(8)
through (b)(2)(ii) .
(A)In general—(1)Fair market value
conformity requirement. A taxpayer may
elect to value all of its U.S. assets on
the basis of fair market value, subject to
the requirements of§1.861–9T(g)(1)(iii),
and provided the taxpayer is eligible
and uses the actual ratio method under
§1.882–5(c)(2) and the methodology pre-
scribed in §1.861–9T(h). Once elected,
the fair market value must be used by the
taxpayer for both Step 1 and Step 2 de-
scribed in §§1.882–5(b) and (c), and must
be used in all subsequent taxable years
unless the Commissioner or his delegate
consents to a change.
(2)Conforming election requirement.
Taxpayers that as of the effective date
of this paragraph (b)(2)(ii)(A)(2)have
elected and currently use both the fair
market value method for purposes of
§1.882–5(b) and a fixed ratio for purposes
of paragraph (c)(4) of this section must
conform either the adjusted basis or fair
market value methods in Step 1 and Step
2 of the allocation formula by making an
adjusted basis election for §1.882–5(b)
purposes while continuing the fixed ratio
forStep2,orbymakinganactualratio
election under §1.882–5(c)(2) while re-
maining on the fair market value method
under §1.882–5(b). Taxpayers who elect
toconformStep1andStep2ofthefor-
mula to the adjusted basis method must
remain on both methods for the minimum
five-year period in accordance with the
provisions of paragraph (a)(7) of this sec-
tion. Taxpayers that elect to conform Step
1 and Step 2 of the formula to the fair
market value method must remain on the
actual ratio method until the consent of the
Commissioner or his delegate is obtained
to switch to the adjusted basis method. If
consent to use the adjusted basis method
in Step 1 is granted in a later year, the
2006–39 I.R.B.525September 25, 2006

taxpayer must remain on the actual ratio
method for the minimum five-year period
unless consent to use the fixed ratio is
independently obtained under the require-
ments of paragraph (a)(7) of this section.
For the first tax year for which an original
income tax return is due (including exten-
sions) after August 17, 2006 and not later
than December 31, 2006, taxpayers that
are required to make a conforming elec-
tion under this paragraph (b)(2)(ii)(A)(2),
maydosoeitheronatimelyfiledoriginal
return or on an amended return within 180
days after the original due date (including
extensions). If a conforming election is
not made within the timeframe provided
in this paragraph, the Director of Field
Operations or his delegate may make the
conforming elections in accordance with
the provisions of paragraph (a)(7)(ii) of
this section.
(B) through (b)(2)(iii)(B) [Re-
served].For further guidance,
see §1.882–5(b)(2)(ii)(B) through
(b)(2)(iii)(B).
(3)Computation of total value of U.S.
assets—(i)General rule.Thetotalvalue
of U.S. assets for the taxable year is the
average of the sums of the values (deter-
mined under paragraph (b)(2) of this sec-
tion) of U.S. assets. For each U.S. asset,
value shall be computed at the most fre-
quent regular intervals for which data are
reasonably available. In no event shall
the value of any U.S. asset be computed
less frequently than monthly (beginning of
taxable year and monthly thereafter) by a
large bank (as defined in section 585(c)(2))
or a dealer in securities (within the mean-
ing of section 475) and semi-annually (be-
ginning, middle and end of taxable year)
by any other taxpayer.
(ii)Adjustment to basis of financial in-
struments. For purposes of determining
the total average value of U.S. assets in
this paragraph (b)(3), the value of a se-
curity or contract that is marked to mar-
ket pursuant to section 475 or section 1256
will be determined as if each determina-
tion date is the most frequent regular inter-
val for which data are reasonably available
that reflects the taxpayer’s consistent busi-
ness practices for reflecting mark-to-mar-
ket valuations on its books and records.
(c) through (c)(2)(iii) [Reserved]. For
further guidance, see §1.882–5(c) through
(c)(2)(iii).
(iv)Determination of value of world-
wide assets. The value of an asset must be
determined consistently from year to year
and must be substantially in accordance
with U.S. tax principles. To be substan-
tially in accordance with U.S. tax princi-
ples, the principles used to determine the
value of an asset must not differ from U.S.
tax principles to a degree that will ma-
terially affect the value of the taxpayer’s
worldwide assets or the taxpayer’s actual
ratio. The value of an asset is the adjusted
basis of that asset for determining the gain
or loss from the sale or other disposition of
that asset, adjusted in the same manner as
the basis of U.S. assets are adjusted under
paragraphs (b)(2)(ii) through (iv) of this
section. The rules of §1.882–5(b)(3)(ii)
apply in determining the total value of
applicable worldwideassetsforthetax-
able year, except that the minimum num-
ber of determination dates are those stated
in §1.882–5(c)(2)(i).
(c)(2)(v) through (c)(3) [Reserved]. For
further guidance, see §1.882–5(c)(2)(v)
through (c)(3).
(4)Elective fixed ratio method of deter-
mining U.S. liabilities. A taxpayer that is
a bank as defined in section 585(a)(2)(B)
(without regard to the second sentence
thereof or whether any such activities are
effectively connected with a trade or busi-
ness within the United States) may elect to
use a fixed ratio of 95 percent in lieu of the
actual ratio. A taxpayer that is neither a
bank nor an insurance company may elect
to use a fixed ratio of 50 percent in lieu of
the actual ratio.
(5) through (d)(2)(ii)(A)(1) [Reserved].
For further guidance, see §1.882–5(c)(5)
through (d)(2)(ii)(A)(1).
(2) The foreign corporation enters the
liability on a set of books reasonably con-
temporaneous with the time at which the
liability is incurred and the liability relates
to an activity that produces ECI.
(3) The foreign corporation maintains a
set of books and records relating to an ac-
tivity that produces ECI and the Director of
Field Operations determines that there is a
direct connection or relationship between
the liability and that activity. Whether
there is a direct connection between the li-
ability and an activity that produces ECI
depends on the facts and circumstances of
each case.
(d)(2)(ii)(B) through (d)(2)(iii) [Re-
served]. For further guidance, see
§1.882–5(d)(2)(ii)(B) through (d)(2)(iii).
(A)In general. A liability, whether
interest bearing or non-interest bearing,
is properly reflected on the books of the
U.S. trade or business of a foreign corpo-
ration that is a bank as described in section
585(a)(2)(B) (without regard to the second
sentence thereof) if—
(1) The bank enters the liability on a
set of books before the close of the day
on which the liability is incurred, and the
liability relates to an activity that produces
ECI; and
(2) There is a direct connection or rela-
tionship between the liability and that ac-
tivity. Whether there is a direct connection
between the liability and an activity that
produces ECI depends on the facts and cir-
cumstances of each case. For example, a
liability that is used to fund an interbranch
or other asset that produces non-ECI may
have a direct connection to an ECI pro-
ducing activity and may constitute a U.S.-
booked liability if both the interbranch or
non-ECI activity is the same type of activ-
ity in which ECI assets are also reflected
on the set of books (for example, lending
or money market interbank placements),
and such ECI activities are notde minimis.
Such U.S. booked liabilities may still be
subject to §1.882–5(d)(2)(v).
(B)through(d)(5)(i)[Re-
served]. For further guidance, see
§1.882–5(d)(2)(iii)(B) through (d)(5)(i).
(ii)Interest rate on excess U.S.-con-
nected liabilities—(A)General rule.
The applicable interest rate on excess
U.S.-connected liabilities is determined by
dividing the total interest expense paid or
accrued for the taxable year on U.S.-dol-
lar liabilities that are not U.S.-booked
liabilities (as defined in §1.882–5(d)(2))
and that are shown on the books of the
offices or branches of the foreign corpo-
ration outside the United States by the
average U.S.-dollar denominated liabili-
ties (whether interest-bearing or not) that
are not U.S.-booked liabilities and that
are shown on the books of the offices or
branches of the foreign corporation out-
side the United States for the taxable year.
(B)Annual published rate election.
For each taxable year beginning with the
first year end for which the original tax
return due date (including extensions) is
after August 17, 2006, in which a tax-
September 25, 20065262006–39 I.R.B.

payer is a bank within the meaning of
section 585(a)(2)(B) (without regard to
the second sentence thereof or whether
any such activities are effectively con-
nected with a trade or business within the
United States), such taxpayer may elect to
compute its excess interest by reference
to a published average 30-day London
Interbank Offering Rate (LIBOR) for the
year. The election may be made for any
eligible year by attaching a statement to
a timely filed tax return (including exten-
sions) that shows the 3-step components of
the taxpayer’s interest expense allocation
under the adjusted U.S.-booked liabilities
method and identifies the provider (for
example, International Monetary Fund
statistics) of the 30-day LIBOR rate se-
lected. Once selected, the provider and the
rate may not be changed by the taxpayer.
If a taxpayer that is eligible to make the
30-day LIBOR election either does not
file a timely return or files a calculation
that allocates interest expense under the
scaling ratio in §1.882–5(d)(4) and it is
determined by the Director of Field Oper-
ations that the taxpayer’s U.S.-connected
liabilities exceed its U.S.-booked liabili-
ties, then the Director of Field Operations,
and not the taxpayer, may choose whether
to determine the taxpayer’s excess interest
rate under paragraph (d)(5)(ii)(A) or (B) of
this section and may select the published
30-day LIBOR rate. For the first taxable
year for which an original tax return due
date (including extensions) is after August
17, 2006 and not later than December 31,
2006, an eligible taxpayer may make the
30-day LIBOR election one time for the
taxable year on an amended return within
180 days after the original due date (in-
cluding extensions).
(d)(6) through (d)(6)Example 4
[Reserved]. For further guidance, see
§1.882–5(d)(6) through (d)(6)Example 4.
Example 5.U.S. booked liabilities— direct rela-
tionship.(i)Facts. Bank A, a resident of Country X
maintains a banking office in the U.S. that records
transactions on three sets of books for State A, an
International Banking Facility (IBF) for its bank
regulatory approved international transactions, and a
shell branch licensed operation in Country C. Bank A
records substantial ECI assets from its bank lending
and placement activities and a mix of interbranch
and non-ECI producing assets from the same or
similar activities on the books of State A branch
and on its IBF. Bank A’s Country C branch borrows
substantially from third parties, as well as from its
home office, and lends all of its funding to its State A
branch and IBF to fund the mix of ECI, interbranch
and non-ECI activities on those two books. The con-
solidated books of State A branch and IBF indicate
that a substantial amount of the total book assets
constitute U.S. assets under §1.882–5(b). Some of
the third-party borrowings on the books of the State
A branch are used to lend directly to Bank A’s home
office in Country X. These borrowings reflect the
average borrowing rate of the State A branch, IBF
and Country C branches as a whole. All third-party
borrowings reflected on the books of State A branch,
the IBF and Country C branch were recorded on such
books before the close of business on the day the
liabilities were acquired by Bank A.
(ii)U.S. booked liabilities. The facts demonstrate
that the separate State A branch, IBF and Country C
branch books taken together, constitute a set of books
within the meaning of (d)(2)(iii)(A)(1)ofthissec-
tion. Such set of books as a whole has a direct rela-
tionship to an ECI activity under (d)(2)(iii)(A)(2)of
this section even though the Country C branch books
standing alone would not. The third-party liabilities
recorded on the books of Country C constitute U.S.
booked liabilities because they were timely recorded
and the overall set of books on which they were re-
flected has a direct relationship to a bank lending
and interbank placement ECI producing activity. The
third-party liabilities that were recorded on the books
of State A branch that were used to lend funds to Bank
A’s home office also constitute U.S. booked liabili-
ties because the interbranch activity the funds were
used for is a lending activity of a type that also gives
rise to a substantial amount of ECI that is properly
reflected on the same set of books as the interbranch
loans. Accordingly, the liabilities are not traced to
their specific interbranch use but to the overall activ-
ity of bank lending and interbank placements which
gives rise to substantial ECI. The facts show that the
liabilities were not acquired to increase artificially the
interest expense of Bank A’s U.S. booked liabilities as
a whole under §1.882–5(d)(2)(v). The third-party lia-
bilities also constitute U.S. booked liabilities for pur-
poses of determining Bank A’s branch interest under
§1.884–4(b)(1)(i)(A) regardless of whether Bank A
uses the Adjusted U.S. booked liability method, or
the Separate Currency Pool method to allocate its in-
terest expense under §1.882–5(e).
(e) through (f)(2) [Reserved]. For fur-
ther guidance, see §1.882–5(e) through
(f)(2).
(g)Effective date. (1) This section is
applicable for the first tax year in which
an original tax return due date (including
extensions) is after August 17, 2006.
(2) The applicability of this section ex-
pires on or before August 14, 2009.
Par. 5. Section 1.884–1 is amended
by revising the entries for paragraphs
(e)(3)(ii), (e)(3)(iv) and (e)(5)Example 2.
§1.884–1 Branch profits tax.
*****
(e)(3)(ii) [Reserved]. For further guid-
ance, see entry in §1.884–1T(e)(3)(ii).
*****
(e)(3)(iv) [Reserved]. For further guid-
ance, see entry in §1.884–1T(e)(3)(iv).
*****
(e)(5)Example 2[Reserved].
For further guidance, see entry in
§1.884–1T(e)(5)Example 2.
*****
Par. 6. Section 1.884–1T is added to
read as follows:
§1.884–1T Branch profits tax (temporary).
(a) through (e)(3)(i) [Reserved]. For
further guidance, see §1.884–1(a) through
(e)(3)(i).
(ii)Limitation. For any taxable year,
a foreign corporation may elect to reduce
the amount of its liabilities determined un-
der paragraph §1.884–1(e)(1) of this sec-
tion by an amount that does not exceed the
lesser of the amount of U.S. liabilities as
of the determination date, or the amount of
U.S. liability reduction needed to reduce a
dividend equivalent amount as of the de-
termination date to zero.
(iii) [Reserved]. For further guidance,
see §1.884–1(e)(3)(iii).
(iv)Method of election.Aforeigncor-
poration that elects the benefits of this
paragraph (e)(3) for a taxable year shall
state on its return for the taxable year (or
on a statement attached to the return) that
it has elected to reduce its liabilities for the
taxable year under this paragraph (e)(3)
and that it has reduced the amount of its
U.S.-connected liabilities as provided in
§1.884–1(e)(3)(iii), and shall indicate the
amount of such reductions on the return or
attachment. An election under this para-
graph (e)(3) must be made before the due
date (including extensions) for the foreign
corporation’s income tax return for the
taxable year, except that for the first tax
year for which the original tax return due
date (including extensions) is after August
17, 2006 and not later than December 31,
2006, an election under this paragraph
(e)(3)maybemadeonanamendedreturn
within 180 days after the original due date
(including extensions).
(v) through (e)(5)Example 1[Re-
served]. For further guidance, see
§1.884–1(e)(3)(v) through (e)(5)Example
1.
Example 2.Election made to reduce liabilities.
(i) As of the close of 2007, foreign corporation A, a
real estate company, owns U.S. assets with an E&P
2006–39 I.R.B.527September 25, 2006

basis of $1000. A has $800 of liabilities under para-
graph (e)(1) of this section. A has accumulated ECEP
of $500 and in 2008, A has $60 of ECEP that it in-
tends to retain for future expansion of its U.S. trade
or business. A elects under paragraph (e)(3) of this
section to reduce its liabilities by $60 from $800 to
$740. As a result of the election, assuming A’s U.S.
assets and U.S. liabilities would otherwise have re-
mained constant, A’s U.S. net equity as of the close
of 1994 will increase by the amount of the decrease
in liabilities ($60) from $200 to $260 and its ECEP
will be reduced to zero. Under §1.884–1(e)(3)(iii),
A’s interest expense for the taxable year is reduced
by the amount of interest attributable to $60 of liabil-
ities and A’s excess interest is reduced by the same
amount. A’s taxable income and ECEP are increased
by the amount of the reduction in interest expense at-
tributable to the liabilities, and A may make an elec-
tion under paragraph (e)(3) of this section to further
reduce its liabilities, thus increasing its U.S. net eq-
uity and reducing the amount of additional ECEP cre-
ated for the election.
(ii) In 2009, assuming A again has $60 of ECEP,
A may again make the election under paragraph (e)(3)
to reduce its liabilities. However, assuming A’s U.S.
assets and liabilities under paragraph (e)(1) of this
section remain constant, A will need to make an elec-
tion to reduce its liabilities by $120 to reduce to zero
its ECEP in 2009 and to continue to retain for expan-
sion (without the payment of the branch profits tax)
the $60 of ECEP earned in 2008. Without an election
to reduce liabilities, A’s dividend equivalent amount
for 2009 would be $120 ($60 of ECEP plus the $60
reduction in U.S. net equity from $260 to $200). If A
makes the election to reduce liabilities by $120 (from
$800 to $680), A’s U.S. net equity will increase by
$60 (from $260 at the end of the previous year to
$320), the amount necessary to reduce its ECEP to $0.
However, the reduction of liabilities will itself create
additional ECEP subject to section 884 because of the
reduction in interest expense attributable to the $120
of liabilities. A can make the election to reduce liabil-
ities by $120 without exceeding the limitation on the
election provided in paragraph (e)(3)(ii) of this sec-
tion because the $120 reduction does not exceed the
amount needed to treat the 2009 and 2008 ECEP as
reinvested in the net equity of the trade or business
within the United States.
(iii) If A terminates its U.S. trade or business in
2009 in accordance with the rules in §1.884–2T(a), A
would not be subject to the branch profits tax on the
$60 of ECEP earned in that year. Under paragraph
§1.884–1(e)(3)(v) of this section, however, it would
be subject to the branch profits tax on the portion of
the $60 of ECEP that it earned in 2008 that became
accumulated ECEP because of an election to reduce
liabilities.
(f) through (j)(2)(ii) [Reserved]. For
further guidance, see §1.884–1(f) through
(j)(2)(ii).
PART 602—OMB CONTROL
NUMBER UNDER THE PAPERWORK
REDUCTION ACT
Par. 7. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 8. In §602.101, paragraph
(b) is amended by adding an entry for
“§1.882–5T” to the table to read as fol-
lows:
§601.101 OMB Control numbers.
*****
(b) * * *
CFR part or section where
identified and described
Current OMB
Control No.
*****
1.882–5T........................................................... 1545–2030
*****
Mark E. Matthews,
Deputy Commissioner
for Services and Enforcement.
Approved August 2, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary
oftheTreasury(TaxPolicy).
(Filed by the Office of the Federal Register on August 15,
2006, 8:45 a.m., and published in the issue of the Federal
Register for August 17, 2006, 71 F.R. 47443)
September 25, 20065282006–39 I.R.B.

Part III. Administrative, Procedural, and Miscellaneous
Extensi
on of Replacement
Period f
or Livestock Sold on
Accoun
t of Drought
Notice 2006–82
SECTION 1. PURPOSE
This not
ice provides guidance regard-
ing the
replacement period under § 1033(e)
of the I
nternal Revenue Code for livestock
sold on
account of drought.
SECTION 2. BACKGROUND
.01Nonrecognition of Gain on Invol-
untary Conversion of Livestock. Section
1033(a) generally provides for nonrecog-
nition of gain when property is involun-
tarily converted and replaced with prop-
erty that is similar or related in service or
use. Section 1033(e)(1) provides that a
sale or exchange of livestock (other than
poultry) held by a taxpayer for draft, breed-
ing, or dairy purposes in excess of the num-
ber that would be sold following the tax-
payer’s usual business practices is treated
as an involuntary conversion if the live-
stock is sold or exchanged solely on ac-
count of drought, flood, or other weather-
related conditions.
.02Replacement Period. Section
1033(a)(2)(A) generally provides that
gain from an involuntary conversion is
recognized only to the extent the amount
realized on the conversion exceeds the
cost of replacement property purchased
during the replacement period. If a sale
or exchange of livestock is treated as an
involuntary conversion under § 1033(e)(1)
and is solely on account of drought, flood,
or other weather-related conditions that re-
sult in the area being designated as eligible
for assistance by the federal government,
§ 1033(e)(2)(A) provides that the replace-
ment period ends four years after the close
of the first taxable year in which any part
of the gain from the conversion is realized.
Section 1033(e)(2)(B) provides that the
Secretary may extend this replacement pe-
riod on a regional basis for such additional
time as the Secretary determines appro-
priate if the weather-related conditions
that resulted in the area being designated
as eligible for assistance by the federal
government continue for more than three
years. S
ection 1033(e)(2) is effective for
any taxa
ble year with respect to which the
due date
(without regard to extensions) for
a taxpay
er’s return is after December 31,
2002.
SECTION
3. EXTENSION OF
REPLAC
EMENT PERIOD FOR
PERSIS
TENT DROUGHT
.01In G
eneral. If a sale or exchange
of live
stock is treated as an involun-
tary co
nversion on account of drought
and th
e taxpayer’s replacement period is
deter
mined under § 1033(e)(2)(A), the
repla
cement period will be extended un-
der § 1
033(e)(2)(B) until the end of the
taxpa
yer’s first taxable year ending after
the f
irst drought-free year for the appli-
cabl
e region. For this purpose, the first
drou
ght-free year for the applicable region
is th
e first 12-month period that—
(1) E
nds on August 31;
(2) E
nds in or after the last year of the
taxp
ayer’s 4-year replacement period de-
term
ined under § 1033(e)(2)(A); and
(3) D
oes not include any weekly period
for w
hich exceptional, extreme, or severe
drou
ght is reported for any location in the
app
licable region.
.02A
pplicable Region. The applicable
reg
ion with respect to a sale or exchange of
liv
estock on account ofdrought conditions
is t
he county that experienced the drought
con
ditions on account of which the live-
sto
ck was sold or exchanged and all coun-
ti
es that are contiguous to that county.
.03
Exceptional, Extreme, or Severe
Dr
ought.(1)U.S. Drought Monitor Maps
.
At
axpayer may determine whether ex-
ce
ptional, extreme, or severe drought is
re
ported for any location in the applica-
bl
e region by reference to U.S. Drought
M
onitor maps produced by the National
D
rought Mitigation Center. In determin-
i
ng whether a 12-month period ending on
A
ugust 31 of a calendar year includes any
p
eriod for which exceptional, extreme,
o
r severe drought is reported, all maps
with dates before September 8 of that
year and after August 31 of the preced-
ing calendar year are taken into account.
U.S. Drought Monitor maps are archived
athttp://www.drought.unl.edu/dm/
archive.html.
(2)Publ
ication of List of Drought
Countie
s. Taxpayers can generally deter-
mine on t
he basis of a visual inspection
of U.S. D
rought Monitor maps whether
excepti
onal, extreme, or severe drought
is repo
rted for all or part of a county. In
some ca
ses, however, on the borders of
a droug
ht zone, it may not be clear on
the bas
is of a visual inspection whether a
count
y is within or partly within the zone.
Accor
dingly, the Internal Revenue Ser-
vice,
after consultation with the National
Droug
ht Mitigation Center, will publish in
Septe
mber of each year a list of counties
for w
hich exceptional, extreme, or severe
drou
ght was reported during the preceding
12 mo
nths. Taxpayers may use this list
inst
ead of U.S. Drought Monitor Maps
to de
termine whether a 12-month period
end
ing on August 31 of a calendar year
inc
ludes any period for which exceptional,
ext
reme, or severe drought is reported for
alo
cation in the applicable region.
SEC
TION 4. EXAMPLE
The
following example illustrates the
app
lication of the rules in this notice.
Dr
ought conditions and designations of
el
igibility for federal assistance are de-
sc
ribed in this example solely for illus-
tr
ative purposes and are not intended to
re
flect actual conditions and designations.
Example. (i) Taxpayer A, a calendar year tax-
payer, raises cattle in Keith County, Nebraska. In
20
02, all of A’s cattle held for breeding purposes are
sold solely on account of drought conditions in Keith
County. Under A’s normal business practices, only
2
5 percent of A’s cattle held for breeding purposes
would have been sold in 2002. In 2003, the Secre-
tary of Agriculture designates Keith County as eligi-
b
le for federal assistance on account of the drought
conditions.
(ii) Under § 1033(e)(1), the sale of 75 percent
o
f the cattle held for breeding purposes is treated as
an involuntary conversion. Section 1033(a) provides
that the gain from this portion of A’s sale is not rec-
ognized except to the extent it exceeds the cost of
replacement property (property that is related in ser-
vice or use) purchased during the replacement period.
Because the Secretary of Agriculture has designated
Keith County as being eligible for federal assistance
on account of the drought conditions, A’s replace-
ment period is determined under § 1033(e)(2)(A) and
ends on December 31, 2006.
(iii) Under § 1033(e)(2) and this notice, A’s re-
placement period is extended until the end of A’s
first taxable year ending after the first drought-free
year for the applicable region. For this purpose, the
applicable region is the county that experienced the
drought conditions on account of which the livestock
2006–39 I.R.B.529September 25, 2006

was sold (Keith County) and all counties contiguous
to Keith County (Deuel, Garden, Arthur, McPher-
son, Lincoln, and Perkins Counties, Nebraska, and
Sedgwick County, Colorado). Sedgwick County is
contiguous even though it is in a different state and
touches Keith County only at Keith County’s south-
west corner.
(iv) For the 12-month period ending on August
31, 2006, severe drought conditions are reported on
U.S. Drought Monitor maps for all counties in the ap-
plicable region, and all of those counties are included
on the list published by the IRS. For the 12-month
period ending on August 31, 2007, the only drought
conditions reported for the applicable region on U.S.
Drought Monitor maps are severe drought conditions
for Sedgwick County for the first week in Septem-
ber 2006. A is unable to determine from the maps
whether drought conditions have been reported for
the applicable region, but the list published by the IRS
for the 12-month period ending on August 31, 2007,
includes Sedgwick County. For the 12-month period
ending August 31, 2008, U.S. Drought Monitor maps
do not report drought conditions for any county in
the applicable region and none of the counties are in-
cluded on the list published by the IRS.
(v) Neither the 12-month period ending on Au-
gust 31, 2006, nor the 12-month period ending on
August 31, 2007, is a drought-free year for the ap-
plicable region because, in each of the 12-month
periods, severe drought conditions have been re-
ported for at least one county in the applicable region
for a part of the 12-month period. Accordingly,
the 12-month period ending on August 31, 2008, is
the first drought-free year for the applicable region.
Under § 1033(e)(2) and this notice, A’s replacement
period is extended through December 31, 2008 (the
last day of A’s first taxable year ending after the first
drought-free year for the applicable region).
SECTION 5. EFFECTIVE DATE
This notice applies to taxable years end-
ing after September 25, 2006.
SECTION 6. DRAFTING
INFORMATION
The principal author of this notice is
Jeffrey Marshall of the Office of Associate
Chief Counsel (Income Tax and Account-
ing). For further information regarding
this notice, contact Mr. Marshall at (202)
622–7287 (not a toll-free call).
26 CFR 601.105: Examination of returns and claims
for refund, credit, or abatement; determination of
correct tax liability.
(Also Part I, § 42; 1.42–14.)
Rev. Proc. 2006–38
SECTION 1. PURPOSE
This revenue procedure publishes the
amounts of unused housing credit carry-
overs allocated to qualified states under
§ 42(h)(3)(D) of the Internal Revenue
Code for calendar year 2006.
SECTION 2. BACKGROUND
Rev. Proc. 92–31, 1992–1 C.B. 775,
provides guidance tostate housing credit
agencies of qualified states on the pro-
cedure for requesting an allocation of
unused housing credit carryovers under
§ 42(h)(3)(D). Section 4.06 of Rev. Proc.
92–31 provides that the Internal Rev-
enue Service will publish in the Internal
Revenue Bulletin the amount of unused
housing credit carryovers allocated to
qualified states for a calendar year from
a national pool of unused credit authority
(the National Pool). This revenue proce-
dure publishes these amounts for calendar
year 2006.
SECTION 3. PROCEDURE
The unused housing credit carryover
amount allocated from the National Pool
by the Secretary to each qualified state for
calendar year 2006 is as follows:
Qualified StateAmount Allocated
Alabama
$119,717
Arizona156,003
California949,059
Connecticut92,203
Delaware22,156
Flori
da
467,2
74
Georgia238,303
Illinois335,247
Indiana164,742
Kansas72,093
Kentucky109,620
Mai
ne
34,
711
Maryland147,102
Massachusetts168,072
Michigan265,838
Minnesota134,820
Missouri152,353
N
ebraska
4
6,197
New Jersey228,988
New York505,748
North Dakota16,723
Oregon95,637
Pennsylvania326,480
Rhode Island28,268
September 25, 20065302006–39 I.R.B.

Qualified StateAmount Allocated
Tennessee156,625
Texas600,447
Utah64,867
Vermont16,365
Virginia198,770
Washington165,156
Wisconsin145,416
SECTION 4. EFFECTIVE DATE
This revenu
e procedure is effective
for alloca
tions of housing credit dollar
amounts at
tributable to the National Pool
component
of a qualified state’s housing
credit cei
ling for calendar year 2006.
DRAFTING INFORMATION
The princip
al author of this revenue
procedure
is Christopher J. Wilson of
the Office
of Associate Chief Counsel
(Passthro
ughs and Special Industries). For
further in
formation regarding this revenue
procedure, contact Mr. Wilson at (202)
622–3040 (not a toll-free call).
2006–39 I.R.B.531September 25, 2006

Part IV. Items of General Interest
Notice of Proposed
Rulemaking and Notice of
Public Hearing
Guidance Regarding
Deduction and Capitalization
of Expenditures Related to
Tangible Property
REG–168745–03
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
and notice of public hearing.
SUMMARY: This document contains
proposed regulations that explain how
section 263(a) of the Internal Revenue
Code (Code) applies to amounts paid to
acquire, produce, or improve tangible
property. The proposed regulations clarify
and expand the standards in the current
regulations under section 263(a), as well
as provide some bright-line tests (for ex-
ample, a 12-month rule for acquisitions
and a repair allowance for improvements).
The proposed regulations will affect all
taxpayers that acquire, produce, or im-
prove tangible property. This document
also provides a notice of public hearing on
the proposed regulations.
DATES: Written or electronic comments
must be received by November 20, 2006.
Requests to speak and outlines of topics to
be discussed at the public hearing sched-
uled for Tuesday, December 19, 2006, at
10:00 a.m., must be received by Novem-
ber 28, 2006.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR(REG–168745–03),
room 5203, Internal Revenue Ser-
vice, POB 7604, Ben Franklin Sta-
tion, Washington, DC 20044. Alter-
natively, comments may be sent elec-
tronically, via the IRS Internet site at
www.irs.gov/regsor via the Federal eRule-
making Portal atwww.regulations.gov
(IRS–REG–168745–03). The public hear-
ing will be held in the auditorium of the
New Carrollton Federal Building, 5000
Ellin Road, Lanham, MD 20706 at 10:00
a.m.
FOR FURTHER INFORMATION
CONTACT: Concerning the proposed
regulations, Kimberly L. Koch, (202)
622–7739; concerning submission of
comments, the hearing, and/or to be
placed on the building access list to at-
tend the hearing, Richard A. Hurst at
Richard.A.Hurst@irscounsel.treas.govor
at (202) 622–7180 (not toll-free numbers).
SUPPLE
MENTARY INFORMATION:
Background
In recent years, much debate has fo-
cused on the extent to which section 263(a)
of the Code requires taxpayers to capital-
izeasanimprovementamountspaidtore-
store property to its former working con-
dition; that is, whether, or the extent to
which, the amounts paid to restore or im-
prove the property are capital expenditures
or deductible ordinary and necessary re-
pair and maintenance expenses. There
has been controversy, for example, regard-
ing what tests to apply for determining
capitalization or expensing, how to ap-
ply the tests, and the appropriate unit of
property with respect to which to apply
the tests. On January 20, 2004, the IRS
and Treasury Department published No-
tice 2004–6, 2004–1 C.B. 308, announc-
ing an intention to propose regulations pro-
viding guidance in this area. The notice
identified issues under consideration by
the IRS and Treasury Department and in-
vited public comment on whether these or
other issues should be addressed in the reg-
ulations and, if so, what specific rules and
principles should be provided. To respond
to various comments and provide a more
comprehensive set of rules regarding tan-
gible property, the proposed regulations in-
clude the treatment of amounts paid to ac-
quire or produce tangible property.
Explanation of Provisions
I.Introduction
The proposed regulations under section
263(a) of the Code set forth the general
statutory principles of capitalization and
provide that capital expenditures generally
include amounts paid to sell, acquire, pro-
duce, or improve tangible property. The
proposed regulations, if promulgated as
final regulations, would replace current
§§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3
of the Income Tax Regulations. The treat-
ment of amounts paid to acquire or create
intangibles was addressed with the pub-
lication of §§1.263(a)–4 and 1.263(a)–5
in theFederal Registeron January 5,
2004 (T.D. 9107, 2004–1 C.B. 447 [69 FR
436]).
Certain sections of the current regula-
tions under section 263(a) are proposed
to be removed entirely and are not re-
stated in the proposed regulations. Section
1.263(a)–1(c) of the current regulations
lists several Code and regulation sections
to which the capitalization provisions do
not apply. Section 1.263(a)–3 (election to
deduct or capitalize certain expenditures)
lists several Code sections under which
a taxpayer may elect to treat certain cap-
ital expenditures as either deductible or
deferred expenses, or to treat deductible
expenses as capital expenditures. These
two sections have not been carried over
to the proposed regulations because the
lists of items in these sections are outdated.
This language is intended to have the same
general effect as current §§1.263(a)–1(c)
and 1.263(a)–3, without citing to specific
Code and regulation sections that may
have been repealed and without omitting
specific Code and regulation sections that
may have been added.
Certain portions of §1.263(a)–2 of the
current regulations(examples of capital
expenditures) also are not restated in the
proposed regulations, or are incorporated
into other sections of the proposed regu-
lations. Section 1.263(a)–2(a) of the cur-
rent regulations (the cost of acquisition of
property with a useful life substantially be-
yond the taxable year) is incorporated into
and expanded upon in §1.263(a)–2 of the
proposed regulations (amounts paid to ac-
quire or produce tangible property). Sec-
tion 1.263(a)–2(b) ofthe current regula-
tions (amounts expended for securing a
copyright and plates) is proposed to be
removed because these amounts are now
addressed by §1.263(a)–4(d)(5) and sec-
tion 263A. The rules in §1.263(a)–2(c) of
the current regulations (the cost of defend-
ing or perfecting title to property) are ad-
dressed in §1.263(a)–4(d)(9) of the current
regulations with regard to intangibles and
September 25, 20065322006–39 I.R.B.

in §1.263(a)–2(d)(2) of the proposed reg-
ulations with regard to tangible property.
Section 1.263(a)–2(d) of the current regu-
lations (amounts expended for architect’s
services) is proposed to be removed be-
cause those amounts are now included in
section 263A. The rules in §1.263(a)–2(f)
and (g) of the current regulations (relating
to certain capital contributions) essentially
are restated in §1.263(a)–1(b) of the pro-
posed regulations. Finally, §1.263(a)–2(h)
of the current regulations (the cost of good-
will in connection with the acquisition of
the assets of a going concern) is proposed
to be removed because this cost is now ad-
dressed by §1.263(a)–4(c)(1)(x).
Taking into account the provisions that
are proposed to be removed and other
modifications to the current regulations
noted above, the remaining guidance in
the current regulations is contained in
§1.263(a)–1(a) and (b) of the proposed
regulations. Section 1.263(a)–1(a) of the
current regulations restates the statutory
rules from section 263(a), which are car-
ried over in §1.263(a)–1(a) of the proposed
regulations. The rules in §1.263(a)–1(b)
of the current regulations address amounts
paid to add to the value, or substantially
prolong the useful life, of property owned
by the taxpayer, and amounts paid to adapt
property to a new or different use. They
also address the treatment of those cap-
italized expenditures, for example, as a
charge to capital account or basis. These
rules are incorporated into and expanded
upon in §1.263(a)–3 of the proposed reg-
ulations. The proposed regulations also
revise §1.162–4 of the current regulations
(allowing a deduction for the cost of inci-
dental repairs) to provide rules consistent
with §1.263(a)–3 of the proposed regula-
tions (requiring capitalization of amounts
paid to improve property).
The proposed regulations do not ad-
dress amounts paid to acquire or cre-
ate intangible interests in land, such as
easements, life estates, mineral interests,
timber rights, zoning variances, or other
intangible interests in land. The IRS and
Treasury Department request comments
on whether these and similar amounts, or
certain of these amounts, should be ad-
dressed in the final regulations and, if so,
what rules should be provided. The pro-
posed regulations also do not address the
treatment of software development costs.
II.General Principle of Capitalization
A.Overview
The proposed regulations require capi-
talization of amounts paid to acquire, pro-
duce, or improve tangible real and personal
property, including amounts paid to facil-
itate the acquisition of tangible property.
The proposed regulations do not address
amounts paid to facilitate an acquisition of
a trade or business because those amounts
are addressed in §1.263(a)–5 of the current
regulations.
The proposed regulations clarify that
they do not change the treatment of any
amount that is specifically provided for
under any provision of the Code or regula-
tions other than section 162(a) or section
212 and the regulations under those sec-
tions. This rule applies regardless of
whether that specific provision is more
or less favorable to the taxpayer than
the treatment in the proposed regula-
tions. Thus, where another section of the
Code or regulations prescribes a specific
treatment of an amount, the provisions
of that section apply and not the rules
contained in the proposed regulations.
This rule is the same as that contained
in §§1.263(a)–4(b)(4) and 1.263(a)–5(j)
of the current regulations. The proposed
regulations, for example, do not preclude
taxpayers from deducting the cost of cer-
tain depreciable business assets under sec-
tion 179. On the other hand, the proposed
regulations do not exempt taxpayers from
applying the uniform capitalization rules
under section 263A when applicable, nor
do they exempt taxpayers from complying
with the timing rules regarding incurring
a liability under section 461 (including
economic performance).
The rule clarifying that the proposed
regulations do not change the treatment of
any other amount that is specifically pro-
vided for under any other provision of the
Code or regulations provides an excep-
tion for the treatment of any amount that
is specifically provided for under section
162(a) or section 212 or the regulations
under those sections. Thus, the proposed
regulations override any conflicting pro-
visions in the regulations under sections
162(a) and 212. For this reason, the pro-
posed regulations amend the current rule
for deductible repairs under §1.162–4 to
provide that amounts paid for repairs and
maintenance to tangible property are de-
ductible if the amounts paid are not re-
quired to be capitalized under §1.263(a)–3
of the proposed regulations. The proposed
regulations, however, do not amend or re-
move any other provisions of the current
regulations under section 162(a), includ-
ing §§1.162–6 (regarding professional ex-
penses) and 1.162–12 (regarding certain
expenses of farmers). Section 1.162–6
permits a deduction for amounts paid for
books, furniture, and professional instru-
ments and equipment, the useful life of
which is short, while §1.162–12 permits a
deduction for the cost of ordinary tools of
short life or small cost. The rules in cur-
rent §§1.162–6 and 1.162–12 are consis-
tent with the rules in the proposed regula-
tions and are not revised.
B.Amounts paid to sell property
The proposed regulations provide that,
except in the case of dealers in property,
commissions and other transaction costs
paid to facilitate the sale of property gen-
erally must be capitalized and treated as a
reduction in the amount realized. Dealers
in property include taxpayers that main-
tain and sell inventories and taxpayers that
produce property for sale in the ordinary
course of business, for example, the home
construction business. The language in
this section is slightly broader than the
current language of §1.263(a)–2(e), which
refers only to commissions paid in sell-
ing securities. However, the language in
the proposed regulations is consistent with
case law that generally treats all trans-
action costs paid in connection with the
sale of any property as capitalized and
offset against the amount realized. See,
Wilson v. Commissioner,49T.C.406,414
(1968); rev’d on other grounds, 412 F.2d
314 (6
th
Cir. 1969) (“The rule is thor-
oughly engrained that commissions and
similar charges must be treated as capi-
tal expenditures which reduce the selling
price when gain or loss is computed on
the transaction”);Frick v. Commissioner,
T.C. Memo 1983–733, aff’d without opin-
ion, 774 F.2d 1168 (7
th
Cir. 1985) (“Fees
paid in connection with the disposition of
real property are capital expenditures and
are deductible from the selling price in de-
termining gain or loss on the ultimate dis-
position”);Hindes v. United States,246
F. Supp. 147, 150 (W.D. Tex. 1965); affd.
2006–39 I.R.B.533September 25, 2006

in part, revd. in part on other grounds,
371F.2d650(5
th
Cir. 1967) (“Fees and
expenses paid in connection with the ac-
quisition or disposition of property, real
or personal, are capital expenditures, and,
in the case of a taxpayer not engaged in
the business of buying and selling real es-
tate, are deductible from the selling price
in determining gain or loss on the ulti-
mate disposition”). The sales cost rule in
the proposed regulations, however, applies
only to transaction costs and does not in-
clude other amounts that might be paid
for the purpose of selling property, such
as amounts paid to repair or improve the
property in preparation for a sale. The
treatment of those amounts is governed by
the general rules under §1.263(a)–3 of the
proposed regulations relating to improve-
ments.
III.Amounts Paid to Acquire or Produce
Tangible Property
A.In general
The current regulations under section
263(a) require capitalization of amounts
paid for the acquisition, construction,
or erection of buildings, machinery and
equipment, furniture and fixtures, and
similar property having a useful life sub-
stantially beyond the taxable year. See
§1.263(a)–2(a) of the current regulations.
The proposed regulations are consistent
with this rule, but treat amounts paid to
construct or erect property as production
costs. Specifically, the proposed regu-
lations require capitalization of amounts
paid for property having a useful life sub-
stantially beyond the taxable year, includ-
ing land and land improvements, build-
ings, machinery and equipment, and fur-
niture and fixtures, and a unit of property
(as determined under §1.263(a)–3(d)(2)),
having a useful life substantially beyond
the taxable year. See §1.263(a)–2(d) of the
proposed regulations. Thus, §1.263(a)–2
of the proposed regulations requires cap-
italization of amounts paid for property
that is not itself a unit of property, such
as property (not treated as a material or
supply under §1.162–3) that is intended
to be used as a component in the repair
or improvement of a unit of property.
Additionally, the current regulations at
§1.263(a)–1(b) list inventory costs as cap-
ital expenditures under §1.263(a)–1(a).
Therefore, §1.263(a)–2 of the proposed
regulations also requires capitalization of
amounts paid to acquire real or personal
property for resale and to produce real or
personal property for sale.
The proposed regulations provide that
the termsamounts paidandpayment
mean, in the case of a taxpayer using
an accrual method of accounting, a li-
ability incurred (within the meaning of
§1.446–1(c)(1)(ii)). The definitions of
real and tangible personal property are
intended to be the same as the defini-
tions used for depreciation purposes as
derived from the language in the regula-
tions at §1.48–1. Thus, for purposes of the
proposed regulations, tangible personal
property means any tangible property
except land and improvements thereto,
such as buildings or other inherently per-
manent structures (including items that
are structural components of buildings or
structures). See,Whiteco Indus., Inc. v.
Commissioner, 65 T.C. 664 (1975) (ap-
plying six factors in determining whether
property is an inherently permanent struc-
ture). Under the proposed regulations,
the definitions of building and structural
components are the definitions provided
in §1.48–1(e). The IRS and Treasury De-
partment considered other definitions of
real and tangible personal property, in-
cluding the definitions in the regulations
under section 263A(f), but believe that the
definitions used for depreciation purposes
are the definitions most consistent with
the purposes of the proposed regulations.
The definition of produce in
§1.263(a)–2(b)(4) of the proposed reg-
ulations is intended to be the same as
the definition used for purposes of sec-
tion 263A(g)(1) and §1.263A–2(a)(1)(i),
except that improvements are separately
defined in §1.263(a)–3 of the proposed
regulations. The costs that are required
to be capitalized to property produced
or to any improvement are the costs that
must be capitalized under section 263A.
Thus, for example, all direct materials
and direct labor, and all indirect costs that
directly benefit or are incurred by reason
of production/improvement activities are
required to be capitalized to the property
being produced or improved.
The proposed regulations require tax-
payers to capitalize an amount paid to de-
fend or perfect title to tangible property.
This rule is consistent with the current reg-
ulations at §1.263(a)–2(c) and parallels the
rule in §1.263(a)–4(d)(9) with regard to in-
tangible property. The proposed regula-
tions also require capitalization of amounts
paid to facilitate the acquisition of real or
personal property. The IRS and Treasury
Department request comments on whether
any specific guidance is needed with re-
gard to employee compensation and over-
head costs that facilitate the acquisition of
tangible property and, if so, what that guid-
ance should provide. The proposed reg-
ulations do not address transaction costs
related to the production or improvement
of tangible property because those costs
are subject to capitalization under section
263A.
B.Materials and supplies
As noted in section II.A. above, the
proposed regulations generally do not
change the treatment of any amount that is
specifically provided for under any provi-
sion of the Code or regulations other than
section 162(a) or section 212 and the reg-
ulations under those sections. However,
with regard to section 162(a), the pro-
posed regulations provide an exception for
amounts paid for materials and supplies
that are properly treated as deductions or
deferred expenses, as appropriate, under
§1.162–3. Thus, the proposed regulations
do not change the treatment of materials
and supplies under §1.162–3, including
property that is treated as a material and
supply that is not incidental under Rev.
Proc. 2002–28, 2002–1 C.B. 815 (regard-
ing the use of the cash method by certain
qualifying small business taxpayers), Rev.
Proc. 2002–12, 2002–1 C.B. 374 (regard-
ing smallwares), and Rev. Proc. 2001–10,
2001–1 C.B 272 (regarding inventory of
certain qualifying taxpayers).
C.12-month rule
The current regulations under sec-
tions 263(a), 446, and 461 require tax-
payers to capitalize amounts paid to ac-
quire property having a useful life sub-
stantially beyond the taxable year. See
§§1.263(a)–2(a), 1.446–1(c)(1)(ii), and
1.461–1(a)(2)(i) of the current regulations.
Section 1.263(a)–2(d) of the proposed reg-
ulations retains this general rule. Some
courts have adopted a 12-month rule for
determining whether property has a use-
ful life substantially beyond the taxable
September 25, 20065342006–39 I.R.B.

year. SeeMennuto v. Commissioner,56
T.C. 910 (1971), acq. (1973–2 C.B. 2);
Zelco, Inc. v. Commissioner, 331 F.2d 418
(1
st
Cir. 1964);International Shoe Co.
v. Commissioner, 38 B.T.A. 81 (1938).
Under the 12-month rule adopted by some
courts, a taxpayer may deduct currently
an amount paid for a benefit or paid for
property having a useful life that does
not extend beyond one year. This rule
was adopted in the regulations relating
to intangibles. See §1.263(a)–4(f). The
proposed regulations provide a similar
12-month rule for amounts paid to acquire
or produce certain tangible property.
The proposed regulations generally
provide that an amount (including trans-
action costs) paid for the acquisition or
production of a unit of property with an
economic useful life of 12 months or less
is not a capital expenditure. The unit of
property and economic useful life determi-
nations are made under the rules described
in §1.263(a)–3 for improved property.
The 12-month rule generally applies un-
less the taxpayer elects not to apply the
12-month rule, which election may be
made with regard to each unit of property
that the taxpayer acquires or produces. An
election not to apply the 12-month rule
may not be revoked. Taxpayers that have
elected to use the original tire capitaliza-
tion method of accounting for the cost of
certain tires under Rev. Proc. 2002–27,
2002–1 C.B. 802, must use that method
for the original and replacement tires of
all their qualifying vehicles. See section
5.01 of Rev. Proc. 2002–27. Therefore,
taxpayers that use that method cannot use
the 12-month rule provided under the pro-
posed regulations to deduct amounts paid
to acquire original or replacement tires.
The proposed regulations clarify the in-
teraction of the 12-month rule with the tim-
ing rules contained in section 461 of the
Code. Nothing in the proposed regula-
tions is intended to change the application
of section 461, including the application
of the economic performance rules in sec-
tion 461(h). This coordination rule is the
same as that provided in the regulations
under section 263(a) relating to intangi-
bles. See §1.263(a)–4(f). In the case of
a taxpayer using an accrual method of ac-
counting, section 461requires that an item
be incurred before it is taken into account
through capitalization or deduction. For
example, under §1.461–1(a)(2), a liabil-
ity generally is not incurred until the tax-
able year in which all the events have oc-
curred that establish the fact of the liabil-
ity, the amount of the liability can be deter-
mined with reasonable accuracy, and eco-
nomic performance has occurred with re-
spect to the liability. Thus, the 12-month
rule provided by the proposed regulations
does not permit an accrual method tax-
payer to deduct an amount paid for tan-
gible property if the amount has not been
incurred under section 461 (for example,
if the taxpayer does not have a fixed lia-
bility to acquire the property). The pro-
posed regulations contain examples illus-
trating the interaction of the 12-month rule
with section 461.
The proposed regulations provide that,
upon a sale or other disposition, property to
which a taxpayer applies the 12-month rule
is not treated as a capital asset under sec-
tion 1221 or as property used in the trade
or business under section 1231. Thus,
12-month property is not of a character
subject to depreciation and any amount re-
alized upon disposition of 12-month prop-
erty is ordinary income to the taxpayer.
The IRS and Treasury Department do
not believe that it is appropriate to apply
the 12-month rule to certain types of prop-
erty. Thus, the proposed regulations pro-
vide that the 12-month rule does not apply
to property that is or will be included in
property produced for sale or property ac-
quired for resale, improvements to a unit
of property, land, or a component of a unit
of property.
D.De minimis rule
In Notice 2004–6, the IRS and Trea-
sury Department requested comments on
whether the regulations should provide
ade minimisrule. Because the notice
refers to the application of section 263(a)
to amounts paid to repair, improve, or
rehabilitate tangible property, most com-
mentators focused on ade minimisrule
for the cost of repairs rather than the cost
to acquire property. However, one com-
mentator requested that the regulations
specifically provide ade minimisrule for
acquisition costs, but allow taxpayers to
continue to use their current method if
they have reached a working agreement
with their IRS examining agent regarding
ade minimisrule.
The IRS and Treasury Department rec-
ognize that for regulatory or financial ac-
counting purposes, taxpayers often have a
policy for deducting an amount paid below
a certain dollar threshold for the acquisi-
tion of tangible property (de minimisrule).
For Federal income tax purposes, the tax-
payer generally would be required to capi-
talize the amount paid if the property has a
useful life substantially beyond the taxable
year. However, in this context some courts
have permitted the use of ade minimis
rule for Federal income tax purposes. See
Union Pacific R.R. Co. v. United States,
524 F.2d 1343 (Ct. Cl. 1975) (permitting
the use of the taxpayer’s $500de minimis
rule, which was in accordance with the
Interstate Commerce Commission (ICC)
minimum rule and generally accepted ac-
counting principles);Cincinnati, N.O. &
Tex. Pac. Ry. v. United States,424
F.2d 563 (Ct. Cl. 1970) (same). But
seeAlacare Home Health Services, Inc. v.
Commissioner, T.C. Memo 2001–149 (dis-
allowing the taxpayer’s use of a $500de
minimisrule because it distorted income).
The proposed regulations do not in-
clude ade minimisrule for acquisition
costs. However, the IRS and Treasury
Department recognize that taxpayers often
reach an agreement with IRS examining
agents that, as an administrative matter,
based on risk analysis and/or materiality,
the IRS examining agents do not select
certain items for review such as the ac-
quisition of tangible assets with a small
cost. This often is referred to by taxpayers
and IRS examining agents as ade minimis
rule. The absence of ade minimisrule in
the proposed regulations is not intended to
change this practice.
The IRS and Treasury Department con-
sidered including ade minimisrule in the
proposed regulations. Thede minimisrule
considered would have provided that tax-
payers are not required to capitalize cer-
tainde minimisamounts paid for the acqui-
sition or production of a unit of property.
Under the rule considered, if a taxpayer
had written accounting procedures in place
treating as an expense on its applicable fi-
nancial statement (AFS) amounts paid for
property costing less than a certain dollar
amount, and treated the amounts paid dur-
ing the taxable year as an expense on its
AFS in accordance with those written ac-
counting procedures, the taxpayer would
not have been required to capitalize those
2006–39 I.R.B.535September 25, 2006

amounts if they did not exceed a certain
dollar threshold. A taxpayer that did not
meet these criteria (for example, a taxpayer
that did not have an AFS) would not have
been required to capitalize amounts paid
for a unit of property that did not exceed
the established dollar threshold. Because
taxpayers without an AFS generally are
smaller than taxpayers with an AFS, the
dollar threshold for thede minimisrule that
would have applied to them would have
been lower than the threshold for taxpay-
ers with an AFS (although thede minimis
rule for taxpayers with an AFS also would
have been limited to the amount treated as
an expense on their AFS). Thede minimis
rule considered by the IRS and Treasury
Department would not have applied to in-
ventory property, improvements, land, or a
component of a unit of property.
Thede minimisrule considered also
would have provided that property to
which a taxpayer applies thede minimis
rule is treated upon sale or disposition
similar to section 179 property. Thus,de
minimisproperty would have been prop-
erty of a character subject to depreciation
and amounts paid that were not capital-
ized under thede minimisrule would have
been treated as amortization subject to
recapture under section 1245. Thus, gain
on disposition of the property would have
been ordinary income to the taxpayer to
the extent of the amount treated as amorti-
zation for purposes of section 1245.
The IRS and Treasury Department de-
cided to not include ade minimisrule
in the proposed regulations but instead
to request comments on whether such a
rule should be included in the final regu-
lations or whether to continue to rely on
the current administrative practice of IRS
examining agents. Therefore, the IRS and
Treasury Department request comments
on whether ade minimisrule for acquisi-
tion costs should be included in the final
regulations, and, if so, whether thede
minimisrule should be the rule described
above and what dollar thresholds are ap-
propriate.
The IRS and Treasury Department also
request comments on the scope of costs
that should be included in ade minimis
rule if one is provided in the final regula-
tions and on the character ofde minimis
rule property. For example, thede min-
imisrule considered by the IRS and Trea-
sury Department would have applied to the
aggregate of amounts paid for the acquisi-
tion or production (including any amounts
paid to facilitate the acquisition or produc-
tion)ofaunitofpropertyandincluding
amounts paid for improvements prior to
the unit of property being placed in service.
If ade minimisrule should be provided in
the final regulations, the IRS and Treasury
Department request comments on what, if
any, type of rule should be provided to pre-
vent a distortion of income when taxpay-
ers acquire a large number of assets, each
of which individually is within thede min-
imisrule (for example, the purchase by a
taxpayer of 2,000 personal computers).
If ade minimisrule for acquisition costs
should be provided in the final regulations,
the IRS and Treasury Department request
comments on whether the rule should per-
mit IRS examining agents and taxpayers
to agree to the use of higherde minimis
thresholds on the basis of materiality and
risk analysis and, if so, under what circum-
stances a higher threshold should be al-
lowed. The IRS and Treasury Department
also request comments on whether, if ade
minimisrule should be provided in the fi-
nal regulations, changes to begin using ade
minimisrule or changes to a higher dollar
amount within ade minimisrule should be
treated as changes in a method of account-
ing.
E.Recovery of costs when property is
used in a repair
AsnotedinsectionIII.A.ofthispre-
amble, §1.263(a)–2 of the proposed regu-
lations generally requires capitalization of
amounts paid for the acquisition or produc-
tion of property having a useful life sub-
stantially beyond the taxable year. Thus,
§1.263(a)–2(d) of the proposed regulations
applies to property that is not itself a unit
of property, such as property (not treated
as a material or supply under §1.162–3)
that is intended to be used as a component
in the repair or improvement of a unit of
property. It must be determined whether
the subsequent use of the component prop-
erty results in an improvement to the unit
of property under §1.263(a)–3 or an oth-
erwise deductible repair or maintenance
cost under §1.162–4. Even if the subse-
quent use of the component is an otherwise
deductible expense under §1.162–4, the
amount paid nonetheless may be required
to be capitalized. For example, it must be
determined whether the amount paid for
the component property is required to be
capitalized under section 263A as an indi-
rect cost that directly benefits or is incurred
by reason of property produced or acquired
for resale. The proposed regulations illus-
trate this concept in an example of a man-
ufacturer that replaces one window in a
building. The taxpayer initially must cap-
italize under §1.263(a)–2(d) amounts paid
to acquire the window. The replacement
of the window subsequently is determined
to be a repair to the building rather than
an improvement. Amounts paid for the re-
pair (or an allocable portion thereof) must
then be capitalized under section 263A to
the inventory that the taxpayer produces to
the extent that the repair directly benefits
or is incurred by reason of the taxpayer’s
production activities.
IV.Amounts Paid to Improve Tangible
Property
A.In general
In response to Notice 2004–6, the IRS
and Treasury Department received several
comments on the issues that should be ad-
dressed in the proposed regulations to pro-
vide guidance on amounts paid to repair,
improve, and rehabilitate tangible prop-
erty. These comments have been taken
into account in drafting §1.263(a)–3 of the
proposed regulations. That section ad-
dresses amounts paid to improve tangible
property and includes the following pro-
visions: (1) rules for determining the ap-
propriate unit of property to which the im-
provement provisions apply; (2) general
rules for improvements; (3) rules for de-
termining whether an amount paid mate-
rially increases the value of the unit of
property; (4) rules for determining whether
an amount paid restores the unit of prop-
erty; and (5) an optional repair allowance
method.
B.Unit of property rules
1.In general
A threshold issue in applying the im-
provement rules under §1.263(a)–3 of the
proposed regulations is determining the
appropriate unit of property to which the
rules should be applied. For example, to
determine whether an amount paid ma-
terially increases the value of property, it
September 25, 20065362006–39 I.R.B.

is necessary to know what property is at
issue. The smaller the unit of property,
the more likely it is that amounts paid
in connection with that unit of property
will materially increase the value of, or
restore, the property. Taxpayers and the
IRS frequently disagree on the unit of
property to which thecapitalization rules
should be applied. Thus, the unit of prop-
erty rules in the proposed regulations are
intended to provide guidance in deter-
mining whether an amount paid improves
the unit of property under §1.263(a)–3.
The unit of property rules also apply for
purposes of §1.263(a)–1 of the proposed
regulations (which references the rules in
§§1.263(a)–2 and 1.263(a)–3 of the pro-
posed regulations) and §1.263(a)–2 of the
proposed regulations (for example, with
regard to the 12-month rule). The unit
of property rules in the proposed regula-
tions apply only for purposes of section
263(a) and §§1.263(a)–1, 1.263(a)–2, and
1.263(a)–3 of the proposed regulations,
and not any other Code or regulation sec-
tion. For example, no inference is intended
that these unit of property rules have any
application for section 263A(f) interest
capitalization purposes.
The current regulations under section
263(a) do not provide any guidance on de-
termining the appropriate unit of property.
Some courts have addressed the unit of
property issue under section 263(a), but
their holdings are based on the particu-
lar facts of each case and do not contain
rules that are generally applicable for pur-
poses of section 263(a). See,FedEx Corp.
v. United States, 291 F. Supp. 2d 699
(W.D. Tenn. 2003), aff’d, 412 F.3d 617
(6
th
Cir. 2005) (concluding that an aircraft,
and not the aircraft engine, was the appro-
priate unit of property);Smith v. Commis-
sioner, 300 F.3d 1023 (9
th
Cir. 2002) (con-
cluding that an aluminum reduction cell,
rather than entire cell line, was the ap-
propriate unit of property);Ingram Indus-
tries, Inc. v. Commissioner, T.C. Memo
2000–323 (concluding that a towboat, and
not the towboat engine, was the appropri-
ate unit of property);LaSalle Trucking Co.
v. Commissioner, T.C. Memo 1963–274
(concluding that truck engines, tanks, and
cabs were each separate units of property).
InFedEx, the court ruled on whether
an aircraft engine or the entire aircraft was
the appropriate unit of property for deter-
mining whether the costs of engine shop
visits (ESVs) must be treated as capital
expenditures. Relying on the opinions in
IngramandSmith, the court concluded that
the following four factors were relevant in
determining the appropriate unit of prop-
erty: (1) whether the taxpayer and the in-
dustry treat the component part as a part
of a larger unit of property for regulatory,
market, management, or accounting pur-
poses; (2) whether theeconomic useful life
of the component part is coextensive with
theeconomicusefullifeofthelargerunit
of property; (3) whether the larger unit of
property and the smaller unit of property
can function without each other; and (4)
whether the component part can be and is
maintained while affixed to the larger unit
of property. Applying these factors to air-
craft engines, the court concluded that the
engines should not be considered a unit of
property separate and apart from the air-
plane.
In Notice 2004–6, the IRS and Trea-
sury Department requested comments on
the relevance of various unit of property
factors derived fromFedExand other cases
that addressed the unit of property issue.
The factors listed in Notice 2004–6 in-
cluded: (1) whether the property is man-
ufactured, marketed,or purchased sepa-
rately; (2) whether the property is treated
as a separate unit by a regulatory agency,
in industry practice, or by the taxpayer
in its books and records; (3) whether the
property is designed to be easily removed
from a larger assembly, is regularly or pe-
riodically replaced, or is one of a fungi-
ble set of interchangeable or rotable assets;
(4) whether the property must be removed
from a larger assembly to be fixed or im-
proved; (5) whether the property has a dif-
ferent economic life than the larger assem-
bly; (6) whether the property is subject to
a separate warranty;(7) whether the prop-
erty serves a discrete purpose or functions
independently from a larger assembly; or
(8) whether the property serves a dual pur-
pose function.
The IRS and Treasury Department
received nine comments on the unit of
property issue, fourof which specifically
recommended that the proposed regula-
tions adopt the factors used by the court
inFedEx. These factors essentially are
containedinfactors1,2,4,5,and7of
Notice 2004–6. Several of the factors
listed in Notice 2004–6 have been in-
corporated into the proposed regulations.
However, the IRS and Treasury Depart-
ment determined that some factors were
not relevant for certain types of property.
For example, the factors listed in Notice
2004–6 primarily derive from case law
that addresses tangible personal property;
therefore, the factors were not as help-
ful in determining the appropriate unit of
property for real property, such as land.
Further, some types of property lend them-
selves to specific unit of property rules,
such as buildings and property owned by
taxpayers in a regulated industry. The
IRS and Treasury Department believe
that the administrative burden associated
with determining the appropriate unit of
property can be reduced for both the IRS
and taxpayers by identifying specific rules
reflecting an approach appropriate for
the taxpayer’s industry and the type of
property at issue. Therefore, the proposed
regulations provide different unit of prop-
erty rules for four categories of property,
rather than prescribing one rule for all
types of property.
The unit of property rules in the pro-
posed regulations apply to all real and
personal property other than network
assets. For purposes of the unit of prop-
erty rules,network assetsmeans railroad
track, oil and gas pipelines, water and
sewage pipelines, power transmission
and distribution lines, and telephone and
cable lines that are owned or leased by
taxpayers in each of those respective in-
dustries. Network assets include, for
example, trunk and feeder lines, pole
lines, and buried conduit. They do not
include property that would be included as
a structural component of a building un-
der §1.263(a)–3(d)(2)(iv) of the proposed
regulations, nor do they include separate
property that is adjacent to, but not part of
a network asset, such as bridges, culverts,
or tunnels. The proposed regulations do
not affect current guidance that addresses
the unit of property or capitalization rules
for network assets, such as Rev. Proc.
2001–46, 2001–2 C.B. 263 (track main-
tenance allowance method for Class I
railroads); Rev. Proc. 2002–65, 2002–2
C.B. 700 (track maintenance allowance
method for Class II and III railroads); and
Rev. Proc. 2003–63, 2003–2 C.B. 304
(safe harbor unit of property rule for ca-
ble television distribution systems). The
IRS and Treasury Department request
comments on the relevant rules for deter-
2006–39 I.R.B.537September 25, 2006

mining the appropriate unit of property for
network assets. Additionally, the IRS and
Treasury Department request comments
on whether to include rules for network
assets in final regulations, or whether to
develop for network assets industry-spe-
cific guidance that is similar to the above
referenced revenue procedures.
With the exception of network assets,
the four categories of property in the pro-
posed regulations are intended to cover all
real and personal property. In addition to
the four categories of property, the unit of
property rules provide for an initial unit
of property determination, which, except
with regard to buildings and structural
components, is made prior to categorizing
the property. The initial unit of property
determination is based on the functional
interdependence test in §1.263A–10(a)(2),
relating to the capitalization of interest.
The initial unit of property determina-
tion is intended to be a common-sense
approach to defining the largest possible
unit of property as a starting point for
analyzing the rules under one of the four
relevant unit of property categories. After
the initial unit of property is determined,
the additional unit of property rules are
intended to result in a determination that
either confirms the initial unit of property
as the unit of property, or that separates
one or more components of the initial unit
of property into separate units of property.
Some commentators suggested that
the functional interdependence test un-
der §1.263A–10(a)(2) regarding interest
capitalization should be the sole test for
determining the appropriate unit of prop-
erty. The IRS and Treasury Department
believe that the functional interdepen-
dence test is a relevant, but not dispositive
factor. The purpose of that test under
§1.263A–10(a)(2) is to calculate the ap-
propriate unit of property for determining
the accumulated production expenditures
at the beginning and end of the production
period. The preamble that accompanied
the promulgation of §1.263A–10 discusses
the reasoning for adopting a broad formu-
lation of the unit of property definition
and states that “this concept of single
property may differ from the concept of
single or separate property that taxpayers
use for other purposes (e.g., for comput-
ing amounts of depreciation deductions or
separately tracking the bases of assets).”
T.D. 8584, 1995–1 C.B. 20, 25; [59 FR
67, 187] Dec. 29, 1994).
In contrast to the unit of property rules
in §1.263A–10(a)(2), the purpose of the
unit of property rules under section 263(a)
is to provide a starting point for determin-
ing whether an amount paid materially in-
creases the value of, or restores, the unit
of property. Thus, §1.263A–10(a)(2) has
a different purpose than the proposed reg-
ulations under section 263(a). Further, in
determining the appropriate unit of prop-
erty for purposes of section 263(a), the
functional interdependence test does not
always produce appropriate results. For
example, a taxpayer might argue that ap-
plication of that test results in an entire
complex of structures and machinery, such
as an entire power plant, being treated as a
single unit of property. The IRS and Trea-
sury Department do not believe that result
is correct for purposes of section 263(a).
After the initial unit of property deter-
mination is made, the unit of property anal-
ysis continues with determining the ap-
propriate category of property and apply-
ing the rules in that category. The pro-
posed regulations provide specific rules
for four categories of property: (1) prop-
erty owned by taxpayers in a regulated in-
dustry; (2) buildings and structural com-
ponents; (3) other personal property; and
(4) other real property. The unit of prop-
erty determination made under the appli-
cable category is then subject to an ad-
ditional rule in §1.263(a)–3(d)(2)(vii) re-
garding treatment for other Federal income
tax purposes. The rules for each of the four
categories are explained below.
2.Category I: Taxpayers in regulated
industries
The first unit of property category in the
proposed regulations is property owned by
taxpayers in a regulated industry. The pro-
posed regulations provide that if the tax-
payer is in an industry for which a Federal
regulator has a uniform system of accounts
(USOA) identifying a particular unit of
property, the taxpayer must use the same
unit of property for Federal income tax
purposes, regardless of whether the tax-
payer is subject to the regulatory account-
ing rules of the Federal regulator and re-
gardless of whether the property is par-
ticular to that industry. This rule derives
from one of the factors cited by the court in
FedExfor determining the appropriate unit
of property — whether the taxpayer and
the industry treat the component part as
part of the larger unit of property for regu-
latory, market, management, or accounting
purposes. Thus, this rule ties into the reg-
ulatory accounting element of theFedEx
factor, as well as the general concept of in-
dustry practice. The IRS and Treasury De-
partment are aware of three Federal regula-
tors that provide a USOA: (1) the Federal
Energy Regulatory Commission (FERC);
(2) the Federal Communications Commis-
sion (FCC); and (3) the Surface Trans-
portation Board (STB). Accordingly, this
unit of property category applies to taxpay-
ers such as power companies, telecommu-
nications companies, and railroads.
The IRS and Treasury Department de-
termined that the regulatory accounting
rule should be applied similarly to all tax-
payers in industries for which a Federal
regulator provides a USOA, regardless
of whether the taxpayer is subject to the
regulatory accounting rules of the Federal
regulator. This rule is consistent with the
general standard of using industry prac-
tice to determine the appropriate unit of
property. Further, it results in all taxpayers
within a specific industry being treated
the same for Federal income tax purposes,
without regard to whether a particular tax-
payer is subject to the accounting rules of
the Federal regulator. The rule is limited
to the regulator’s USOA and does not ap-
ply to other Federal regulatory rules, such
as rules concerning safety or health. The
proposed regulations apply only to USOA
provided by Federal regulators and do not
apply to USOA issued by any state or local
agencies. Rules of state and local agencies
may be different than Federal regulatory
rules and can vary widely within an indus-
try depending on the taxpayer’s location.
Four of the commentators on this aspect
of Notice 2004–6 recommended adopting
the four factors cited inFedEx,fromwhich
the regulated industry rule was derived.
None of the commentators specifically ob-
jected to a regulatory accounting rule, al-
though one commentator suggested that
where cost recovery is determined for non-
tax purposes by a Federal or state agency,
the regulations should provide a special
election that may be made on an annual ba-
sis under which the taxpayer may use the
same unit of property for tax purposes as it
must use for regulatory purposes. The IRS
September 25, 20065382006–39 I.R.B.

and Treasury Department believe the unit
of property inquiry should result in one
clear determination that will be used con-
sistently by the taxpayer unless the under-
lying facts change and, therefore, do not
believe an annual election is appropriate.
3.Category II: Buildings and structural
components
In general, a building and its struc-
tural components must be treated as one
unit of property. This rule is based on
the definitions ofbuildingandstructural
componentin the regulations under sec-
tion 48. The repair allowance regulations
under the Class Life Asset Depreciation
Range (CLADR) system also provide that
a building and its structural components
generally are a single unit of property.
See §1.167(a)–11(d)(2)(vi). The IRS and
Treasury Department believe that these
definitions are useful in determining the
appropriate unit of property for buildings
and structural components. One com-
mentator specifically requested that the
proposed regulations use the definition of
building under §1.48–1(e) to determine
a unit of property. The proposed regu-
lations rely on the definition of building
under §1.48–1(e). Property located inside
a building that is not a structural com-
ponent of the building must be analyzed
under one of the other three unit of prop-
erty categories; for example, machinery
and equipment inside a factory must be
analyzed under Category III (the other
personal property category).
This Category II is the only category
to which the initial unit of property de-
termination does not apply. Applying
the functional interdependence test to a
building would raiseissues in cases where
certain floors or portions of a building
are placed in service independently of an-
other. The IRS and Treasury Department
believe that, unless the additional rule in
§1.263(a)–3(d)(2)(vii) of the proposed
regulations (regarding treatment for other
Federal income tax purposes) applies to
require a component of a building to be
treated as a separate unit of property, the
building and its structural components
should be the unit of property. The IRS
and Treasury Department recognize, how-
ever, that it is not always appropriate to
treat the entire building as the unit of prop-
erty. For example, a taxpayer who owns a
unit in a condominium building, whether
the unit is used for personal or investment
purposes, should not treat the entire build-
ing as the unit of property. Therefore,
the IRS and Treasury request comments
on how the unit of property rules should
apply to condominiums, cooperatives, and
similar types of property.
4.Category III: Other personal property
The unit of property determination for
personal property not included in Category
I (taxpayers in a regulated industry) is a
facts and circumstances test, based on four
exclusive factors, none of which is dispos-
itive or weighs more heavily than the oth-
ers.
a. Factor 1: Marketplace treatment factor
The first exclusive factor is whether
the component is (1) marketed separately
to or acquired or leased separately by
the taxpayer (from a party other than the
seller/lessor of the property of which the
component is a part) at the time it is ini-
tially acquired or leased; (2) subject to a
separate warranty contract (from a party
other than the seller/lessor of the property
of which the component is a part); (3) sub-
ject to a separate maintenance manual or
written maintenance policy; (4) appraised
separately; or (5) sold or leased separately
by the taxpayer to another party. This
factor contains a number of items intended
to determine the treatment in the market-
place of the component as a separate unit
of property.
Whether the component is acquired
separately was a factor addressed by the
courts inFedExandIngram,andisalso
part of the CLADR repair allowance reg-
ulations under section 167 and the unit of
property determination for interest capi-
talization in §1.263A–10. InFedEx,the
court discussed this issue in the context of
whether the taxpayer and the industry treat
the component part as part of the larger
unit of property for regulatory, market,
management, or accounting purposes. In
finding that the aircraft engines were not
purchased separately, the court relied on
the fact that the engines and aircraft were
designed to be compatible and were gen-
erally acquired by the taxpayer at the same
time. The court disregarded the fact that
the taxpayer purchased the engines and
airframes from different sellers when the
aircraft were initially acquired. The IRS
and Treasury Department believe that the
acquisition of a component from a differ-
ent seller at the time the larger property
is acquired should be a relevant factor,
and that the same rule should apply if
the taxpayer leases the component from a
different party than the seller of the larger
property.
The IRS and Treasury Department rec-
ognize that this factor may produce differ-
ent results depending on whether the prop-
erty is new or used. When a taxpayer ac-
quires or leases used property, it is possible
that items that were separate units of prop-
erty when purchased new will be treated
as one unit of property because the ini-
tial purchaser has assembled the units into
one functional item that it sells or leases.
The IRS and Treasury Department consid-
ered whether it was appropriate to have a
factor that could treat new and used prop-
erty differently, and decided that the differ-
ence reasonably reflects the substance of
the transactions — where the taxpayer ac-
quires or leases a component from a differ-
ent party from whom it acquires or leases
the larger property, the taxpayer typically
is conducting different, but related, trans-
actions with separately negotiated terms.
Whether the component is subject to a
separate warranty contract, maintenance
manual, or written maintenance policy was
cited as a factor inFedExand is adopted
as part of the marketplace treatment factor
in the proposed regulations. The warranty
contract factor applies only to a warranty
that is provided by a party other than the
seller/lessor of the larger property. It is not
intended to apply to a warranty provided
by the sellor/lessor that may contain sepa-
rate warranties (for example, for different
time periods) on various components of
the larger property. Whether the property
is manufactured separately was a possi-
ble factor cited in Notice 2004–6. The
proposed regulations do not specifically
adopt this factor because components that
are subject to a separate warranty or main-
tenance procedures also are likely to be
manufactured separately. TheFedExcase
used as a factor whether the component
was appraised or valued separately and
the CLADR repair allowance regulations
under section 167 addressed whether the
component was sold separately to another
party. The proposed regulations adopt
2006–39 I.R.B.539September 25, 2006

these tests as part of the marketplace fac-
tor.
The IRS and Treasury Department be-
lieve that it is important that all the crite-
ria in this factor be taken into account to-
gether when weighing this factor with the
other three factors. Some criteria may be
stronger indicators warranting treatment of
the component as a separate unit of prop-
erty than others. The IRS and Treasury
Department acknowledge that several of
the criteria within this factor do not work
well for property produced by the taxpayer,
and request comments regarding how and
whether a marketplace factor should apply
to self-constructed property.
b. Factor 2: Industry practice and
financial accounting factor
The second exclusive factor in this
Category III is whether the component
is treated as a separate unit of property
in industry practice or by the taxpayer in
its books and records. This factor was
citedbythecourtinFedEx.TheIRS
and Treasury Department believe that the
taxpayer’s treatment of the component
as separate in its books and records is a
relevant factor in determining whether the
component should be treated as a separate
unit of property in the proposed regula-
tions. In particular, if the taxpayer’s books
and records assign different economic use-
ful lives to the component and the larger
property, this factorwould weigh heavily
toward treating the component as a sepa-
rate unit of property.
The IRS and Treasury Department con-
sidered whether to use as a factor whether
the component has a different economic
useful life than the property of which it is
a part. This factor was cited by the courts
inSmith,Ingram,andFedEx. However,
for this factor to be useful, the regula-
tions would need to define economic
useful life. The proposed regulations at
§1.263(a)–3(f) (with regard to restoration
of a unit of property) provide a definition
of economic useful life, which has dif-
ferent meanings depending on whether a
taxpayer has an AFS. If the unit of property
rules adopted this definition, the economic
useful life test under this factor would
produce different results depending on
whether the taxpayer has an AFS. These
different results are not justified in this
context. Further, a taxpayer’s treatment
of the component in its books and records
under this Factor 2 includes any useful
life determinations of the component and
the property of which the component is a
part in the books and records. Therefore,
the economic useful life factor was not
specifically adopted as a separate factor.
c. Factor 3: Rotable part factor
The third exclusive factor in the other
personal property category is whether the
taxpayer treats the component as a rotable
part. A rotable part is defined as a part
that is removeable from property, repaired
or improved, and either immediately rein-
stalled on other property or stored for later
installation. This factor was cited by the
courts inSmithandLaSalle. The court in
FedExignored this factor, but considered
as a separate concept whether the compo-
nent can be and is maintained while affixed
to the larger unit. The IRS and Treasury
Department considered this separate con-
cept as well, but believe that the rotable
part factor incorporates this concept from
FedEx. As the examples in the proposed
regulations illustrate, this factor focuses on
the particular taxpayer’s treatment of the
property as a rotable part in determining
whether the rotable is a separate unit of
property. Therefore, for example, if the
rotable part is a separate unit of property
to the taxpayer and the taxpayer incorpo-
rates the rotable into other property for re-
sale, the rotable part will not necessarily be
a separate unit of property to the purchaser.
Two commentators stated that the treat-
ment of a component as a rotable part is of
limited or no relevance. While treatment
of minor parts as rotable would not weigh
heavily toward separate unit of property
treatment, the IRS and Treasury Depart-
ment believe that the treatment of major
components as rotable is a relevant factor
in determining whether a component is a
separate unit of property, particularly when
the economic useful life of the larger prop-
erty is limited by the expected useful life
of the rotable part. Many taxpayers do not
maintain an inventory of rotable spares for
their major components. Although it is un-
derstood that the purpose for maintaining
an inventory of rotables is to minimize the
time that the larger property is out of ser-
vice, treatment of a major component as a
rotable has consequences that tend to be
indicative of a separate unit of property.
For example, in the case of a taxpayer that
does not maintain an inventory of rotable
spare parts, if a major component of the
larger property breaks down, then the en-
tire larger property must be taken out of
service while the major component is be-
ing repaired. This is indicative of the larger
property and the component collectively
being treated as one unit of property. Con-
versely, a taxpayer that does maintain an
inventory of rotable spare parts for a ma-
jor component is able to continue to use the
larger property without regard to the time
required to repair the broken down compo-
nent. In this instance, the IRS and Treasury
Department believe that continued use of
the larger property is indicative of separate
unit of property treatment for the rotable
part. In addition, rotables being depre-
ciated as rotable spare parts is indicative
of separate treatment because the compo-
nents are depreciated separately from the
larger property.
In the request for comments, Notice
2004–6 combined several other factors
with the rotables factor, including whether
a component is designed to be easily re-
moved from a larger assembly, is regularly
or periodically replaced, or is one of a
fungible set of interchangeable assets.
These factors are broader than the rota-
bles factor in the proposed regulations and
would sweep in many minor components
that rarely, if ever, would be appropriately
considered a separate unit of property.
Further, these factors are duplicative of
the rotables part factor, because a rotable
generally meets all of these factors. The
IRS and Treasury Department believe that
these factors are not more helpful in deter-
mining whether a component is a separate
unit of property than the rotables factor
described in the proposed regulations.
Therefore, the proposed regulations do not
include these other factors.
d. Factor 4: Function factor
The fourth and final factor in Category
III is whether the property of which the
component is a part generally functions
for its intended use without the compo-
nent property. This factor was cited by the
court inFedExand is similar to the dis-
crete purpose test under the CLADR re-
pair allowance regulations. It is also simi-
lar to the functional interdependence test
under §1.263A–10(a)(2) and the rules in
September 25, 20065402006–39 I.R.B.

these proposed regulations regarding the
initial unit of property determination. As
noted in the discussion of the initial unit of
property determination, the IRS and Trea-
sury Department agree with commentators
that the functional interdependence test is
a relevant, although not dispositive, factor
in the unit of property analysis. Although
the proposed regulations use the functional
interdependence test to determine the ini-
tial unit of property, the functional inter-
dependence test in that context is merely
a starting point in determining the appro-
priate unit of property, rather than a spe-
cific factor to be considered. Providing
this version of the functional interdepen-
dence test as a specific factor gives appro-
priate weight to that test in the unit of prop-
erty analysis for other personal property.
5.Category IV: Other real property
The unit of property determination for
real property not included in Category I or
II is based on a facts and circumstances
test. The property subject to this category
is primarily land and land improvements
owned or leased by taxpayers not in a reg-
ulated industry. This category does not
list specific factors because land and land
improvements are such unique assets that
specific factors cannot uniformly provide
appropriate results. Thus, the unit of prop-
erty determination for property in this cat-
egory may be based on some, all, or none
of the factors listed in Category III for per-
sonal property, or may be based on other
factors. The IRS and Treasury Depart-
ment request comments on whether addi-
tional guidance is needed for this category
of property and, if so, what unit of property
guidance would be appropriate.
6.Additional rule for unit of property
After determining the initial unit of
property and applying the unit of property
rules under the appropriate category, the
additional rule in §1.263(a)–3(d)(2)(vii)
must be applied. Under this rule, if a
taxpayer properly treats a component as a
separate unit of property for any Federal
income tax purpose, the taxpayer must
treat the component as a separate unit of
property for purposes of §1.263(a)–3. The
purpose of this rule is to prevent taxpay-
ers from taking inconsistent positions by
arguing that a component of property is a
unit of property for one tax purpose and
that it is not a separate unit of property for
capitalization purposes. For example, if a
taxpayer does a cost segregation study on
a building and properly identifies separate
section 1245 property, the taxpayer must
treat that separate property as the unit of
property for capitalization purposes.
As a further example, if a taxpayer
properly recognizes a loss under section
165, or under another applicable provi-
sion, from a retirement of a component
of property or from the worthlessness or
abandonment of a component of property,
the taxpayer must treat the component as
a separate unit of property. A loss arising
under another applicable provision in this
context includes a loss arising under (1)
§1.167(a)–8 or 1.167(a)–11, as applica-
ble, from a retirement of a component
of property if the component is not sub-
ject to section 168 (MACRS property)
or former section 168 (ACRS property);
(2) §1.167(a)–8(a) from a retirement of a
component of property if the component
is MACRS or ACRS property (applying
§1.167(a)–8(a) as though the retirement
is a normal retirement from a single as-
set account) unless the component is a
structural component or the component
is in a mass asset account (ACRS prop-
erty) or a general asset account (MACRS
property); or (3) §1.168(i)–1(e) from the
disposition of a component of property if
the component is MACRS property and in
a general asset account. No inference is
intended that this rule in the proposed reg-
ulations requires or allows taxpayers that
are using a unit of property for purposes of
the proposed regulations to use the same
unit of property for purposes of any Code
or regulation section other than section
263(a) and §§1.263(a)–1, 1.263(a)–2, and
1.263(a)–3 of the proposed regulations.
This rule is intended to prevent tax-
payers from taking a loss deduction on a
component of a unit of property, and then
deducting the cost of the replaced com-
ponent as a repair. The application of
this rule results in the replacement com-
ponent being treated as a separate unit of
property, thus requiring capitalization un-
der §1.263(a)–2 of amounts paid to acquire
or produce the replacement component.
The IRS and Treasury Department believe
that taxpayers must be consistent in the
treatment of a unit of property for capital-
ization (other than interest capitalization),
depreciation, and loss deduction purposes.
The IRS and Treasury Department recog-
nize that the language of this consistency
rule is very broad, and request comments
regarding circumstances in which this rule
should not apply.
V.Improvements in General
Section 1.263(a)–1(b) of the current
regulations provides that an amount must
be capitalized if it (1) adds to the value,
or substantially prolongs the useful life,
of property owned by the taxpayer, or (2)
adapts the property to a new or different
use. Notice 2004–6 requested comments
on what general principles of capitaliza-
tion should apply to amounts paid to repair
or improve tangible property. Commenta-
tors were almost unanimous in their sug-
gestion that the current principles of value,
useful life, and new or different use be re-
tained. The IRS and Treasury Department
agree with the commentators that the cur-
rent guidelines generally are appropriate.
However, the current regulations require a
subjective inquiry into the application of
the particular facts at issue, which often
results in disagreements between taxpay-
ers and the IRS. Accordingly, the proposed
regulations attempt to clarify and expand
the standards in the current regulations by
setting forth rules to determine whether
there has been a material increase in value
(including adapting property to a new or
different use) and to determine whether
there has been a restoration of property
(the useful life rules). In addition, the pro-
posed regulations provide objective rules
for improvements in an optional repair
allowance method.
The proposed regulations generally
provide that a taxpayer must capitalize
the aggregate of related amounts paid that
improve a unit of property, whether the
improvements are made by the taxpayer
or a third party. The aggregate of related
amounts does not encompass otherwise
deductible repair costs unless those costs
directly benefit or are incurred by reason
of a capital improvement. Instead, the
aggregation language is intended to in-
clude amounts paid for an entire project,
including removal costs and other project
costs, regardless of whether amounts are
paid to more than one party or whether the
work spans more than one taxable year.
The proposed regulations do not affect the
treatment of amounts paid to retire and
2006–39 I.R.B.541September 25, 2006

remove a unit of property in connection
with the installation or production of a
replacement asset. See Rev. Rul. 2000–7,
2000–1 C.B. 712.
Several commentators suggested that
the proposed regulations provide that
the relevant distinction between capital
improvements and deductible repairs is
whether the amounts were paid to put the
property in ordinarily efficient operating
condition or to keep the property in ordi-
narily efficient operating condition. See
Estate of Walling v. Commissioner,373
F.2d 190 (3d Cir. 1967);Illinois Mer-
chants Trust Co. v. Commissioner,4
B.T.A. 103 (1926), acq. (V–2 C.B. 2);
Rev. Rul. 2001–4, 2001–1 C.B. 295. The
improvement rules in the proposed regu-
lations are consistent with the put versus
keep standard, to the extent that standard
is relevant. An amount paid may be a
capital expenditure even if it does not put
the property in ordinarily efficient oper-
ating condition because not all repair or
improvement costs affect the functional-
ity of the property. Thus, amounts paid
that keep property in ordinarily efficient
operating condition are not necessarily
deductible repair costs, particularly if the
useful life is extended. On the other hand,
amounts that put property in ordinarily
efficient operating condition are likely to
be amounts paid prior to the property’s
being placed in service or to ameliorate a
pre-existing condition or defect. Amounts
paid in these later situations would be
capital expendituresunder either the value
rule or the restoration rule in the proposed
regulations.
Some commentators suggested that the
frequency of the expenditure should be
considered, noting that an expenditure be-
ing regularly incurred on a cyclical basis
should be a strong indication of deductible
maintenance. The IRS and Treasury De-
partment considered this comment but
concluded that the frequency of the ex-
penditure was too vague a standard to be
administrable. Further, the IRS and Trea-
sury Department believe that the proposed
regulations provide appropriate guidance
on cyclical maintenance by clarifying
other rules, such as the appropriate com-
parison rule for adding value and the rules
relating to prolonging economic useful
life.
In accordance with several comments
received in response to Notice 2004–6, the
proposed regulations provide that a Fed-
eral, state, or local regulator’s requirement
that a taxpayer perform certain repairs or
maintenance is not relevant in determin-
ing whether the amount paid improves
the unit of property. Several courts have
held that amounts paid to bring property
into compliance with government regu-
lations were capital expenditures, in part
because they made the taxpayer’s prop-
erty more valuable for use in its trade or
business. See,Swig Investment Co. v.
United States, 98 F.3d 1359 (Fed. Cir.
1996) (replacing cornices and parapets
on hotel to comply with city earthquake
ordinance);Teitelbaum v. Commissioner,
294F.2d541(7
th
Cir. 1961) (converting
electrical system from direct current to
alternating current to comply with city
ordinance);RKO Theatres, Inc. v. United
States, 163 F. Supp. 598 (Ct. Cl. 1958)
(installing fire-proof doors and fire es-
capes to comply with city code);Hotel
Sulgrave, Inc. v. Commissioner,21T.C.
619 (1954) (installing sprinkler system
to comply with city code). In each case,
however, the court did not rely entirely
on regulatory compliance as a basis for
requiring capitalization. For example, in
Hotel SulgraveandRKO Theatres, both
involving the installation of certain equip-
ment to comply with city fire codes, the
courts emphasized that the work involved
the addition of property with a useful
life extending beyond the taxable year.
Moreover, bothSwigandTeitelbaumin-
volved expenditures for the replacement
of major structural components of a build-
ing (parapets and cornices inSwigand
an electrical system inTeitelbaum)with
upgraded components. Thus, in all these
cases, even without the legal compulsion
to make these changes, the taxpayers’
amounts paid would have constituted cap-
ital expenditures.
In contrast to the cases discussed above,
both the courts and the IRS have permitted
a current deduction for some government
mandated expenditures. For example, in
Midland Empire Packing Co. v. Commis-
sioner, 14 T.C. 635 (1950), acq. (1950–2
C.B. 3), the court allowed the taxpayer
to deduct the costs of applying a concrete
liner to its basement walls to satisfy Fed-
eral meat inspectors. Similarly, the IRS
has permitted taxpayers to treat as other-
wise deductible repairs amounts paid to re-
mediate certain environmental contamina-
tion and to replace certain waste storage
tanks to comply with applicable state and
Federal regulations. See Rev. Rul. 94–38,
1994–1 C.B. 35; Rev. Rul. 98–25, 1998–1
C.B. 998. The IRS specifically recognized
in Rev. Rul. 2001–4, 2001–1 C.B. 295 that
the requirement of a regulatory authority to
make certain repairs or to perform certain
maintenance on an asset to continue oper-
ating the asset does not mean that the work
performed must be capitalized. Thus, the
proposed regulations reiterate that state-
ment in Rev. Rul. 2001–4 and provide
that a legal compulsion to repair or main-
tain tangible property is not a relevant fac-
tor in the repair versus improvement anal-
ysis. The IRS and Treasury Department
further believe that a new government re-
quirement for existing property that man-
dates certain expenditures with respect to
the property does not create an inherent de-
fect in the property.
In response to several comments, the
proposed regulations provide that if a
taxpayer needs to replace part of a unit
of property that cannot practicably be
replaced with the same type of part, the
replacement of the part with an improved
but comparable part does not, by itself,
result in an improvement to the unit of
property. This rule is intended to apply
in cases where the same replacement part
is no longer available, generally because
of technological advancements or product
enhancements. This rule, however, is not
intended to apply if, instead of replacing
an obsolete part with the most similar
comparable part available, the taxpayer
replaces the part with one of a better qual-
ity than what would have sufficed.
The proposed regulations do not pre-
scribe a plan of rehabilitation doctrine as
traditionally described in the case law.
That judicially-created doctrine provides
that a taxpayer must capitalize otherwise
deductible repair costs if they are incurred
as part of a general plan of rehabilitation
to the property. See,Norwest Corp. v.
Commissioner, 108 T.C. 265 (1997);Moss
v. Commissioner, 831 F.2d 833 (9
th
Cir.
1987);United States v. Wehrli,400F.2d
686 (10
th
Cir. 1968). Specifically, if an
expenditure is made as part of a general
plan of rehabilitation, modernization, and
improvement of the property, the expen-
diture must be capitalized, even though,
standing alone, the item may be classified
as one of repair or maintenance.Wehrli,
September 25, 20065422006–39 I.R.B.

400 F.2d at 689. Whether a general plan
of rehabilitation exists, and whether a par-
ticular repair or maintenance item is part
of it, are questions of fact to be determined
based upon all the surrounding facts and
circumstances, including, but not limited
to, the purpose, nature, extent, and value
of the work done.Id.at 690.
The issue of whether an amount paid
must be capitalized under the plan of re-
habilitation doctrine has been the subject
of much litigation, with varying results.
For example, some cases have limited ap-
plication of the plan of rehabilitation doc-
trine to buildings that are not suitable for
their intended use in the taxpayer’s trade or
business. SeeSchroeder v. Commissioner,
T.C. Memo 1996–336;Koanis v. Commis-
sioner, T.C. Memo 1978–184, aff’d mem.,
639F.2d788(9
th
Cir. 1981);Keller Street
Dev. Co. v. Commissioner,37T.C.559
(1961); acq., 1962–2 C.B. 5, aff’d in part,
rev’dinpartonothergrounds,323F.2d
166 (9
th
Cir. 1963). Other courts, as well
astheIRS,haveviewedtheplanofrehabil-
itation doctrine more broadly, emphasiz-
ing the planned aspect of the work done by
the taxpayer, rather than the condition of
the property. SeeMountain Fuel Supply
Co.v.UnitedStates, 449 F.2d 816 (10
th
Cir. 1971);Wolfsen Land & Cattle Co. v.
Commissioner, 72 T.C. 1 (1979); Rev. Rul.
88–57, 1988–2 C.B. 36.
In Rev. Rul. 2001–4, 2001–1 C.B. 295,
the IRS clarified its view of the plan of re-
habilitation doctrine. In applying the plan
of rehabilitation doctrine to the facts in Sit-
uation 3 of that ruling, the IRS noted that
(1) the taxpayer planned to perform sub-
stantial capital improvements to upgrade
the unit of property; (2) the repairs were in-
cidental to the taxpayer’s plan to upgrade
the unit of property; and (3) the effect of
all the work performed on the unit of prop-
erty, including the repairs and maintenance
work, was to materially increase the value
or prolong the useful life of the unit of
property. The ruling also notes that the ex-
istence of a written plan, by itself, is not
sufficient to trigger the plan of rehabilita-
tion doctrine. The ruling’s interpretation
of the plan of rehabilitation doctrine is con-
sistent with the majority of cases apply-
ing that doctrine. SeeCalifornia Casket
Co. v. Commissioner, 19 T.C. 32 (1952),
acq., 1953–1 C.B. 3;Stoeltzing v. Com-
missioner, 266 F.2d 374 (3d Cir. 1959);
Bank of Houston v. Commissioner, T.C.M.
1960–110.
The IRS and Treasury Department do
not believe it is appropriate to capitalize as
an improvement otherwise deductible re-
pair costs solely because the taxpayer has
a plan (written or otherwise) to perform
periodic repairs or maintenance or solely
because the taxpayer performs several re-
pairs to the same property at one time. The
IRS and Treasury Department believe that
it is appropriate to capitalize otherwise de-
ductible repair costs as part of an improve-
ment only if the taxpayer improves a unit
of property and the otherwise deductible
repair costs directly benefit or are incurred
by reason of the improvement to the prop-
erty. Section 263A applies to these expen-
ditures. Section 263A requires that all di-
rect costs of an improvement and all in-
direct costs that directly benefit or are in-
curred by reason of the improvement must
be capitalized. This application of section
263A to otherwise deductible repair costs
in this context is consistent with the appli-
cation of the plan of rehabilitation doctrine
described in Rev. Rul. 2001–4. The pro-
posed regulations provide that repairs that
aremadeatthesametimeasanimprove-
ment, but that do not directly benefit or
are not incurred by reason of the improve-
ment, are not required to be capitalized un-
der section 263(a).
VI.Value
A.In general
The proposed regulations provide that
a taxpayer must capitalize amounts paid
that materially increase the value of a unit
of property and provide an exclusive list
of five tests for determining whether an
amount paid materially increases value.
An amount paid must be capitalized if it
meets any of the five tests. The first test
is whether the amount paid ameliorates a
condition or defect that either existed prior
to the taxpayer’s acquisition of the unit
of property or arose during the production
of the unit of property. SeeUnited Dairy
Farmers, Inc. v. United States, 267 F.3d
510 (6
th
Cir. 2001);Dominion Resources,
Inc. v. United States, 219 F.3d 359 (4
th
Cir. 2000);Jones v. Commissioner,242
F.2d 616 (5
th
Cir. 1957). This rule is con-
sistent with the concept that amounts paid
to put property into ordinarily efficient op-
erating condition must be capitalized. This
pre-existing defect rule applies regardless
of whether the taxpayer was aware of the
condition or defect at the time of acqui-
sition or production. The IRS and Trea-
sury Department considered but rejected
as too subjective the idea of providing dif-
ferent treatment based on the taxpayer’s
prior knowledge of the condition or defect.
The IRS and Treasury Department request
comments on whether, and in what circum-
stances, the pre-existing defect rule should
take into account the condition of the prop-
erty in the hands of a transferor. For ex-
ample, if an individualtransfers property
to a corporation in exchange for stock in
a transaction under section 351, should
the pre-existing defect rule take into ac-
count the condition of the property when
acquired by the individual, rather than the
condition of the property when received by
the corporation?
The second test for materially increas-
ing value is whether the work was per-
formed prior to the date the property is
placed in service by the taxpayer. This
test essentially restates the concept that
amounts paid to put property into ordinar-
ily efficient operating condition must be
capitalized. The IRS and Treasury Depart-
ment believe that if the property cannot be
placed in service prior to work being per-
formed, that work necessarily increases the
value of the property.
Thethirdvaluetestiswhetherthe
amounts paid adapt the property to a new
or different use. The commentators agreed
that this factor should remain a standard
for capitalization. The new or different
use standard is unchanged from the current
regulations, but it is included in the value
section of the proposed regulations, rather
than as its own standard. The new or dif-
ferent use test is not intended to apply to
amounts paid to prepare a unit of property
for sale (for example, painting a house).
The fourth value test is whether the
amount paid results in a betterment or
material addition to the unit of property.
The betterment language is consistent
with the statutory language of section
263(a)(1) as well as the current regulations
at §1.263(a)–1(a)(1). A betterment is an
improvement that does more than restore
to a former good condition. The better-
ment test is intended to capture amounts
paid that are qualitative improvements to
the property that make the property bet-
2006–39 I.R.B.543September 25, 2006

ter and more valuable than mere repairs
would do, such as using upgraded mate-
rials when materials comparable to the
original were available and would have
sufficed. However, the betterment test is
not intended to be a fair market value test.
The fifth test in the value section of
the proposed regulations is whether the
amount paid results in a material increase
in capacity, productivity, efficiency, or
quality of output of the unit of property.
These standards are consistent with case
law under the current regulations.
The proposed regulations provide an
exception to the value tests if the original
economic useful life of the unit of property
is 12 months or less and the taxpayer does
not elect to capitalize amounts paid for the
property. The purpose of this rule is to not
require capitalization under the value rules
for improvements made to 12-month prop-
erty. This exception, however, does not ap-
ply to the restoration rule for determining
whether an amount paid improves prop-
erty. Thus, for example, if a taxpayer per-
forms work on 12-month property that pro-
longs the economic useful life of the prop-
erty, the amount paid must be capitalized.
The proposed regulations do not adopt
an increase in fair market value as a stan-
dard for capitalization. In response to
Notice 2004–6, most commentators stated
that value means fair market value. How-
ever, in practice, taxpayers generally do
not measure, and would have no reason to
measure, the fair market value of a unit of
property prior to some condition necessi-
tating the expenditure. Further, taxpayers
generally have no reason to measure the
fair market value of a unit of property
after the work is performed. The IRS
and Treasury Department did not want
to propose regulations with a standard
that required taxpayers to have property
appraised solely for the purpose of apply-
ing a capitalization standard. In fact, the
courts rarely have applied a strict increase
in fair market value standard. Usually,
the courts rely on some surrogate for fair
market value to determine whether value
is increased. For example, courts have
looked to the amount of the expenditure
versus (1) the cost of the property (see
Stoeltzing v. Commissioner, 266 F.2d 374
(3d Cir. 1959)); (2) the cost of comparable
new property (seeLaSalle Trucking Co.
v. Commissioner, T.C. Memo 1963–274);
and (3) the cost of comparable used prop-
erty (seeIngram Industries, Inc. v. Com-
missioner, T.C. Memo 2000–323). Courts
have considered fair market value only
in a few cases when property has been
appraised for some other purpose (see
Jones v. United States, 279 F. Supp. 772,
774 (D. Del. 1968)), or when property
has been appraised in the course of the
litigation (seeFedEx, 291 F. Supp. 2d at
706–707).
Additionally, the fair market value of
property may change over time without re-
gard to the use, upkeep, or improvements
made by the taxpayer, due to other factors
such as supply and demand or changes in
style, trends, technologies, etc. For ex-
ample, land may increase in fair market
value over time without the taxpayer per-
forming any activities to improve it. Con-
versely, amounts paid to make substantial
improvements to a unit of property may
not always increase fair market value, or
may not increase the fair market value by
the full amount paid for the improvements.
See,Harrah’s Club v. United States,661
F.2d 203 (Ct. Cl. 1981) (amount paid to
restore antique automobiles must be capi-
talized even though restoration did not in-
crease fair market value by the amount
paid for the restoration). Attempting to ad-
just fair market value for factors like these
further complicates any possible compar-
ison. The IRS and Treasury Department
believe that the fair market value standard
is too subjective and impractical, particu-
larly because most repairs also increase the
fair market value of property if the value is
compared immediately before and after the
work is performed. Therefore, the IRS and
Treasury Department do not believe that
fair market value is an appropriate stan-
dard. The value factors in the proposed
regulations are intended to be objective in-
dications of work performed that generally
would increase the fair market value of the
unit of property. Whether amounts paid
materially increase the value of a unit of
property requires an analysis of the pur-
pose, the physical nature, and the effect of
the work for which the amounts were paid,
and not an analysis of the fair market value
of the property or the level of monetary ex-
penditures.
Some commentators requested that the
regulations provide a bright line rule defin-
ing a material increase in value with re-
spect to a specified percentage increase,
for example a twenty-five percent increase
in capacity. The IRS and Treasury De-
partment do not believe that providing a
fixed percentage as a presumption of what
is a material increase would be an ap-
propriate safe harbor. Although perhaps
measurable, the same fixed percentage in-
crease in capacity would not work well as
a rule applicable to all types of property.
A twenty-five percent increase in capacity
may be a reasonable litmus test for deter-
mining whether there has been a material
increase in value for certain types of prop-
erty. However, for many types of property,
a much smaller increase in capacity may
be an extraordinary, or in some cases im-
possible, improvement. For example, an
increase in the square footage of a 50,000
square foot building by 5 percent would be
a rather large improvement that should be
capitalized. Therefore, the determination
of whether an increase in capacity, produc-
tivity, efficiency, or quality is a material in-
crease in value should be based on all the
facts and circumstances.
B.Appropriate comparison
Notice 2004–6 requested comments
on the proper starting point for compar-
ing whether an expenditure materially
increases the value of property. Almost all
the commentators suggested that the pro-
posed regulations adopt the test set forth
inPlainfield-Union Water Co. v. Commis-
sioner, 39 T.C. 333 (1962), nonacq. on
other grounds (1964–2 C.B. 8) (the Plain-
field-Union test). In that case, the court
noted that almost any properly performed
repair adds value as compared with the
situation existing immediately prior to
that repair. The proper test, the court
said, is whether the expenditure materially
enhances the value of the property as com-
pared with the status of the property prior
to the condition necessitating the expen-
diture. The court also noted that the test
is appropriate even when the expenditure
does not arise from a sudden, unexpected,
or unusual external circumstance.
The IRS and Treasury Department
agree with this application of the Plain-
field-Union test and believe that the test is
appropriately applied to cases of normal
wear and tear as well as cases when the
expenditure arises from a sudden, unex-
pected, or unusual external circumstance.
The proposed regulations adopt the Plain-
field-Union test for cases in which a partic-
September 25, 20065442006–39 I.R.B.

ular event necessitates the expenditure and
clarify that when the event necessitating
the expenditure is normal wear and tear,
the condition of the property immediately
prior to the event necessitating the ex-
penditure is the condition of the property
after the last time the taxpayer corrected
the effects of normal wear and tear or, if
the taxpayer has not previously corrected
the effects of normal wear and tear, the
condition of the property when placed in
service by the taxpayer. This comparison
rule for wear and tear is intended to apply
when a taxpayer engages in regular, cycli-
cal maintenance of a unit of property to
correct the effects of normal wear and tear.
Although wear and tear begins affecting
the condition of property as soon as it is
placed in service, the proposed regulations
do not adopt the placed-in-service date
as the appropriate comparison point. Al-
though the placed-in-service date would
be the appropriate comparison point when
the taxpayer first corrects the effects of
normal wear and tear, the IRS and Trea-
sury Department believe that the condition
of the property after the previous mainte-
nance cycle is the appropriate comparison
point for each subsequent maintenance
cycle.
The Plainfield-Union test works well
when the amount paid is necessitated by a
specific event (like amounts paid to repair
damage or amounts paid to maintain prop-
erty by correcting the effects of wear and
tear). However, the test does not work in
a pure improvement setting; that is, when
a taxpayer decides to improve property
without any event causing the taxpayer
to perform the work to restore the prop-
erty to a former good condition. There-
fore, the proposed regulations do not ap-
ply the Plainfield-Union test to the first
three value factors (pre-existing defects,
work performed prior to the property being
placed in service, and adapting the prop-
erty to a new or different use). These fac-
tors are more appropriately analyzed on an
absolute, rather than relative basis. Sim-
ilarly, the test does not work well for bet-
terments, which by definition are improve-
ments that do more than restore property to
a former good condition.
VII.Restoration
The proposed regulations provide that
a taxpayer must capitalize amounts paid to
restore property. The restoration lan-
guage is from section 263(a)(2) and
§1.263(a)–1(a)(2) of the current regu-
lations and generally has been viewed
as a rule requiring the capitalization
of amounts paid that substantially pro-
long the useful life of the property. See
§1.263(a)–1(b). This section of the pro-
posed regulations defines economic useful
life and what it means to substantially
prolong economic useful life.
The comments received in response
to Notice 2004–6 varied greatly with re-
gard to useful life, with two commentators
specifically suggesting that the concept of
useful life be eliminated from the regula-
tions. The other commentators suggested
that economic useful life be defined as the
period of time over which the property
is expected to be useful to the taxpayer,
taking into account the various factors
listed in §1.167(a)–1(b). The proposed
regulations adopt this definition of eco-
nomic useful life for taxpayers that do not
have an AFS. Economic useful life is not
determined by reference to the recovery
period under section 168 for the property.
For a taxpayer that has an AFS, the eco-
nomic useful life of the property is pre-
sumed to be the same as the useful life
used by the taxpayer for purposes of deter-
mining depreciation in its AFS. The IRS
and Treasury Department believe that the
economic useful life definition is subjec-
tive and difficult to apply; therefore, this
rule provides certainty for taxpayers with
an AFS. The regulations provide an excep-
tion to this rule for situations in which a
taxpayer does not assign a useful life to
certain property in its AFS, even though
thepropertyhasausefullifeofmorethan
one year. For example, a taxpayer may
treat amounts paid for a unit of property
as an expense in its AFS if the property is
used in a specific research project and has
no alternative future uses. Additionally,
many taxpayers have a policy of treating
as an expense in their AFS an amount paid
for tangible property below a certain dol-
lar threshold, despite the fact that the prop-
erty has a useful life of more than one year.
This type of property does not have a use-
ful life for purposes of determining depre-
ciation in the taxpayer’s AFS, even though
itmayhaveausefullifeofmorethanone
year. Therefore, the IRS and Treasury De-
partment believe that in these situations it
is appropriate for taxpayers to use the eco-
nomic useful life definition that applies to
taxpayers without an AFS.
One commentator stated that the useful
life used for book depreciation purposes is
not appropriate fortax purposes because
the book useful life takes into account fac-
tors that do not measure the inherent useful
life, but rather the period over which the
property is expected to be useful (on av-
erage) to the taxpayer. The IRS and Trea-
sury Department believe it is appropriate
to take into account the period over which
the property may reasonably be expected
to be useful to the taxpayer, as required by
taxpayers without an AFS, rather than the
inherent useful life of the property.
The proposed regulations also provide
four rules for determining when an amount
paid substantially prolongs economic use-
ful life. The first rule requires capitaliza-
tion when the amount paid extends the pe-
riod over which the property may reason-
ably be expected to be useful to the tax-
payer beyond the end of the taxable year
immediately succeeding the taxable year
in which the economic useful life of the
property was originally expected to cease.
One commentator suggested that the reg-
ulations provide a safe harbor bright line
rule to define whether an amount substan-
tially prolongs the useful life. The IRS
and Treasury Department believe that a
one year rule is an appropriate bright line.
Therefore, the regulations require capital-
ization when the amount paid extends the
original useful life of the property by more
than one taxable year. The IRS and Trea-
sury Department believe that a one year
rule is a more appropriate bright line than
a rule based on a percentage of the useful
life, because the one-year rule corresponds
with the 12-month safe harbor rule for the
acquisition or production of property.
The second rule requires capitalization
if a major component or a substantial struc-
tural part of the unit of property is replaced
and notes that the replacement of a rela-
tively minor portion of the physical struc-
ture of the unit of property or a relatively
minor portion of any of its major parts does
not constitute the replacement of a major
component or substantial structural part of
the unit of property. It is possible, how-
ever, for amounts paid to replace a rela-
tively minor portion of the physical struc-
ture of the unit of property or a relatively
minorportionofanyofitsmajorparts
to substantially prolong the economic use-
2006–39 I.R.B.545September 25, 2006

ful life of the property if the property is
near the end of its economic useful life,
in which case the amounts paid neverthe-
less must be capitalized. The rule is not in-
tended to require capitalization if a major
component is replaced with a similar, used
component that has not been rebuilt, for
example, if the engine in a car is replaced
with a used engine with similar mileage
obtained from a junkyard, or a component
of property subject to a warranty or main-
tenance agreement is replaced with a used
part that has been repaired.
Although the replacement of minor
parts does not usually prolong the eco-
nomic useful life of most property, the
replacement of most or all minor parts for
some types of property may be the equiva-
lent of rebuilding the property, particularly
in cases in which the property consists al-
most entirely of minor parts. Therefore,
the third rule provides that amounts paid
that restore a unit of property (or a major
component or substantial structural part of
the unit of property) to a like-new condi-
tion substantially prolong the useful life.
The IRS and Treasury Department intend
that this test be applied to situations in
which the property undergoes the equiva-
lent of being rebuilt. Merely recondition-
ing a property by dismantling the property,
and cleaning and inspecting components,
is not the equivalent of rebuilding. All or
almost all major and minor parts of the
unit of property (or the major component
or substantial structural part of the unit of
property) must be returned to the original
manufacturers’ specifications.
The fourth rule relates to the restoration
of a unit of property after the taxpayer has
properly deducted a casualty loss under
section 165 with respect to the property.
Section 165(a) allows a taxpayer to deduct
any loss sustained during the taxable year
and not compensated for by insurance
or otherwise. Generally, any loss arising
from a fire, storm, shipwreck, or other
casualty is allowable as a deduction under
section 165(a). Section 1.165–7(a)(1).
The amount of the deduction is the dif-
ference between the fair market value of
the property before and after the casualty,
to the extent the amount does not exceed
the property’s adjusted basis. Section
1.165–7(b)(1). A casualty loss deduction
under section 165(a) results in a decrease
in the taxpayer’s basis in the property.
The courts have distinguished between
losses that are deductible as casualties
under section 165(a) and incidental repair
costs that are deductible under section
162(a) as ordinary and necessary business
expenses. In general, if property is lost,
destroyed, or abandoned as a result of a
casualty, a loss deduction under section
165(a) is appropriate; however, if property
is simply damaged in a casualty and ex-
penditures are made to repair the property
in a manner that does not permanently im-
proveorbetteritorprolongitsusefullife,
those expenditures are business expenses
deductible under section 162(a).Hensler
v. Commissioner, 73 T.C. 168, 179 (1979);
see alsoHubinger v. Commissioner,36
F.2d 724, 726 (2d Cir. 1929) (expenses
resulting from “trifling accidental causes”
are deductible only under section 162(a)
and not under section 165(a));Atlantic
Greyhound Corp. v. United States,111
F. Supp. 953 (1953) (“the provisions for
deductions of ‘ordinary and necessary ex-
penses’ and ‘casualty losses’ would seem
to be mutually exclusive, for the normal
connotation of one negates, at least by
implication, the idea of the other”). Thus,
the mere fact that the damage results from
a casualty is not controlling; instead, the
nature of the damage resulting from the ca-
sualty is relevant in determining whether
the expenditure should be treated as a loss
or deduction.
The IRS and Treasury Department
believe that when a taxpayer properly
deducts a casualty loss, the nature of the
damage resulting from the casualty is
such that any repairs done to restore the
property after the casualty should not be
treated as ordinary and necessary repair
costs. Thus, the proposed regulations
provide that any amounts paid to repair
property after a casualty loss must be cap-
italized.
Commentators stated that amounts paid
at any point during the property’s eco-
nomic useful life that do not change the
function, design, etc., but enable prop-
erty to be used for itsexpected useful life
should not be determined to extend the
useful life. The IRS and Treasury Depart-
ment believe that there are circumstances
in which amounts paid that merely restore
property to a former good condition may
properly be capitalized as substantially
prolonging useful life, for example, when
repairs are made to property after a ca-
sualty loss. As another example, work
performed at the end of the economic use-
ful life of the unit of property may extend
the property’s useful life. Additionally,
replacement of a major component or a
substantial structural part of a unit of prop-
erty extends the useful life, particularly
when the expected life of the component is
coterminous with the economic useful life
of the unit of property, and the economic
useful life of the unit of property is in
fact limited by the period over which the
component is expected to be useful. Thus,
the proposed regulations do not adopt the
commentators’ suggestion.
VIII.Repair Allowance Method
A.In general
The primary focus of the proposed
regulations is to provide guidance that dis-
tinguishes deductible repair expenses from
capital expenditures. However, because
this remains inherently a facts-and-cir-
cumstances based determination, the IRS
and Treasury Department requested com-
ments in Notice 2004–6 on whether the
regulations should provide a repair al-
lowance. Six commentators suggested
the regulations should provide a repair
allowance or otherde minimisrules for
repair expenditures. Two commentators
specifically proposed a repair allowance
system modeled on the former CLADR re-
pair allowance system. The proposed reg-
ulations adopt these suggestions and pro-
vide an optional repair allowance method,
similar to the CLADR repair allowance,
to create objective rules in this area. Al-
though some commentators additionally
requested otherde minimisrules for re-
pair expenditures as well, the IRS and
Treasury Department believe that a repair
allowance is an appropriate safe harbor
for repair expenditures. Therefore, the
proposed regulations do not provide a safe
harbor other than the repair allowance.
Under the repair allowance in the pro-
posed regulations, the taxpayer compares
the amounts paid for materials and labor
during the taxable yearto repair, maintain,
or improve repair allowance property to
the repair allowanceamount. The amounts
paid are deductible under section 162 to
the extent of the repair allowance amount,
and any excess amounts paid are capital-
ized. Under the proposed repair allowance
September 25, 20065462006–39 I.R.B.

method, a repair allowance amount is
determined separately for each MACRS
class. The repair allowance amount for
a particular class is determined by multi-
plying the repair allowance percentage in
effect for that class by the average unad-
justed basis of repair allowance property
in that class. For buildings that are repair
allowance property, the repair allowance
method is applied separately to each build-
ing. This rule is consistent with the rule
for buildings under the CLADR repair
allowance system.
B.Capitalized amount
The excess of amounts paid to re-
pair, maintain, or improve all the repair
allowance property in a MACRS class
over the repair allowance amount for the
class must be capitalized (the capital-
ized amount). The capitalized amount
includes the taxpayer’s direct costs of re-
pairing, maintaining, or improving repair
allowance property in a particular MACRS
class. In addition, the taxpayer must add
to the capitalized amount any allocable
indirect costs of producing the repair al-
lowance property in the MACRS class,
which must be capitalized in accordance
with the taxpayer’s method of accounting
for section 263A costs. Except with re-
gard to repair allowance property that is
depreciated under section 168(g) or repair
allowance property that is public utility
property (for which separate rules are pro-
vided), the proposed regulations permit
taxpayers to choose one of two methods of
treating the capitalized amount. The first
method is to treat the capitalized amount
as a separate single asset and to depreciate
the asset in accordance with that MACRS
class. The second method is to allocate
the capitalized amount for a particular
MACRS class to all repair allowance
property in the particular MACRS class
in proportion to the unadjusted basis of
thepropertyinthatMACRSclassasof
the beginning of the taxable year. Under
either the single asset method or the allo-
cation method, the capitalized amount is
treated as a section 168(i)(6) improvement
and is treated as placed in service by the
taxpayer on the last day of the first half
of the taxable year in which the amount is
paid, before application of the convention
under section 168(d). For example, the
capitalized amount for a calendar year tax-
payer would be treated as placed in service
on June 30 of the taxable year.
Because the single asset treatment does
not permit taxpayers to recognize a gain or
loss on the disposition of repair allowance
property, the IRS and Treasury Depart-
ment request comments on whether, in the
final regulations, taxpayers should be per-
mitted to change to the allocation treat-
ment for the taxable year of disposition and
if so, what record keeping rules or other
rules should be required for taxpayers to
make that change. With regard to the allo-
cation treatment, the IRS and Treasury De-
partment request comments on whether the
allocation should be based on an amount
other than the unadjusted basis as of the
beginning of the taxable year, such as the
unadjusted basis at the end of the taxable
year or the average unadjusted basis.
C.Repair allowance property
Repair allowance property is defined
in the proposed regulations as real or per-
sonal property subject to MACRS that
is used in the taxpayer’s trade or busi-
ness or for the production of income. It
also includes certain tangible property
not otherwise subject to MACRS if the
taxpayer, solely for purposes of the repair
allowance method, classifies the property
in the appropriate MACRS class in which
the property would be included if the prop-
erty were subject to MACRS. Taxpayers
arenotrequiredtoclassifynon-MACRS
property (property placed in service be-
fore the effective date of section 168 and
property for which the taxpayer properly
elected out of section 168). Non-classi-
fied property will not be repair allowance
property eligible for the repair allowance
method. Certain types of property are
not included in repair allowance prop-
erty, including any property for which the
taxpayer has elected to use the CLADR
repair allowance method and property for
which the taxpayer uses the method of ac-
counting provided in Rev. Proc. 2001–46,
2001–2 C.B. 263, or Rev. Proc. 2002–65,
2002–2 C.B. 700 (both with regard to rail-
road track). Thus, the repair allowance in
the proposed regulations does not repeal
the CLADR repair allowance, nor does it
prohibit taxpayers from using the repair
allowance method in these regulations for
repair allowance property, while contin-
uing to use the CLADR repair allowance
for other property.
D.Excluded additions
Repair allowance property also does
not include excluded additions, the cost of
which must be capitalized. The CLADR
repair allowance system has a similar rule.
Under the CLADR repair allowance sys-
tem, excluded additions are defined as
any expenditures (1) that increase by 25%
or more the productivity or capacity of
an existing identifiable unit of property
over its productivity or capacity when first
acquired; (2) that modify an existing iden-
tifiable unit of property for a substantially
different use; (3) for an additional iden-
tifiable unit of property or a replacement
of an identifiable unit of property that was
retired; (4) for a replacement of a part in
or a component or portion of an existing
identifiable unit of property if such part,
component, or portion is for replacement
of a part, component or portion which was
retired in a retirement upon which gain or
loss was recognized; (5) in the case of a
building or other structure, for additional
cubic or linear space; and (6) in the case of
those units of property of pipelines, elec-
tric utilities, telephone companies, and
telegraph companies consisting of lines,
cables, and poles, for replacement of 5%
or more of the unit of property with respect
to which the replacement is made.
One commentator suggested that the
proposed regulations should not have
excluded additions similar to those in the
CLADR repair allowance because they are
too qualitative and difficult to administer.
The IRS and Treasury Department agree
that some of the items listed as excluded
additions under the CLADR system are
too subjective and do not provide the kind
of objective determination the proposed
repair allowance is intended to provide.
For this reason, the proposed regulations
limit the excluded additions to amounts
paid (1) for the acquisition or produc-
tion of a specific unit of property; (2)
for work that ameliorates a condition or
defect that either existed prior to the tax-
payer’s acquisition of the unit of property
or arose during the production of the unit
of property, whether or not the taxpayer
was aware of the condition or defect at
the time of acquisition or production; (3)
for work performed prior to the date the
2006–39 I.R.B.547September 25, 2006

unit of property is placed in service by the
taxpayer (without regard to any applicable
convention under section 168(d)); (4) that
adapts the unit of property to a new or dif-
ferent use; or (5) that increases the cubic
or square space of a building.
Thus, the proposed regulations adopt
excluded additions 2, 3, and 5 in the
CLADR repair allowance. These ex-
cluded additions are also listed in
§1.263(a)–3(e)(1) of the proposed reg-
ulations as factors that indicate a material
increase in value. The regulations do not
adopt excluded addition 1 in the CLADR
repair allowance because an increase in
productivity or capacity of 25% or more
may be too difficult to measure. The reg-
ulations do not specifically cite excluded
addition 4 from the CLADR repair al-
lowance; however, if a part, component,
or portion of a unit of property is retired
in a retirement upon which gain or loss
properly was recognized, the replacement
of that component is a separate unit of
property under §1.263(a)–3(d)(2) of the
proposed regulations and thus is addressed
by excluded addition 1 of the proposed
regulations. Excluded addition 6 in the
CLADR repair allowance addresses net-
work assets and was not adopted in the
proposed regulations pending comments
on how the final regulations should ad-
dress the unit of property rules relating to
network assets.
In addition to the three excluded addi-
tions that the proposed regulations carry
over from the CLADR repair allowance,
the excluded additions in the proposed reg-
ulations include amounts paid for work
that ameliorates a pre-existing condition
or defect and for work performed prior to
the date the unit of property is placed in
service by the taxpayer. These two ex-
cluded additions also are listed as factors
in §1.263(a)–3(e)(1) of the proposed reg-
ulations that indicate a material increase
value. The IRS and Treasury Department
believe that the excluded additions pro-
vided in the repair allowance in the pro-
posed regulations are more objective than
those in the CLADR regulations and are
easier to verify.
E.Leased property
Like the repair allowance under
CLADR, repair allowance property does
not include property leased by the tax-
payer from another party. One commen-
tator suggested that the repair allowance
apply to leased property. The IRS and
Treasury Department recognize that tax-
payers that lease property confront the
same issues as owners in distinguishing
deductible repairs from capital improve-
ments. However, the application of the re-
pair allowance method to leased property
raises several difficult issues. The IRS and
Treasury Department request comments
on whether the repair allowance method
should be extended toleased property and,
if so, how the following issues should be
resolved: (1) How should the unadjusted
basis of leased property be determined?
Should fair market value be used instead
of unadjusted basis and, if so, how and
when should fair market value be deter-
mined? (2) How should the regulations be
drafted to prevent abuse between related
lessors and lessees? (3) How should the
regulations be drafted to prevent both the
lessor and lessee from using the repair
allowance method for the same property?
(4) How should the regulations address
qualified lessee construction allowances
for short-term leases under section 110?
(5) What is the proper treatment of the
capitalized amount for leased property
under the repair allowance? (6) Should
lessees be permitted to classify the leased
property to a MACRS class and use one of
the treatments of the capitalized amount
in the proposed regulations? (7) Should
the capitalized amount be allocated to
individual leases and amortized over the
remaining term of each lease and, if so,
how should that allocation be made? (8) If
the taxpayer has a number of leases with
varying lease terms, should the capitalized
amount be allocated to certain groups of
leases and amortized over the average re-
maining term of the leases and if so, how
should the leases be grouped? (9) Are
there any other issues with regard to the
application of a repair allowance to leased
property that need to be addressed?
F.Network assets
The definition of repair allowance prop-
erty in the proposed regulations does not
specifically exclude network assets. How-
ever, application of the repair allowance
requires a determination of the appropriate
unit of property, in particular with regard
to identifying excluded additions. The unit
of property determination with regard to
network assets is not addressed in the pro-
posed regulations and is an issue on which
the IRS and Treasury Department have re-
quested comments. Therefore, the IRS and
Treasury Department anticipate that final
regulations specifically will include net-
work assets as repair allowance property
if appropriate unit of property rules can be
determined. If appropriate unit of property
rules cannot be determined for network as-
sets, the IRS and Treasury Department re-
quest comments on whether to develop in-
dustry-specific guidance on how the repair
allowance method should apply (in partic-
ular, how excluded additions should be de-
termined) with regard to network assets in
a particular industry.
G.Repair allowance percentages
The repair allowance percentages un-
der the CLADR repair allowance were
determined by the Treasury Department’s
Office of Industrial Economics, which
is no longer in existence. The percent-
ages were published in various revenue
procedures (most recently in Rev. Proc.
83–35, 1983–1 C.B. 745), made obsolete
by Rev. Proc. 87–56, 1987–2 C.B. 674,
with regard to property subject to section
168, and were revised and supplemented
periodically. The proposed regulations
create a new repair allowance percent-
age for each MACRS class. These rates
are based on the principle that a taxpayer
will spend 50% of the property’s unad-
justed basis on repairs over the property’s
MACRS recovery period. Thus, the re-
pair allowance percentages for a particular
MACRS class in the proposed regulations
were computed by: (1) dividing 100% by
the number of years in the recovery period
for the MACRS class, which represents
the portion of the property’s unadjusted
basis that is allocable to each year of the
recovery period, and; (2) multiplying the
result by 50%. For example, if a tax-
payer has repair allowance property in
a MACRS class with a 5 year recovery
period, 100% divided by 5 is 20%, which
represents the portion of the property’s
unadjusted basis that is allocable to each
year of the recovery period. Multiplying
the 20% amount by 50% results in a re-
pair allowance percentage of 10% for that
MACRS class.
September 25, 20065482006–39 I.R.B.

The IRS and Treasury Department re-
quest comments on whether the repair
allowance percentages should be different
than those provided in the proposed reg-
ulations, whether the rates in Rev. Proc.
83–35 should be used, and whether the
final regulations should permit taxpay-
ers to choose between repair allowance
percentages in Rev. Proc. 83–35 and
the final regulations. The IRS and Trea-
sury Department also request comments
on whether a separate repair allowance
percentage should be provided for certain
types of property, such as repair allowance
property subject to section 168(g) (for
example, a percentage that reflects the
recovery period under the alternative de-
preciation system in section 168(g) rather
than the MACRS recovery period under
section 168). Finally, the IRS and Trea-
sury Department request comments on
whether industries should be permitted
to request guidance through the Industry
Issue Resolution program to establish dif-
ferent repair allowance percentages for
their particular industry.
H.Manner of electing and manner of
revoking election
The proposed regulations reserve the is-
sue of how a taxpayer will elect the re-
pair allowance method. Two commenta-
tors suggested that taxpayers be permitted
to elect the repair allowance on a year by
year basis. The IRS and Treasury Depart-
ment disagree with this suggestion. The
repair allowance method is a method of ac-
counting under section 446(e) and should
be used consistently by taxpayers. Allow-
ing a year by year election would com-
plicate a taxpayer’s record keeping and
would create a burden on IRS examining
agents when auditing a taxpayer’s com-
pliance with the repair allowance method.
Therefore, the IRS and Treasury Depart-
ment do not expect to permit a year by
year election. However, even though the
repair allowance method is a method of
accounting under section 446(e), the IRS
and Treasury Department expect to pro-
vide that taxpayers may elect the repair
allowance method prospectively without
having to file an application for change in
accounting method and that the election
be done on a cutoff basis. Procedures for
electing the repair allowance method will
be provided either in the final regulations
or in published guidance in the Internal
Revenue Bulletin.
The proposed regulations provide that
the repair allowance method, if elected,
must be elected for all repair allowance
property. A taxpayer may revoke an elec-
tion made under the repair allowance
method only by obtaining the Commis-
sioner’s consent. Procedures for obtaining
the Commissioner’s consent to revoke an
electionwillbeprovidedeitherinthefinal
regulations or in published guidance in the
Internal Revenue Bulletin. The IRS and
Treasury Department expect to provide
that a taxpayer that revokes an election
may not re-elect the repair allowance
method for a period of at least five tax-
able years, beginning with the year of the
revocation unless, based on a showing of
unusual and compelling circumstances,
consent is specifically granted by the
Commissioner to re-elect the repair al-
lowance at an earlier time. The IRS and
Treasury Department request comments
on the appropriateness of the five year
waiting period, as well as on the circum-
stances that should be considered unusual
and compelling so that the Commissioner
would grant consent to re-elect the repair
allowance prior to expiration of the five
year waiting period.
I.Record keeping
The proposed regulations do not impose
any specific record keeping requirements.
However, under section 6001, taxpayers
are required to keep books and records suf-
ficient to establish the amounts used to
compute a deduction under the repair al-
lowance method. For example, taxpayers
must maintain books and records reason-
ably sufficient to determine (1) the total
amounts paid (other than amounts paid for
excluded additions) during the taxpayer
year for the repair, maintenance, or im-
provement of repair allowance property in
the specific MACRS class; (2) the unad-
justed basis of all repair allowance prop-
erty in the specific MACRS class at the
beginning and the end of the taxable year;
(3) the repair allowance percentages used
for the specific MACRS class for the tax-
able year; and (4) the treatment of the cap-
italized amounts (whether capitalized as a
single asset or allocated to all repair al-
lowance property in the specific MACRS
class).
Proposed Effective Date
These regulations are proposed to ap-
ply to taxable years beginning on or af-
ter the date the final regulations are pub-
lished in theFederal Register.Thefinal
regulations will provide rules applicable to
taxpayers that seek to change a method of
accounting to comply with the rules con-
tained in the final regulations. Taxpay-
ers may not change a method of account-
ing in reliance upon the rules contained in
the proposed regulations until the rules are
published as final regulations in theFed-
eral Register.
The IRS and Treasury Department an-
ticipate that, except as otherwise provided
(for example, in the repair allowance sec-
tion), the final regulations will provide
that a taxpayer seeking to change to a
method of accounting provided in the fi-
nal regulations mustfollow the applicable
procedures for obtaining the Commis-
sioner’s automatic consent to a change in
accounting method. Generally, a change in
method of accounting is made using an ad-
justment under section 481(a). However,
the IRS and Treasury Department are con-
cerned about the potential administrative
burden on taxpayers and the IRS that may
result from section 481(a) adjustments that
originate many years prior to the effective
date of the final regulations. The IRS and
Treasury Department request comments
on whether there are circumstances in
which it is appropriate to permit a change
in method of accounting to be made using
a cut-off basis instead of a section 481(a)
adjustment. Finally, the IRS and Treasury
Department request comments on any ad-
ditional terms and conditions for changes
in methods of accounting that would be
helpful to taxpayers in adopting the rules
contained in these proposed regulations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in Exec-
utive Order 12866. Therefore, a regula-
tory assessment is not required. It also has
been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regu-
lations, and, because the regulation does
not impose a collection of information on
small entities, the Regulatory Flexibility
2006–39 I.R.B.549September 25, 2006

Act (5 U.S.C. chapter 6) does not apply.
Pursuant to section 7805(f) of the Code,
this notice of proposed rulemaking will be
submitted to the Chief Counsel for Advo-
cacy of the Small Business Administration
for comment on its impact on small busi-
ness.
Comments and Public Hearing
Before the proposed regulations are
adopted as final regulations, consideration
will be given to any written comments
(a signed original and eight (8) copies)
or electronic comments that are submitted
timely to the IRS. Comments are requested
on all aspects of the proposed regulations.
In addition, the IRS and Treasury Depart-
ment specifically request comments on
the clarity of the proposed rules and how
they may be made easier to understand.
All comments will be available for public
inspection and copying.
A public hearing has been scheduled
for Tuesday, December 19, 2006, at 10:00
a.m., in the auditorium of the New Car-
rollton Federal Building, 5000 Ellin Road,
Lanham, MD 20706. Due to building se-
curity procedures, visitors must enter at
the main front entrance. In addition, all
visitors must presentphoto identification
to enter the building. Because of access
restrictions, visitors will not be admitted
beyond the immediate entrance area more
than 30 minutes before the hearing starts.
For information about having your name
placed on the building access list to attend
the hearing, see the “FOR FURTHER IN-
FORMATION CONTACT” section of this
preamble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
present oral comments at the hearing must
submit electronic or written comments and
an outline of the topics to be discussed and
the time to be devoted to each topic (signed
original and eight (8) copies) by Novem-
ber 28, 2006. A period of 10 minutes will
be allotted to each person for making com-
ments. An agenda showing the scheduling
of the speakers will be prepared after the
deadline for receiving outlines has passed.
Copies of the agenda will be available free
of charge at the hearing.
Drafting Information
The principal author of these regula-
tions is Kimberly L. Koch, Office of the
Associate Chief Counsel (Income Tax and
Accounting), IRS. However, other person-
nel from the IRS and Treasury Department
participated in their development.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR part 1 is proposed
to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.162–4 is revised to
read as follows:
§1.162–4 Repairs.
Amounts paid for repairs and mainte-
nance to tangible property are deductible
if the amounts paid are not required to be
capitalized under §1.263(a)–3.
Par. 3. Section 1.263(a)–0 is amended
by revising the entries for §1.263(a)–1
through §1.263(a)–3 to read as follows:
§1.263(a)–0 Table of contents. * * *
§1.263(a)–1 Capital expenditures; in
general.
(a) General rule for capital expendi-
tures.
(b) Examples of capital expenditures.
(c) Amounts paid to sell property.
(1) In general.
(2) Treatment of capitalized amount.
(3) Examples.
(d) Amount paid.
(e) Effective date.
(f) Accounting method changes.
§1.263(a)–2 Amounts paid to acquire or
produce tangible property.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(4) Produce.
(c) Coordination with other provisions
of the Internal Revenue Code.
(1) In general.
(2) Materials and supplies.
(d) Acquired or produced tangible prop-
erty.
(1) In general.
(i) Requirement of capitalization.
(ii) Examples.
(2) Defense or perfection of title to tan-
gible property.
(i) In general.
(ii) Examples.
(3) Transaction costs.
(i) In general.
(ii) Examples.
(4) 12-month rule.
(i) In general.
(ii) Coordination with section 461.
(iii) Exceptions to 12-month rule.
(iv) Character of property subject to
12-month rule.
(v) Election to capitalize.
(vi) Examples.
(e) Treatment of capital expenditures.
(f) Recovery of capitalized amounts.
(1) In general.
(2) Examples.
(g) Effective date.
(h) Accounting method changes.
§1.263(a)–3 Amounts paid to improve
tangible property.
(a) Overview.
(b) Definitions.
(1) Amount paid.
(2) Personal property.
(3) Real property.
(c) Coordination with other provisions
of the Internal Revenue Code.
(1) In general.
(2) Example.
(d) Improved property.
(1) Capitalization rule.
(2) Determining the appropriate unit of
property.
(i) In general.
(ii) Initial unit of property determina-
tion.
(iii) Category I: Taxpayers in regulated
industries.
(iv) Category II: Buildings and struc-
tural components.
(v) Category III: Other personal prop-
erty.
(vi) Category IV: Other real property.
(vii) Additional rule.
(viii) Examples.
(3) Compliance with regulatory re-
quirements.
(4) Unavailability of replacement parts.
September 25, 20065502006–39 I.R.B.

(5) Repairs performed during an im-
provement.
(i) In general.
(ii) Exception for individuals.
(e) Value.
(1) In general.
(2) Exception.
(3) Appropriate comparison.
(4) Examples.
(f) Restoration.
(1) In general.
(2) Economic useful life.
(i) Taxpayers with an applicable finan-
cial statement.
(ii) Taxpayers without an applicable fi-
nancial statement.
(iii) Definition of “applicable financial
statement.”
(3) Substantially prolonging economic
useful life.
(i) In general.
(ii) Replacements.
(iii) Restoration to like-new condition.
(iv) Restoration after a casualty loss.
(4) Examples.
(g) Repair allowance method.
(1) In general.
(2) Election of repair allowance
method.
(3) Application of repair allowance
method.
(4) Repair allowance amount.
(i) In general.
(ii) Average unadjusted basis.
(iii) Unadjusted basis.
(iv) Buildings.
(5) Capitalized amount.
(i) In general.
(ii) Single asset treatment of capitalized
amount.
(iii) Allocation treatment of capitalized
amount.
(iv) Section 168(g) repair allowance
property.
(v) Section 168(g) election.
(vi) Public utility property.
(6) Repair allowance property.
(i) In general.
(ii) Certain property not subject to sec-
tion 168.
(iii) Exclusions from repair allowance
property.
(7) Excluded additions.
(i) In general.
(ii) Treatment of excluded additions.
(8) Repair allowance percentage.
(9)Mannerofelection.
(10) Manner of revoking election.
(11) Examples.
(h) Treatment of capital expenditures.
(i) Recovery of capitalized amounts.
(j) Effective date.
(k) Accounting method changes.
*****
Par. 4. Sections 1.263(a)–1 through
1.263(a)–3 are revised to read as follows:
§1.263(a)–1 Capital expenditures; in
general.
(a)General rule for capital expendi-
tures. Except as provided in chapter 1 of
the Internal Revenue Code, no deduction
is allowed for—
(1) Any amount paid for new buildings
or for permanent improvements or better-
mentsmadetoincreasethevalueofany
property or estate, or
(2) Any amount paid in restoring prop-
erty or in making good the exhaustion
thereof for which an allowance is or has
been made in the form of a deduction for
depreciation, amortization, or depletion.
(b)Examples of capital expenditures.
The following amounts paid are examples
of capital expenditures:
(1) An amount paid to acquire or
produce real or personal property. See
§1.263(a)–2.
(2) An amount paid to improve real or
personal property. See §1.263(a)–3.
(3) An amount paid to acquire or create
intangibles. See §1.263(a)–4.
(4) An amount paid or incurred to facil-
itate an acquisition of a trade or business,
a change in capital structure of a business
entity, and certain other transactions. See
§1.263(a)–5.
(5) An amount assessed and paid un-
der an agreement between bondholders or
shareholders of a corporation to be used in
a reorganization of thecorporation or vol-
untary contributions by shareholders to the
capital of the corporation for any corporate
purpose. See section 118 and §1.118–1.
(6) An amount paid by a holding com-
pany to carry out a guaranty of dividends
at a specified rate on the stock of a sub-
sidiary corporation for the purpose of se-
curing new capital for the subsidiary and
increasing the value of its stockholdings in
the subsidiary. This amount must be added
to the cost of the stock in the subsidiary.
(c)Amounts paid to sell property—(1)
In general. Commissions and other trans-
action costs paid to facilitate the sale
of property generally must be capitalized.
However, in the case of dealers in property,
amounts paid to facilitate the sale of prop-
erty are treated as ordinary and necessary
business expenses. See §1.263(a)–5(g) for
the treatment of amounts paid to facilitate
the disposition of assets that constitute a
trade or business.
(2)Treatment of capitalized amount.
Amounts capitalized under paragraph
(c)(1) of this section are treated as a reduc-
tion in the amount realized and generally
are taken into account either in the taxable
year in which the sale occurs or in the
taxable year in which the sale is aban-
doned if a loss deduction is permissible.
The capitalized amount is not added to the
basis of the property and is not treated as
an intangible under §1.263(a)–4.
(3)Examples. The following examples,
which assume the sale is not an installment
sale under section 453, illustrate the rules
of this paragraph (c):
Example 1.Sales costs of real property.Xowns
a parcel of real estate. X sells the real estate and pays
legal fees, recording fees, and sales commissions to
facilitate the sale. X must capitalize the fees and com-
missions and, in the taxable year of the sale, offset
the fees and commissions against the amount realized
from the sale of the real estate.
Example 2.Sales costs of dealers. Assume the
same facts as inExample 1, except that X is a dealer
in real estate. The commissions and fees paid to facil-
itate the sale of the real estate are treated as ordinary
and necessary business expenses under section 162.
Example 3.Sales costs of personal property used
in the trade or business. X is a farmer and owns a
truck for use in X’s trade or business. X decides to
sell the truck and on November 15, 2008, X pays
to advertise the sale of the truck in the local news
media. On February 15, 2009, X sells the truck to Y.
X is required to capitalize in 2008 the amount paid to
advertise the sale of the truck and, in 2009, is required
to offset the amount paid against the amount realized
from the sale of the truck.
Example 4.Costs of abandoned sale of personal
property used in a trade or business. Assume the
same facts as inExample 3, except that, instead of
selling the truck on February 15, 2009, X decides on
that date not to sell the truck and takes the truck off the
market. X is required to capitalize in 2008 the amount
paid to advertise the sale of the truck. However, X
may treat the amount paid as a loss under section 165
in 2009 when the sale is abandoned.
Example 5.Sales costs of personal property not
used in a trade or business.Assumethesamefactsas
inExample 3, except that X does not use the truck in
X’s trade or business, but instead uses it for personal
purposes. X decides to sell the truck and on Novem-
ber 15, 2008, X pays to advertise the sale of the truck
in the local news media. On February 15, 2009, X
sells the truck to Y. X is required to capitalize in 2008
the amount paid to advertise the sale of the truck and,
in 2009, is required to offset the amount paid against
the amount realized from the sale of the truck.
2006–39 I.R.B.551September 25, 2006

Example 6.Costs of abandoned sale of personal
property not used in a trade or business. Assume the
samefactsasinExample 5, except that, instead of
selling the truck on February 15, 2009, X decides on
that date not to sell the truck and takes the truck off the
market. X is required to capitalize in 2008 the amount
paid to advertise the sale of the truck. Although the
sale is abandoned in 2009, X may not treat the amount
paid as a loss under section 165 because the truck was
not used in X’s trade or business or in a transaction
entered into for profit.
(d)Amount paid. For purposes of this
section, the termsamounts paidandpay-
mentmean, in the case of a taxpayer us-
ing an accrual method of accounting, a
liability incurred (within the meaning of
§1.446–1(c)(1)(ii)). A liability may not be
taken into account under this section prior
to the taxable year during which the liabil-
ity is incurred.
(e)Effective date.Therulesinthissec-
tion apply to taxableyears beginning on or
after the date of publication of the Treasury
decision adopting these rules as final reg-
ulations in theFederal Register.
(f)Accounting method changes.[Re-
served]
§1.263(a)–2 Amounts paid to acquire or
produce tangible property.
(a)Overview. This section provides
rules for applying section 263(a) to
amounts paid to acquire or produce real
or personal property. See §1.263(a)–3
for the treatment of amounts paid to im-
prove tangible property, §1.263(a)–4 for
the treatment of amounts paid to acquire
or create intangibles, and §1.263(a)–5 for
the treatment of amounts paid to facilitate
an acquisition of a trade or business, a
change in capital structure of a business
entity, and certain other transactions.
(b)Definitions. For purposes of this
section, the following definitions apply:
(1)Amount paid. In the case of a tax-
payer using an accrual method of account-
ing, the termsamounts paidandpayment
mean a liability incurred (within the mean-
ing of §1.446–1(c)(1)(ii)). A liability may
not be taken into account under this section
prior to the taxable year during which the
liability is incurred.
(2)Personal property.Personal prop-
ertymeans tangible personal property as
defined in §1.48–1(c).
(3)Real property.Real propertymeans
land and improvements thereto, such as
buildings or other inherently permanent
structures (including items that are struc-
tural components of such buildings or
structures) that are not personal prop-
erty as defined in paragraph (b)(2) of this
section. Local law is not controlling in
determining whether property is real prop-
erty for purposes of this section.
(4)Produce.Producemeans construct,
build, install, manufacture, develop, cre-
ate, raise, or grow. See §1.263(a)–3 for
capitalization rules applicable to amounts
paid to improve property.
(c)Coordination with other provisions
of the Internal Revenue Code—(1)In gen-
eral. Nothing in this section changes the
treatment of any amount that is specifically
provided for under any provision of the In-
ternal Revenue Code or regulations other
than section 162(a) or section 212 and the
regulations under those sections.
(2)Materials and supplies. Nothing
in this section changes the treatment of
amounts paid for materials and supplies
that are properly treated as deductions or
deferred expenses, as appropriate, under
§1.162–3.
(d)Acquired or produced tangible
property—(1)In general—(i)Require-
ment of capitalization. A taxpayer must
capitalize amounts paid to acquire or
produce real or personal property hav-
ing a useful life substantially beyond the
taxable year, including land and land im-
provements, buildings, machinery and
equipment, and furniture and fixtures, and
a unit of property (as determined under
§1.263(a)–3(d)(2)), having a useful life
substantially beyond the taxable year. A
taxpayer also must capitalize amounts
paid to acquire real or personal property
for resale and to produce real or personal
property for sale. See section 263A for the
scope of costs required to be capitalized
to property produced by the taxpayer or to
property acquired for resale.
(ii)Examples. The following examples
illustrate the rule of this paragraph (d)(1):
Example 1.Acquisition of personal property —
coordination with §1.162–3. X, an airline, operates a
fleet of aircraft. X purchases and maintains in stock
for repairs to its aircraft a great number of differ-
ent expendable flight equipment spare parts (includ-
ing cartridges, canisters, cylinders, and disks), based
in part on the manufacturer’s recommendations and
in part on the airline’s experience. The expendable
flight equipment spare parts are carried on hand by X
until they are installed in the particular type of aircraft
for which purchased. The expendable flight equip-
ment spare parts are of a type normally not repaired
and reused. As these parts are taken from stock and
used to repair aircraft, the stock supply is replenished
by X purchasing new parts. In 2008, X purchases
expendable flight equipment spare parts. X prop-
erly treats the amount paid for the expendable flight
equipment spare parts as a deferred expense under
§1.162–3. Nothing in this section changes the treat-
ment of the original acquisition cost as a deferred ex-
pense.
Example 2.Acquisition of personal property —
coordination with §1.162–3.X,anindustriallaundry
business, leases many products, including garments,
linens, shop towels, continuous roll towels, and mops
(rental items). X maintains a supply of rental items on
hand to replace worn or damaged items. The rental
items have useful lives of 12 months or less. In 2008,
X purchases a large quantity of rental items. The
amount paid for the rental items is properly treated
by X as a deferred expense under §1.162–3. Nothing
in this section changes the treatment of the original
acquisition cost as a deferred expense.
Example 3.Acquisition of personal property.In
2008, X purchases new cash registers, which have a
useful life substantially beyond the taxable year, for
use in its retail store located in a leased space in a
shopping mall. X must capitalize under this para-
graph (d)(1) the amount paid to purchase each cash
register.
Example 4.Relocation and installation of per-
sonal property.AssumethesamefactsasinExample
3, except that X’s lease expires in 2009 and X decides
to relocate its retail store to a different building. In ad-
dition to various other costs, X pays $5,000 to move
the cash registers and $1,000 to reinstall them in the
other store. X is not required to capitalize under this
paragraph (d)(1) the $5,000 amount paid for moving
the cash registers; however, X must capitalize under
this paragraph (d)(1) the $1,000 amount paid to rein-
stall the cash registers in its other store because, under
paragraph (b)(4) of this section, installation costs are
production costs.
Example 5.Acquisition of land. X purchases a
parcel of undeveloped real estate. X must capitalize
under this paragraph (d)(1) the amount paid to acquire
the real estate. See §1.263(a)–2(d)(3) for the treat-
ment of amounts paid to facilitate the acquisition of
real property.
Example 6.Acquisition of building. X purchases
a building. X must capitalize under this paragraph
(d)(1) the amount paid to acquire the building. See
§1.263(a)–2(d)(3) for the treatment of amounts paid
to facilitate the acquisition of real property.
Example 7.Acquisition of property for resale.X
purchases goods for resale. X must capitalize under
this paragraph (d)(1) the amounts paid to acquire the
goods. See section 263A for the treatment of amounts
paid to acquire property for resale.
Example 8.Production of property for sale.X
produces goods for sale. X must capitalize under
this paragraph (d)(1) the amount paid to produce the
goods. See section 263A for the treatment of amounts
paid to produce property.
Example 9.Production of building. X constructs
a building. X must capitalize under this paragraph
(d)(1) the amount paid to construct the building. See
section 263A for the treatment of amounts paid to
produce real property.
Example 10.Acquisition of assets constituting a
trade or business. Y owns tangible and intangible as-
sets that constitute a trade or business. X purchases
all the assets of Y in a taxable transaction. X must
September 25, 20065522006–39 I.R.B.

capitalize under this paragraph (d)(1) the amount paid
for the tangible assets of Y. See §1.263(a)–4 for the
treatment of amounts paid to acquire intangibles and
§1.263(a)–5 for the treatment of amounts paid to fa-
cilitate the acquisition of assets that constitute a trade
or business. See section 1060 for special allocation
rules for certain asset acquisitions.
(2)Defense or perfection of title to
property—(i)In general. Amounts paid
to defend or perfect title to real or per-
sonal property constitute amounts paid to
acquire or produce property within the
meaning of this section and must be capi-
talized. See section 263A for the scope of
costs required to be capitalized to property
produced by the taxpayer or to property
acquired for resale.
(ii)Examples. The following examples
illustrate the rule of this paragraph (d)(2):
Example 1.Amounts paid to contest condemna-
tion. X owns real property located in County. County
filed an eminent domain complaint condemning a
portion of X’s property to use as a roadway. X hired
an attorney to contest the condemnation. Amounts
paid by X to the attorney must be capitalized because
they were to defend X’s title to the property.
Example 2.Amounts paid to invalidate or-
dinance. X is in the business of quarrying and
supplying sand and stone in a certain municipality.
Several years after X established its business, the
municipality in which it was located passed an ordi-
nance that prohibited the operation of X’s business.
X incurred attorney’s feesin a successful prosecution
of a suit to invalidate the municipal ordinance. X
prosecuted the suit to preserve its business activities
and not to defend X’s title in the property. Therefore,
attorney’s fees paid by X are not required to be capi-
talized under this paragraph (d)(2). However, under
section 263A, all indirect costs, including otherwise
deductible costs, that directly benefit or are incurred
by reason of the taxpayer’s production activities
must be capitalized to the property produced for sale.
Therefore, because the amounts paid to invalidate the
ordinance are incurred by reason of X’s production
activities, the amounts paid must be capitalized under
section 263A to the property produced for sale by X.
Example 3.Amounts paid to challenge building
line. The board of public works of a municipality
established a building line across X’s business prop-
erty, adversely affecting the value of the property. X
incurred legal fees in unsuccessfully litigating the es-
tablishment of the building line. Amounts paid by X
to the attorney must be capitalized because they were
to defend X’s title to the property.
(3)Transaction costs—(i)In general.
A taxpayer must capitalize amounts paid to
facilitate the acquisition of real or personal
property, including shipping costs, bidding
costs, sales and transfer taxes, legal and ac-
counting fees, title fees, engineering fees,
survey costs, inspection costs, appraisal
fees, recording fees, application fees, com-
missions, and compensation for the ser-
vices of a qualified intermediary or other
facilitator of an exchange under section
1031. See §1.263(a)–5 for the treatment
of amounts paid to facilitate the acquisi-
tion of assets that constitute a trade or busi-
ness. See section 263A for the scope of
costs required to be capitalized to property
produced by the taxpayer or to property ac-
quired for resale.
(ii)Examples. The following examples
illustrate the rule of this paragraph (d)(3):
Example 1.Legal fees, taxes, and commissions
to facilitate an acquisition. X purchases a building
and pays legal fees, sales taxes, and sales commis-
sions to facilitate the acquisition. X must capitalize
the amounts paid for legal fees, sales taxes, and sales
commissions.
Example 2.Moving costs to facilitate an acqui-
sition. X purchases all the assets of Y and, in con-
nection with the purchase, hires a transportation com-
pany to move storage tanks from Y’s plant to X’s
plant. X must capitalize the amount paid to move the
tanks from Y’s plant to X’s plant because the amount
paid facilitates the acquisition of the storage tanks.
(4)12-month rule—(i)In general.
Except as otherwise provided in this para-
graph (d)(4), an amount paid for the
acquisition or production (including any
amount paid to facilitate the acquisition
or production) of a unit of property (as
determined under §1.263(a)–3(d)(2)) with
an economic useful life (as defined in
§1.263(a)–3(f)(2)) of 12 months or less is
not a capital expenditure under paragraph
(d)ofthissection.
(ii)Coordination with section 461.In
the case of a taxpayer using an accrual
method of accounting, the rules of this
paragraph (d)(4) do not affect the deter-
mination of whether a liability is incurred
during the taxable year, including the de-
termination of whether economic perfor-
mance has occurred with respect to the li-
ability. See §1.461–4 for rules relating to
economic performance.
(iii)Exceptions to 12-month rule.The
12-month rule in paragraph (d)(4)(i) of this
section does not apply to the following:
(A) Amounts paid for property that is or
will be included in property produced for
sale or property acquired for resale;
(B) Amounts paid to improve property
under §1.263(a)–3;
(C) Amounts paid for land; and
(D) Amounts paid for any component
of a unit of property.
(iv)Character of property subject to
12-month rule. Property to which a tax-
payer applies the 12-month rule contained
in paragraph (d)(4)(i) of this section is not
treated upon sale or disposition as a capi-
tal asset under section 1221 or as property
used in the trade or business under section
1231.
(v)Election to capitalize. A taxpayer
may elect not to apply the 12-month rule
contained in paragraph (d)(4)(i) of this
section with regard to a unit of property.
An election made under this paragraph
(d)(4)(v) applies to any unit of property
during the taxable year to which para-
graph (d)(4)(i) of this section would apply
(but for the election under this paragraph
(d)(4)(v)). A taxpayer makes the election
by treating the amount paid as a capital
expenditure in its timely filed original
Federal income tax return (including ex-
tensions) for the taxable year in which
the amount is paid. In the case of a
pass-through entity, the election is made
by the pass-through entity, and not by the
shareholders, partners, etc. An election
may not be made through the filing of
an application forchange in accounting
method or by an amended Federal income
tax return and an election may not be re-
voked.
(vi)Examples. The rules of this para-
graph (d)(4) are illustrated by the follow-
ing examples, in which it is assumed (un-
less otherwise stated) that the taxpayer is
a calendar year, accrual method taxpayer
that has not elected out of the 12-month
rule under paragraph (d)(4)(v) of this sec-
tion with regard to the unit of property, and
that none of the property is materials and
supplies under §1.162–3:
Example 1.Production cost. X corporation
manufactures and sells aluminum storm windows
and doors. To conduct its business, X purchases
strips of aluminum called extrusions and applies
paint electrostatically to the extrusions through a
complex process. In 2008, X installs a leaching pit
to provide a draining area for liquid waste produced
in the process of painting the extrusions. X previ-
ously had dumped this waste into a creek bed, but
the local water department ordered it to cease this
practice. The economic useful life of the leaching
pit is 12 months, after which time the factory will be
connected to the local sewer system. Assume that the
leaching pit is the unit of property, as determined un-
der §1.263(a)–3(d)(2). X is not required to capitalize
under paragraph (d) of this section the amount paid
to produce the leaching pitbecause the useful life of
the leaching pit is 12 months or less. However, under
section 263A, all indirect costs, including otherwise
deductible costs, that directly benefit or are incurred
by reason of the taxpayer’s manufacturing activities
must be capitalized to the property produced for sale.
Therefore, because the amounts paid for the leaching
pit are incurred by reason of X’s manufacturing op-
erations, the amounts paid must be capitalized under
section 263A to the property produced for sale by X.
2006–39 I.R.B.553September 25, 2006

Example 2.Acquisition or production cost.X
purchases or produces jigs, dies, molds, and patterns
for use in the manufacture of motor vehicles and mo-
tor vehicle parts. The economic useful life of the
jigs, dies, molds, and patterns is 12 months. Assume
each jig, die, mold, and pattern is a separate unit of
property, as determined under §1.263(a)–3(d)(2). X
is not required to capitalize under paragraph (d) of
this section the amounts paid to produce or purchase
the jigs, dies, molds, and patterns because the eco-
nomic useful life is 12 months or less. However, un-
der section 263A, all indirect costs, including other-
wise deductible costs, that directly benefit or are in-
curred by reason of the taxpayer’s manufacturing ac-
tivities must be capitalized to the property produced
for sale. Therefore, because the amounts paid for the
jigs, dies, molds, and patterns are incurred by reason
of X’s manufacturing operations, the amounts paid
must be capitalized under section 263A to the prop-
erty produced for sale by X.
Example 3.Acquisition or production cost.As-
sume the same facts as inExample 2, but the eco-
nomic useful life of the jigs, dies, molds, and patterns
is 3 years. X is required to capitalize under paragraph
(d) of this section the amounts paid to produce or pur-
chase the jigs, dies, molds, and patterns because the
economic useful life is more than 12 months.
Example 4.Acquisition cost. X corporation is
an interstate motor carrier. On December 1, 2008, X
purchases, pays for, and takes delivery of truck tires
with an economic useful life of 12 months. Assume
X does not use the original tire capitalization method
described in Rev. Proc. 2002–27, 2002–1 C.B. 802
(see §601.601(d)(2) of this chapter). Also assume
that each tire is a separate unit of property, as de-
termined under §1.263(a)–3(d)(2). X is not required
under paragraph (d) of this section to capitalize the
amount paid for the tires because the economic use-
ful life of the tires is 12 months or less.
Example 5.Transaction costs. Assume the same
factsasinExample 4, but in addition to the amount
paid for the tires, X also pays sales tax and delivery
charges for the tires. X is not required to capitalize
under paragraph (d) of this section the sales tax and
delivery charges because they were paid to facilitate
the acquisition of property with an economic useful
life of 12 months or less.
Example 6.Coordination with section 461 fixed
liability rule. Assume the same facts as inExample 4,
except that instead of purchasing the tires on Decem-
ber 1, 2008, X enters into a contract with the tire man-
ufacturer on that date to purchase tires from the man-
ufacturer in 2009. X purchases, pays for, and takes
delivery of the tires on March 31, 2009. X does not
incur a liability under section 461 for the tires in 2008
because X does not have a fixed liability with respect
to the tires until 2009. When X incurs the amount in
2009, X is not required under paragraph (d) of this
section to capitalize that amount.
Example 7.Coordination with section 461 eco-
nomic performance rule. Assume the same facts as
inExample 4, except that the tires are not delivered
to X until March 31, 2009. X does not incur a liability
under section 461 for the tires in 2008 because eco-
nomic performance does not occur with respect to the
liability until the property is provided to X in 2009.
See §1.461–4(d)(2). When X incurs the amount in
2009, X is not required under paragraph (d) of this
section to capitalize that amount.
Example 8.Election not to capitalize. Assume
thesamefactsasinExample 4, except that X elects
under paragraph (d)(4)(v) of this section not to apply
the 12-month rule contained in paragraph (d)(4)(i) of
this section to the tires purchased on December 1,
2008. X must capitalize under paragraph (d) of this
section the amount paid for the tires.
Example 9.Exception to 12-month rule — prop-
erty acquired for resale. Assume the same facts as in
Example 4, except that X purchases the tires for re-
sale. The 12-month rule in paragraph (d)(4)(i) of this
section does not apply because the tires are property
acquired for resale. Thus, X is required under para-
graph (d) of this section to capitalize the amount paid
for the tires.
Example 10.Exception to 12-month rule — com-
ponentofproperty. Assume the same facts as in
Example 4, except that the tires are the first set of
tires to be installed on a truck tractor acquired by X
and X uses the original tire capitalization method de-
scribed in Rev. Proc. 2002–27 (see §601.601(d)(2)
of this chapter) so that the truck tractor (including
the tires) is the unit of property, as determined under
§1.263(a)–3(d)(2). Also assume that the truck tractor
has an economic useful life of more than 12 months
and that the invoice for the acquisition of the truck
tractor separately states the cost of tires and various
other components of the truck tractor. X is required
under paragraph (d) of this section to capitalize the
amount paid for the trucktractor because the eco-
nomic useful life of the truck tractor is more than 12
months. Further, X may not use the 12-month rule to
currently deduct the amount paid for the tires or any
other component of the truck tractor, regardless that
some components may have an economic useful life
of 12 months or less and regardless that the cost of
individual components is separately stated in the in-
voice.
(e)Treatment of capital expenditures.
Amounts required to be capitalized un-
der this section are capital expenditures
and must be taken into account through
a charge to capital account or basis, or in
the case of property that is inventory in
the hands of a taxpayer, through inclusion
in inventory costs. See section 263A for
the treatment of amounts referred to in
this section as well as other amounts paid
in connection with the production of real
property and personal property, includ-
ing films, sound recordings, video tapes,
books, or similar properties.
(f)Recovery of capitalized
amounts—(1)In general.Amounts
that are capitalized under this section
are recovered through depreciation, cost
of goods sold, or by an adjustment to
basis at the time the property is placed in
service, sold, used, or otherwise disposed
of by the taxpayer. Cost recovery is
determined by the applicable Internal
Revenue Code and regulation provisions
relating to the use, sale, or disposition of
property. For example, §§1.162–4 and
1.263(a)–3 determine whether amounts
capitalized under this section §1.263(a)–2
for property that is used to replace a
component of a unit of property are repair
or maintenance expenses or capitalized as
an improvement to the unit of property.
(2)Examples. The following examples
illustrate the rule of this paragraph (f)(1)
and assume that the taxpayer does not treat
the acquired property as materials and sup-
plies under §1.162–3:
Example 1.Recovery when property placed in
service. X owns a 10-unit apartment building. The
refrigerator in one of the apartments stops function-
ing and X purchases a new refrigerator to replace the
old one. X pays for the acquisition, delivery, and
installation of the new refrigerator. Assume the re-
frigerator is the unit of property, as determined under
§1.263(a)–3(d)(2). Section 1.263(a)–2(d) requires
capitalization of amounts paid for the acquisition, de-
livery, and installation of the refrigerator. Under this
paragraph (f), the capitalized amounts are recovered
through depreciation when the refrigerator is placed
in service by X.
Example 2.Recoverywhenpropertyusedinare-
pair. Assume the same facts as inExample 1, except
that a window in one of the apartments needs to be
replaced. X pays for the acquisition, delivery, and
installation of a new window. Assume the window
is a structural component of the apartment building
and that the apartment building is the unit of prop-
erty, as determined under §1.263(a)–3(d)(2). Section
1.263(a)–2(d) requires capitalization of amounts paid
for the acquisition and delivery of the window be-
cause the window is property with a useful life sub-
stantially beyond the end of the taxable year. As-
sume the replacement of the old window with the new
one does not improve the apartment building under
§1.263(a)–3. Under this paragraph (f), the capital-
ized amounts paid to acquire the window are recov-
ered as ordinary and necessary repair expenses under
§1.162–4 when the window is used in the repair by
its installation in the apartment building.
Example 3.Recovery when property used in a
repair; coordination with section 263A. Assume the
same facts as inExample 2, except that the window
that is replaced is in an office in a plant where X man-
ufactures widgets for sale. Section 1.263(a)–2(d) re-
quires capitalization of amounts paid to produce in-
ventory. Under section 263A, all indirect costs, in-
cluding otherwise deductible repair costs that directly
benefit or are incurred by reason of the production of
inventory must be capitalized to the inventory pro-
duced. Although the repair cost otherwise would be
deductible as an expense under §1.162–4, X must de-
termine whether the cost of the repair, or an allocable
portion thereof, is required to be capitalized to the in-
ventory produced as an indirect expense that directly
benefits or is incurred by reason of the production ac-
tivities. Any portion of the repair capitalized to in-
ventory is recovered through cost of goods at the time
the property is sold or otherwise disposed of in accor-
dance with the taxpayer’s method of accounting for
inventories.
(g)Effective date.Therulesinthissec-
tion apply to taxable years beginning on or
September 25, 20065542006–39 I.R.B.

after the date of publication of the Treasury
decision adopting these rules as final reg-
ulations in theFederal Register.
(h)Accounting method changes.[Re-
served]
§1.263(a)–3 Amounts paid to improve
tangible property.
(a)Overview. This section provides
rules for applying section 263(a) to
amounts paid to improve tangible prop-
erty. Paragraph (b) of this section contains
definitions. Paragraph (c) of this section
contains rules for coordinating this section
with other provisions of the Internal Rev-
enue Code. Paragraph (d) of this section
provides rules for determining the treat-
ment of amounts paid to improve tangible
property, including rules for determining
the appropriate unit of property. Paragraph
(e) of this section contains rules for deter-
mining whether amounts paid materially
increase the value of the unit of property.
Paragraph (f) of this section contains rules
for determining whether amounts paid
restore the unit of property. Paragraph (g)
of this section describes an optional repair
allowance method.
(b)Definitions. For purposes this sec-
tion, the following definitions apply:
(1)Amount paid. In the case of a tax-
payer using an accrual method of account-
ing, the termsamounts paidandpayment
mean a liability incurred (within the mean-
ing of §1.446–1(c)(1)(ii)). A liability may
not be taken into account under this section
prior to the taxable year during which the
liability is incurred.
(2)Personal property.Personal prop-
ertymeans tangible personal property as
defined in §1.48–1(c).
(3)Real property.Real propertymeans
land and improvements thereto, such as
buildings or other inherently permanent
structures (including items that are struc-
tural components of such buildings or
structures) that are not personal prop-
erty as defined in paragraph (b)(2) of this
section. Local law is not controlling in
determining whether property is real prop-
erty for purposes of this section.
(c)Coordination with other provisions
of the Internal Revenue Code—(1)In gen-
eral. Nothing in this section changes the
treatment of any amount that is specifically
provided for under any provision of the In-
ternal Revenue Code or regulations (other
than section 162(a) or section 212 and the
regulations under those sections).
(2)Example. The following example
illustratestherulesofthisparagraph(c):
Example.Railroad rolling stock. X is a railroad
that properly treats amounts paid for the rehabilitation
of railroad rolling stock as deductible expenses un-
der section 263(d). X is not required to capitalize the
amounts paid because nothing in this section changes
the treatment of amounts specifically provided for un-
der section 263(d).
(d)Improved property—(1)Capitaliza-
tion rule. Except as provided in the re-
pair allowance method in paragraph (g)
of this section, a taxpayer must capital-
ize the aggregate of related amounts paid
to improve a unit of property (including a
unit of property for which the acquisition
or production costs were deducted under
the 12-month rule in §1.263(a)–2(d)(4)),
whether the improvements are made by
the taxpayer or by a third party. See sec-
tion 263A for the scope of costs required
to be capitalized to property produced by
the taxpayer or to property acquired for re-
sale; section 1016 for adding capitalized
amounts to the basis of the unit of prop-
erty; and section 168(i)(6) for the treat-
ment of additions or improvements to a
unit of property. For purposes of this para-
graph (d), a unit of property is improved if
the amounts paid—
(i) Materially increase the value of the
unit of property (see paragraph (e) of this
section); or
(ii) Restore the unit of property (see
paragraph (f) of this section).
(2)Determining the appropriate unit of
property—(i)In general. The unit of prop-
erty rules in this paragraph (d)(2) apply
only for purposes of section 263(a) and
§§1.263(a)–1, 1.263(a)–2, and 1.263(a)–3,
and not any other Internal Revenue Code
or regulation section. Under this para-
graph (d)(2), the appropriate unit of prop-
erty is initially determined by applying the
rules in paragraph (d)(2)(ii) of this section,
except as provided in paragraph (d)(2)(iv)
of this section (relating to buildings and
structural components). The initial unit
of property determination is further ana-
lyzed in accordance with the appropriate
hierarchical category described in one of
paragraphs (d)(2)(iii) through (d)(2)(vi) of
this section and by applying the additional
rule in paragraph (d)(2)(vii) of this section.
The specific rules contained in paragraphs
(d)(2)(iii) through (d)(2)(vii) of this sec-
tion dictate whether one or more compo-
nents of the initial unit of property deter-
mination must be treated as separate units
of property.
This paragraph (d)(2) applies to all real
and personal property, other than network
assets. For purposes of this paragraph
(d)(2), network assets means railroad
track, oil and gas pipelines, water and
sewage pipelines, power transmission and
distribution lines, and telephone and cable
lines that are owned or leased by taxpay-
ers in each of those respective industries.
The term includes, for example, trunk and
feeder lines, pole lines, and buried conduit.
It does not include property that would be
included as a structural component of a
building under paragraph (d)(2)(iv), nor
does it include separate property that is
adjacent to, but not part of a network asset,
such as bridges, culverts, or tunnels.
(ii)Initial unit of property determina-
tion. Except for property described in
paragraph (d)(2)(iv) of this section (re-
garding buildings and structural compo-
nents), the unit of property determination
under this paragraph (d)(2) begins by
identifying property that consists entirely
of components that are functionally inter-
dependent. Components of property are
functionally interdependent if the plac-
ing in service of one component by the
taxpayer is dependent on the placing in
service of the other component by the
taxpayer. For purposes of this section,
property that is aggregated and subject to
a general asset account election may not
be treated as a single unit of property.
(iii)Category I: Taxpayers in regulated
industries. In the case of a taxpayer en-
gagedinatradeorbusinessinaregulated
industry, the unit of property is the USOA
(uniform system of accounts) unit of prop-
erty. For purposes of this section, a reg-
ulated industry is an industry for which a
Federal regulator (including any Federal
department, agency, commission, board,
or similar entity) has a USOA identifying
a particular unit of property (USOA unit
of property). This rule applies to any tax-
payer engaged in a trade or business in the
regulated industry, regardless of whether
the taxpayer is subject to the regulatory
accounting rules of the Federal regulator.
The unit of property determination made
under this paragraph (d)(2)(iii) is subject to
paragraph (d)(2)(vii) of this section, which
may require one or more components to be
treated as separate units of property.
2006–39 I.R.B.555September 25, 2006

(iv)Category II: Buildings and struc-
tural components. In the case of a building
(as defined in §1.48–1(e)(1)) other than
that described in paragraph (d)(2)(iii) of
this section, the building and its structural
components (as defined in §1.48–1(e)(2))
are a single unit of property. The unit of
property determination made under this
paragraph (d)(2)(iv) is subject to para-
graph (d)(2)(vii) of this section, which
may require one or more components to
be treated as separate units of property.
(v)Category III: Other personal prop-
erty. In the case of personal property other
than that described in paragraph (d)(2)(iii)
of this section, the unit of property deter-
mination must be made on the basis of
the four factors listed in this paragraph
(d)(2)(v). These four factors are the exclu-
sive factors under this paragraph (d)(2)(v).
No one factor is determinative and it is not
intended that a determination be made on
the basis of the number of factors indicat-
ing that a component is, or is not, a sepa-
rate unit of property. The unit of property
determination made under this paragraph
(d)(2)(v) is subject to paragraph (d)(2)(vii)
of this section, which may require one or
more components to be treated as separate
units of property. The following factors
must be taken into account:
(A) Whether the component is—
(1) Marketed separately to the taxpayer
by a party other than the seller/lessor of the
property of which the component is a part
at the time the property is initially acquired
or leased;
(2) Acquired or leased separately by
the taxpayer from a party other than the
seller/lessor of the property of which the
component is a part at the time the prop-
erty is initially acquired or leased;
(3) Subject to a separate warranty
contract (from a party other than the
seller/lessor of the property of which the
component is a part);
(4) Subject to a separate maintenance
manual or written maintenance policy;
(5) Appraised separately; or
(6) Sold or leased separately by the tax-
payer to another party;
(B) Whether the component is treated
as a separate unit of property in industry
practice or by the taxpayer in its books and
records;
(C) Whether the taxpayer treats the
component as a rotable part (a part that
is removable from property, repaired or
improved, and eitherimmediately rein-
stalled on other property or stored for later
installation); and
(D) Whether the property of which the
component is a part generally functions
for its intended use without the component
property.
(vi)Category IV: Other real property.
In the case of real property other than
that described in paragraphs (d)(2)(iii) and
(d)(2)(iv) of this section, the unit of prop-
erty determination must be made on the
basis of all the facts and circumstances.
The unit of property determination made
under this paragraph (d)(2)(vi) is subject to
paragraph (d)(2)(vii) of this section, which
may require one or more components to
be treated as separate units of property.
(vii)Additional rule. If the taxpayer
properly treats a component as a sepa-
rate unit of property for any Federal in-
come tax purpose, the taxpayer must treat
the component as a separate unit of prop-
erty for purposes of this paragraph (d)(2).
For purposes of paragraph (d)(2), the term
any Federal income tax purposeincludes,
but is not limited to, the use of different
placed-in-service dates (other than the use
of a new placed-in-service date for an im-
provement (as determined under this sec-
tion) to the unit of property or a different
placed-in-service date for a particular floor
of a building) or different classes of prop-
erty as set forth in section 168(e) (MACRS
classes), for the component and the prop-
erty of which the component is a part. If
the taxpayer properly recognizes a loss un-
der section 165, or under another applica-
ble provision, from a retirement of a com-
ponent of property or from the worthless-
ness or abandonment of a component of
property, the taxpayer must treat the com-
ponent as a separate unit of property for
purposes of this paragraph (d)(2). There-
fore, any property that replaces the compo-
nent also will be treated as a separate unit
of property. See §1.263(a)–2(d)(1). For
purposes of this paragraph (d)(2), merely
claiming a tax credit related to tangible
property does not constitute treatment of
that property as a separate unit of property
for a Federal income tax purpose.
(viii)Examples. The rules of this para-
graph (d)(2) are illustrated by the follow-
ing examples, in which it is assumed (un-
less otherwise stated) that the taxpayer has
not made a general asset account election
with regard to the property and that para-
graph (d)(2)(vii) of this section does not re-
quire the use of a different unit of property:
Example 1.Category I. X is an electric utility
company that operates a power plant to generate elec-
tricity. X’s operation previously was regulated by the
Federal Energy Regulatory Commission (FERC) but,
for various reasons, is no longer subject to regulation
by FERC. Under FERC’s USOA, each turbine, econ-
omizer, generator, and pulverizer is treated as a sepa-
rate unit of property for regulatory accounting pur-
poses. The initial unit of property determined un-
der paragraph (d)(2)(ii) of this section is the entire
power plant, which consists entirely of components
that are functionally interdependent. The power plant
must next be analyzed under paragraph (d)(2)(iii) of
this section because X is engaged in a trade or busi-
ness in an industry for which a Federal regulator has
a USOA. Under the rules in that paragraph, X must
treat each turbine, economizer, generator, and pul-
verizer as a separate unit of property for determining
whether an amount paid improves the unit of property
for Federal income tax purposes.
Example 2.Category I. X is a Class I railroad. All
Class I railroads are regulated by the Surface Trans-
portation Board (STB). Under STB’s USOA, each
locomotive and each freight car is treated as a sep-
arate unit of property for regulatory accounting pur-
poses. Although each locomotive consists of various
components, such as an engine, generators, batteries,
trucks, etc., those components are functionally inter-
dependent. Thus, the locomotive is an initial unit of
property as determined under paragraph (d)(2)(ii) of
this section. Similarly, each freight car consists en-
tirely of functionally interdependent components and,
thus, each freight car is an initial unit of property un-
der paragraph (d)(2)(ii) of this section. Each loco-
motive and freight car must next be analyzed under
paragraph (d)(2)(iii) of this section because X is en-
gaged in a trade or business in an industry for which a
Federal regulator has a USOA. Under the rules in that
paragraph, X must treateach locomotive and each
freight car as a separate unit of property for deter-
mining whether an amount paid improves the unit of
property for Federal income tax purposes.
Example 3.Category I. Assume the same facts as
inExample 2, except that X is a Class II railroad. The
STB does not regulate Class II railroads. However,
because X is engaged in a trade or business in an in-
dustry (the railroad industry) for which a Federal reg-
ulator has a USOA, the rules in paragraph (d)(2)(iii)
of this section apply, regardless of whether X is sub-
ject to those rules. Based on these facts, X must treat
each locomotive and each freight car as a separate
unit of property for determining whether an amount
paid improves the unit of property for Federal income
tax purposes.
Example 4.Category I. X is a telecommunica-
tions company regulatedby the Federal Communi-
cations Commission (FCC) and subject to a USOA
for telephone companies. The assets of X include a
telephone central office switching center, which con-
tains numerous switches and various other switching
equipment that all work together to provide telephone
service to customers. The initial unit of property de-
termined under paragraph (d)(2)(ii) of this section is
the central office switching center, which consists en-
tirely of components that are functionally interdepen-
dent. The telecommunications system must next be
analyzed under paragraph (d)(2)(iii) of this section
September 25, 20065562006–39 I.R.B.

because X is engaged in a trade or business in an
industry for which a Federal regulator has a USOA.
Under the rules in that paragraph, X must treat each
switch and/or piece of equipment as defined in the
USOA of the FCC and used in the central office op-
eration as a separate unit of property for determining
whether an amount paid improves the unit of property
for Federal income tax purposes.
Example 5.Category II. X owns a manufactur-
ing building containing various types of manufactur-
ing equipment that are not structural components of
the manufacturing building. Because the property
is a building, as defined in §1.48–1(e)(1), paragraph
(d)(2)(ii) of this section does not apply and the prop-
erty must be analyzed under paragraph (d)(2)(iv) of
this section. Under the rules in that paragraph, X
must treat the manufacturing building and its struc-
tural components as a single unit of property for de-
termining whether an amount paid improves the unit
of property for Federal income tax purposes. The ap-
propriate unit of property determination for the man-
ufacturing equipment must be made separately under
paragraph (d)(2)(v) of this section.
Example 6.Category III; additional rule.As-
sume the same facts as inExample 5, except that
X does a cost segregation study of the manufactur-
ing building and properly determines that refriger-
ation equipment used to create a walk-in freezer in
the manufacturing building is section 1245 property
as defined in section 1245(a)(3). The refrigeration
equipment is not part of the HVAC system that re-
lates to the general operation or maintenance of the
building. For Federal income tax purposes, X prop-
erly treats the refrigeration equipment as a separate
unit of property for depreciation purposes. The rules
of paragraph (d)(2)(v) of this section apply to deter-
mine whether the refrigeration equipment, or some
smaller component, is the appropriate unit of prop-
erty. In this example, assume that no components
of the refrigeration equipment meet any of the facts
and circumstances listed in paragraph (d)(2)(v) of this
section. Based on these facts, X must treat the refrig-
eration equipment as the unit of property for deter-
mining whether an amount paid improves the unit of
property for Federal income tax purposes.
Example 7.Category III; additional rule.As-
sume the same facts as inExample 6, except that
the refrigeration equipment for the walk-in freezer
ceases to function. X decides not to repair the re-
frigeration equipment, but to replace it altogether. X
abandons the refrigeration equipment for the walk-in
freezer and properly recognizes a loss under section
165 from the abandonment of the refrigeration equip-
ment. Therefore, X must treat the refrigeration equip-
ment for the walk-in freezer as a separate unit of prop-
erty for determining whether amounts paid to replace
the equipment must be capitalized for Federal income
tax purposes. See §1.263(a)–2(d)(1).
Example 8.Category III. (i) X is a commercial
airline engaged in the business of transporting pas-
sengers and freight throughout the United States and
abroad. To conduct its business, X owns or leases var-
ious types of aircraft. X purchases the aircraft engine
separately at the time the aircraft is acquired. The
engine is subject to a separate warranty and written
maintenance policy provided by the engine manufac-
turer. For financial accounting purposes, X accounts
for each type of aircraft by maintaining separate ac-
counts on its books for each type of airframe and en-
gine in its fleet. To perform maintenance on an en-
gine, X removes the engine from the aircraft and re-
places it with another used engine that has returned
from a maintenance visit.
(ii) The initial unit of property determined under
paragraph (d)(2)(ii) of this section is the aircraft (and
not the entire fleet of aircraft), which consists entirely
of components that are functionally interdependent.
The aircraft must next be analyzed under one of para-
graphs (d)(2)(iii) through (d)(2)(vi) of this section.
AlthoughXisengagedinatradeorbusinessinanin-
dustry regulated by the Federal Aviation Administra-
tion (FAA), the FAA does not have a USOA. There-
fore, the rules of paragraph (d)(2)(iii) of this section
do not apply to X; instead, the rules of paragraph
(d)(2)(v) of this section apply to determine whether
the entire aircraft, or the engine, is the appropriate
unit of property. In thisExample 8, the aircraft engine
is acquired separately, is subject to a separate war-
ranty and maintenance policy, is treated separately for
financial accounting purposes, and is rotable. Based
on these facts, X must treat the engine as the unit of
property for determining whether an amount paid im-
proves the engine for Federal income tax purposes. X
must treat the aircraft without the engine as a unit of
property for determining whether an amount paid im-
proves the aircraft for Federal income tax purposes.
Example 9.Category III. X is a corporation that
owns a small aircraft for use in its trade or business.
X performs required maintenance on its aircraft en-
gines. The aircraft engine is not marketed, purchased,
leased, appraised, or sold separately, but it is subject
to a separate warranty and written maintenance policy
provided by the engine manufacturer. For financial
accounting purposes, X doesnot maintain separate
accounts on its books for individual engines. X does
not treat the engine as a rotable part. The initial unit of
property determined under paragraph (d)(2)(ii) of this
section is the aircraft, which consists entirely of com-
ponents that are functionally interdependent. The air-
craftmustnextbeanalyzedunder paragraph (d)(2)(v)
of this section to determine whether the entire air-
craft, or the engine, is the appropriate unit of prop-
erty. Based on these facts, the engine is not a separate
unit of property. Therefore,X must treat the aircraft,
including the aircraft engine, as the unit of property
for determining whether an amount paid improves the
unit of property for Federal income tax purposes.
Example 10.Category III. X is a towboat op-
erator that owns and leases a fleet of towboats. X
performs maintenance on its towboat engines every
3 to 4 years, in accordance with the engine manufac-
turer’s maintenance manuals. Towboat engines are
not marketed, purchased, leased, appraised, or sold
separately; however, the engines are subject to a sep-
arate warranty and written maintenance policy pro-
vided by the engine manufacturer. For financial ac-
counting purposes, X does not maintain separate ac-
counts on its books for individual engines. X does not
treat the engine as a rotable part. The initial unit of
property determined under paragraph (d)(2)(ii) of this
section is the towboat (and not the entire fleet of tow-
boats), which consists entirely of components that are
functionally interdependent. The towboat must next
be analyzed under paragraph (d)(2)(v) of this section.
Based on these facts, the engine is not a separate unit
of property. Therefore, X must treat the towboat, in-
cluding the towboat engine, as the unit of property
for determining whether an amount paid improves the
unit of property for Federal income tax purposes.
Example 11.Category III. X purchases a car to
use in X’s taxi service. The invoice received by X
for the purchase of the car separately lists several op-
tions, including air conditioning, automatic transmis-
sion, antilock braking system, side impact air bags,
power group, and special alloy wheels. Under para-
graph (d)(2)(ii) of this section, the initial unit of prop-
erty is the car because the options are functionally in-
terdependent with the car. The options are not subject
to separate warranties. X is an individual and does not
keep books and records other than for tax purposes.
For depreciation purposes, X properly treats the car
and options as one unit of property. X does not treat
any of the options as rotable parts. Based on these
facts, the options are not separate units of property.
X must treat the car, including the options, as the unit
of property for determining whether an amount paid
improves the unit of property for Federal income tax
purposes.
Example 12.Category III.Xisacommoncar-
rier that owns a fleet of fuelhauling trucks and peri-
odically performs maintenance on its truck engines.
The entire fleet of trucks is subject to a general as-
set account election, one for the truck trailers and one
for the truck tractors. Under paragraph (d)(2)(ii) of
this section, X may not treat the entire fleet as the
unit of property. Instead, the initial units of property
determined under paragraph (d)(2)(ii) of this section
are each truck tractor and each truck trailer. Each
tractor consists entirely of functionally interdepen-
dent components and each trailer consists entirely of
functionally interdependent components. To deter-
mine whether the engine is a separate unit of property
from the tractor, the factors in paragraph (d)(2)(v) of
this section apply. The engines are marketed sepa-
rately from the tractor and are subject to a separate
warranty and written maintenance policy provided by
the engine manufacturer. The engines are not treated
as a separate unit of property in industry practice or
by X in its books and records. The engine is removed
from the tractor, repaired or improved, and stored for
later installation on another tractor. Based on these
facts, the engine is a separate unit of property. There-
fore, X must treat the engine as the unit of property
for determining whether an amount paid improves the
unit of property for Federal income tax purposes.
Example 13.Category III. Assume the same facts
as inExample 12, except that the inquiry is whether
the oil filter in the tractor engine is a separate unit
of property. The oil filter is not marketed, acquired,
leased, appraised, or sold separately, nor is it subject
to a separate warranty or maintenance manual. The
filter is not treated as a separate unit of property in
industry practice or by X in its books and records, nor
is it treated as a rotable part. Based on these facts, the
oil filter is not a separate unit of property. Therefore,
X must treat the engine, including the oil filter, as the
unit of property for determining whether an amount
paid improves the unit of property for Federal income
tax purposes.
Example 14.Category III. (i) X manufactures
and sells computers and computer equipment. It also
operates a separate computer maintenance business,
for which X maintains pools of rotable spare parts
that are primarily used to repair computer equipment
purchasedorleasedbyitscustomers. Most of X’s
computer maintenance business is conducted pur-
2006–39 I.R.B.557September 25, 2006

suant to standardized maintenance agreements that
obligate X to provide all parts and labor, product
upgrades, preventive maintenance, and telephone
assistance necessary to keep a customer’s computer
operational for the duration of the contract (usually
one year) in exchange for a predetermined fee. In its
computer maintenance business, X sends technicians
to its customer’s location, who use the supply of
rotable spare parts to diagnose problems in the cus-
tomer’s equipment, and then exchange the working
parts for any malfunctioning parts. A customer’s
part that is identified as the cause of the malfunction
is replaced with the identical functioning part from
X’s rotable spare parts pool. The malfunctioning
part removed from the customer’s equipment is then
repaired and placed in X’s rotable spare parts pool for
continued use in the computer maintenance business.
(ii) Under paragraph (d)(2)(ii) of this section, X
may not treat the entire pool of rotable spare parts
as the unit of property. Instead, the initial unit of
property determined under paragraph (d)(2)(ii) of this
section is each rotable spare part because each part
consists entirely of functionally interdependent com-
ponents. Assume for purposes of thisExample 14
that paragraph (d)(2)(v) of this section does not re-
quire any components of the rotable spare parts to be
treated as separate units of property. Based on these
facts, the entire pool of spare parts is not the unit of
property. Therefore, X must treat each rotable spare
part as a unit of property for determining whether an
amount paid improves the unit of property for Federal
income tax purposes.
Example 15.Category III. (i) X is a dentist and
operates a small dental clinic. On March 1, 2008, X
purchases a new laptop computer, with a one-year
warranty, for use in the dental business. On May 1,
2009, after the warranty has expired, the computer
malfunctions and X contacts the manufacturer’s
computer maintenance shop for assistance. The
maintenance shop sends a technician to X’s dental
clinic, who uses a supply of rotable spare parts to
diagnose problems in X’s computer. The technician
determines that the circuit board must be replaced
and exchanges X’s malfunctioning circuit board with
the identical functioning circuit board from the com-
puter maintenance operation’s rotable spare parts
pool. The malfunctioning circuit board removed
from X’s computer is then repaired and placed in the
manufacturer’s rotable spare parts pool for continued
use in the computer maintenance business.
(ii) The initial unit of property determined under
paragraph (d)(2)(ii) of this section is the computer,
which consists entirely of components (circuit board
or motherboard, central processing unit or CPU, hard
drive, RAM, keyboard, monitor, case, etc.) that are
functionally interdependent. To determine whether
the circuit board is a separate unit of property from
the computer, the factors in paragraph (d)(2)(v) of this
section apply. The circuit board was not marketed
separately to X or acquired separately by X, nor is it
subject to a separate warranty. The CPU, however,
was marketed separately to the taxpayer, but not ac-
quired separately. No component, including the cir-
cuit board and CPU of the laptop computer, is treated
as a separate unit of property by X in its books and
records, nor does X treat any component as a rotable
part. The computer does not function for its intended
use without the circuit board and the CPU. Based on
these facts, neither the circuit board nor the CPU is a
separate unit of property. X must treat the entire lap-
top computer, including the circuit board and CPU,
as the unit of property for determining whether an
amount paid improves the unit of property for Fed-
eral income tax purposes.
(3)Compliance with regulatory re-
quirements. For purposes of this section,
a Federal, state, or local regulator’s re-
quirement that a taxpayer perform certain
repairs or maintenance on a unit of prop-
erty to continue operating the property is
not relevant in determining whether the
amount paid improves the unit of property.
(4)Unavailability of replacement parts.
For purposes of this section, if a taxpayer
needs to replace part of a unit of property
that cannot practicably be replaced with
the same type of part (for example, because
of technological advancements or prod-
uct enhancements), the replacement of the
part with an improved but comparable part
does not, by itself, result in an improve-
ment to the unit of property.
(5)Repairs performed during an im-
provement—(i)In general. Repairs that do
not directly benefit or are not incurred by
reason of an improvement are not required
to be capitalized under section 263(a), re-
gardless of whether they are made at the
same time as an improvement. See section
263A for rules requiring capitalization of
all direct costs of an improvement and all
indirect costs that directly benefit or are in-
curred by reason of the improvement.
(ii)Exception for individuals.Atax-
payer who is an individual may capital-
ize amounts paid for repairs that are made
at the same time as substantial capital im-
provements to property not used in the tax-
payer’s trade or business or for the produc-
tion of income if the repairs are done as
part of a remodeling or restoration of the
taxpayer’s residence.
(e)Value—(1)In general. A taxpayer
must capitalize amounts paid that materi-
ally increase the value of a unit of prop-
erty. An amount paid materially increases
the value of a unit of property only if it—
(i) Ameliorates a condition or defect
that either existed prior to the taxpayer’s
acquisition of the unit of property or arose
during the production of the unit of prop-
erty, whether or not the taxpayer was aware
of the condition or defect at the time of ac-
quisition or production;
(ii) Is for work performed prior to the
date the property is placed in service by the
taxpayer (without regard to any applicable
convention under section 168(d));
(iii) Adapts the unit of property to a new
or different use (including a permanent
structural alteration to the unit of prop-
erty);
(iv) Results in a betterment (including a
material increase in quality or strength) or
a material addition (including an enlarge-
ment, expansion, or extension) to the unit
of property; or
(v) Results in a material increase in
capacity (including additional cubic or
square space), productivity, efficiency, or
quality of output of the unit of property.
(2)Exception. Notwithstanding the
rules in paragraph (e)(1)(i) through
(e)(1)(v) of this section, an amount
paid does not result in a material in-
crease in value to a unit of property if
the economic usefullife (as defined in
§1.263(a)–3(f)(2)) of the unit of property
is 12 months or less and the taxpayer did
not elect to capitalize the amounts paid
originally for the unit of property.
(3)Appropriate comparison.For
purposes of paragraphs (e)(1)(iv) and
(e)(1)(v) of this section, in cases in which
a particular event necessitates an ex-
penditure, the determination of whether
the amount paid materially increases the
value of the unit of property is made by
comparing the condition of the property
immediately after the expenditure with
the condition of the property immediately
prior to the event necessitating the expen-
diture. When the event necessitating the
expenditure is normal wear and tear to
the unit of property, the condition of the
property immediately prior to the event
necessitating the expenditure is the condi-
tion of the property after the last time the
taxpayer corrected the effects of normal
wear and tear (whether the amounts paid
were for maintenance or improvements)
or, if the taxpayer has not previously cor-
rected the effects of normal wear and tear,
the condition of the property when placed
in service by the taxpayer.
(4)Examples. The following examples
illustrate the rules of this paragraph (e) and
assume that the amounts paid are not re-
quired to be capitalized under any other
provision of this section (paragraph (f), for
example):
Example 1.Pre-existing condition. In 2008, X
purchased a store located on 10 acres of land that
contained underground gasoline storage tanks left by
September 25, 20065582006–39 I.R.B.

prior occupants. The tanks had leaked, causing soil
contamination. X was not aware of the contamination
at the time of purchase. When X discovered the con-
tamination, it incurred costs to remediate the soil. For
purposes of thisExample 1, assume the 10 acres of
land is the appropriate unit of property. The amounts
paid for soil remediation must be capitalized as an
improvement to the land because they ameliorated a
condition or defect that existed prior to the taxpayer’s
acquisition of the land. The comparison rule in para-
graph (e)(3) of this section does not apply to these
amounts paid.
Example 2.Not a pre-existing condition; repair
performed during an improvement.(i)Xowned
land on which it constructed a building in 1969 for
use as a bank. The building was constructed with
asbestos-containing materials. The health dangers of
asbestos were not widely known when the building
was constructed. The presence of asbestos did not
necessarily endanger the health of building occu-
pants. The danger arises when asbestos-containing
materials are damaged or disturbed, thereby releas-
ing asbestos fibers into the air (where they can be
inhaled). In 1971, Federal regulatory agencies des-
ignated asbestos a hazardous substance. In 2008, X
determined it needed additional space in its building
to accommodate additional operations at its branch
and decided to remodel the building. However, any
remodeling work could not be undertaken without
disturbing the asbestos-containing materials. The
governmental regulations required that asbestos be
removed if any remodeling was undertaking that
would disturb asbestos-containing materials. There-
fore, X decided to remove the asbestos-containing
materials from the building in coordination with the
overall remodeling project.
(ii) For purposes of thisExample 2, assume that
the building is the appropriate unit of property and
that the amounts paid to remodel are required to be
capitalized under §1.263(a)–3. The amounts paid to
remove the asbestos are not required to be capitalized
as a separate improvement under paragraph (e)(1)(i)
of this section because the asbestos, although later de-
termined to be unsafe under certain circumstances,
was not an inherent defect to the property. The re-
moval of the asbestos, by itself, also did not result in a
material increase in value under paragraphs (e)(1)(ii)
through (e)(1)(v) of this section. Under paragraph
(d)(5)(i) of this section, repairs that do not directly
benefit or are not incurred by reason of an improve-
ment are not required to be capitalized under sec-
tion 263(a). Under section 263A, all indirect costs,
including otherwise deductible repair costs, that di-
rectly benefit or are incurred by reason of the im-
provement must be capitalized as part of the improve-
ment. The amounts paid to remove the asbestos were
incurred by reason of the remodeling project, which
was an improvement. Therefore, X must capitalize
under section 263A to the remodeling improvement
amounts paid to remove the asbestos.
Example 3.Work performed prior to placing the
property in service. In 2008, X purchased a build-
ing for use as a business office. The building was
in a state of disrepair. In 2009, X incurred costs to
repair cement steps; shore up parts of the first and
second floors; replace electrical wiring; remove and
replace old plumbing; and paint the outside and in-
side of the building. Assume all the work was per-
formed on the building or its structural components.
In 2010, X placed the building in service and began
using the building as its business office. For purposes
of thisExample 3, assume the building and its struc-
tural components are the appropriate unit of property.
The amounts paid must be capitalized as an improve-
ment to the building because they were for work per-
formed prior to X’s placing the building in service.
The comparison rule in paragraph (e)(3) of this sec-
tion does not apply to these amounts paid.
Example 4.Work performed prior to placing the
property in service. In January 2008, X purchased
new machinery for use in an existing production line
of its manufacturing business. After the machinery
was installed, X performed critical testing on the ma-
chinery to ensure that it was operational. On Novem-
ber 1, 2008, the new machinery became operational
and, thus, the machinery was placed in service on
November 1, 2008 (although X continued to perform
testing for quality control). The amounts paid must
be capitalized as an improvement to the machinery
because they were for work performed prior to X’s
placing the machinery in service. The comparison
rule in paragraph (e)(3) of this section does not ap-
ply to these amounts paid.
Example 5.New or different use. X is an inte-
rior decorating company and manufactures its own
designs. In 2008, X decides to stop manufacturing
and converts the manufacturing facility into a show-
room for X’s business. To convert the facility, X
removes certain load-bearing walls and builds new
load-bearing walls to provide a better layout for the
showroom and its offices. As part of building the new
walls, X moves or replaces electrical, cable, and tele-
phone wiring and paints the walls. X also repairs the
floors, builds a fire escape, and performs small car-
pentry jobs related to making the showroom acces-
sible, including installing ramps and widening door-
ways. For purposes of thisExample 5, assume the
building and its structural components are the unit of
property and that the work is performed on the struc-
tural components. The amounts paid by X to con-
vert the manufacturing facility into a showroom must
be capitalized as an improvement to the building be-
cause they adapted the building to a new or different
use. The comparison rule in paragraph (e)(3) of this
section does not apply to these amounts paid.
Example 6.New or different use. X owned a
building consisting of five separate retail stores, each
of which it rented to different tenants. In 2008, two
of the stores rented became vacant and remained va-
cant for several months. One of the remaining ten-
ants agreed to expand its occupancy to the two va-
cant stores, which adjoined its own retail store. X in-
curred costs to break down walls between the exist-
ing stores and construct an additional rear entrance.
For purposes of thisExample 6, assume the building
and its structural components are the appropriate unit
of property. The amounts paid by X to convert three
retail stores into one larger store must be capitalized
because they resulted in a permanent structural alter-
ation, and thus a new or different use, to the building.
The comparison rule in paragraph (e)(3) of this sec-
tion does not apply to these amounts paid.
Example 7.Not a new or different use. X owns
a building for rental purposes and decides to sell it.
In preparation of selling, X paints the interior walls,
cleans the gutters, repairscracks in the porch, and re-
finishes the hardwood floors. For purposes of thisEx-
ample 7, assume the building and its structural com-
ponents are the unit of property. Amounts paid for
work done in anticipation of selling the building are
not required to be capitalized unless the amounts paid
materially increase the value as defined in paragraph
(e)(3) of this section or prolong the economic useful
life as defined in paragraph (f)(3). The amounts paid
by X are not transaction costs paid to facilitate the sale
of property under §1.263(a)–1(c), nor do they mate-
rially increase the value of the building. Although
the amounts were paid for the purpose of selling the
building, the sale does not constitute a new or differ-
ent use. Therefore, X is not required to capitalize as
an improvement under paragraph (e) of this section
the amounts paid for work performed on the build-
ing. The comparison rule in paragraph (e)(3) of this
section does not apply to these amounts paid.
Example 8.Not a material increase in value.(i)
X is a commercial airline engaged in the business
of transporting passengers and freight throughout the
United States and abroad. To conduct its business, X
owns or leases various types of aircraft. As a con-
dition of maintaining its airworthiness certification
for these aircraft, X is required by the Federal Avia-
tion Administration (FAA) to establish and adhere to
a continuous maintenance program for each aircraft
within its fleet. These programs, which are designed
by X and the aircraft’s manufacturer and approved by
the FAA are incorporated into each aircraft’s main-
tenance manual. The maintenance manuals require
a variety of periodic maintenance visits at various
intervals during the operating lives of each aircraft.
One type of maintenance visit is an engine shop visit
(ESV), which is performed onX’s aircraft engines ap-
proximately every 4 years.
(ii) In 2004, X purchased a new aircraft and en-
gine. In 2008, X performs its first ESV on the air-
craft engine. The ESV includes some or all of the fol-
lowing activities: disassembly, cleaning, inspection,
repair, replacement, reassembly, and testing. Dur-
ing the ESV, the engine is removed from the aircraft
and shipped to an outside vendor who performs the
ESV. When the engine arrives at the vendor, the en-
gine is cleaned and externally inspected. Regard-
less of condition, it is thoroughly inspected visually
and, as appropriate, further inspected using a number
of non-destructive testing procedures. The engine is
then disassembled into major parts and, if necessary,
into smaller parts. If inspection or testing discloses
a discrepancy in a part’s conformity to the specifi-
cations in X’s maintenance program, the part is re-
paired, or if necessary, replaced with a new or used
serviceable part conforming to the specifications. If
a part can be repaired, but not in time to be returned to
the engine with which the part had arrived, the ven-
dor first attempts to replace the part with a similar part
from customer stock (used parts from X’s aircraft that
were replaced or exchanged and repaired during an
earlierESVandthenstoredforfutureuseonX’sair-
craft). If a part is not available from customer stock,
the part is exchanged with a used, serviceable part in
the vendor’s inventory. A part is replaced (generally
with a used serviceable part) only if the part removed
from X’s engine cannot be repaired timely.
(iii) For purposes of thisExample 8,assume
the aircraft engine is the appropriate unit of prop-
erty. To determine whether the ESV results in a
material increase in value under paragraph (e)(1)(iv)
or (e)(1)(v) of this section, the comparison rule in
paragraph (e)(3) of this section applies. Because the
2006–39 I.R.B.559September 25, 2006

event necessitating the ESV was normal wear and
tear, and X had not previously performed an ESV on
the engine, the relevant comparison is the condition
of the property immediately after the ESV with the
condition of the property when placed in service by
X. Using this comparison, the ESV did not result in a
material addition, betterment, or material increase in
capacity, productivity, efficiency, or quality of output
of the engine compared to the condition of the engine
when placed in service, nor did it adapt the engine
to a new or different use. Therefore, the amounts
paid by X for the ESV did not result in a material
increase in value to the engine. X is not required to
capitalize as an improvement under paragraph (e) of
this section amounts paid for the ESV.
Example 9.Betterment; regulatory requirement.
X owned a hotel in City that included five foot high
unreinforced terra cotta and concrete parapets with
overhanging cornices around the entire roof perime-
ter. The parapets and cornices were in good condi-
tion. In 2008, City passed an ordinance setting higher
safety standards for parapets and cornices because
of the hazardous conditions caused by earthquakes.
To comply with the ordinance, X replaced the old
parapets and cornices with new ones made of glass
fiber reinforced concrete, which made them lighter
and stronger than the original ones. They were at-
tached to the hotel using welded connections instead
of wire supports, making them more resistant to dam-
age from lateral movement. For purposes of thisEx-
ample 9, assume the hotel building and its structural
components are the appropriate unit of property. The
event necessitating the expenditure was the 2008 City
ordinance. Prior to the ordinance, the old parapets
and cornices were in good condition, but were deter-
mined by City to create a potential hazard. After the
expenditure, the new parapets and cornices signifi-
cantly improved the structural soundness of the hotel.
Therefore, the amounts paid by X to replace the para-
pets and cornices must be capitalized because they re-
sulted in a betterment to the hotel. City’s requirement
that X correct the potential hazard to continue oper-
ating the hotel is not relevant in determining whether
the amount paid improved the hotel. See paragraph
(d)(3) of this section.
Example 10.Not a material increase in value;
regulatory requirement. X owned a meat process-
ing plant. In 2008, X discovered that oil was seep-
ing through the concrete walls of the plant, creating
a fire hazard. Federal meat inspectors advised X that
it must correct the seepage problem or shut down its
plant. To correct the problem, X incurred costs to add
a concrete lining to the walls from the floor to a height
of about four feet and also to add concrete to the floor
of the plant. For purposes of thisExample 10, assume
the plant building and its structural components are
the appropriate unit of property. The event necessitat-
ing the expenditure was the seepage of the oil. Prior
to the seepage, the plant did not leak and was func-
tioning for its intended use. The expenditure did not
result in a material addition, betterment, or material
increase in capacity, productivity, efficiency, or qual-
ity of output of the plant compared to the condition
of the plant prior to the seepage of the oil, nor did it
adapt the plant to a new or different use. Therefore,
the amounts paid by X to correct the seepage do not
materially increase the value of the plant. X is not
required to capitalize as an improvement under para-
graph (e) of this section amounts paid to correct the
seepage problem. The Federal meat inspectors’ re-
quirement that X correct the seepage to continue oper-
ating the plant is not relevant in determining whether
the amount paid improved the plant. See paragraph
(d)(3) of this section.
Example 11.Not a material increase in value; re-
placement with same part. X owns a small retail shop.
In 2008, a storm damaged the roof of X’s shop by dis-
placing numerous wooden shingles. X decides to re-
place all the wooden shingles on the roof and hired
a contractor to replace all the shingles on the roof
with new wooden shingles. No part of the sheath-
ing, rafters, or joists was replaced. For purposes of
thisExample 11, assume the shop and its structural
components are the appropriate unit of property. The
event necessitating the expenditure was the storm.
Prior to the storm, the retail shop was functioning for
its intended use. The expenditure did not result in a
material addition, betterment, or material increase in
capacity, productivity, efficiency, or quality of out-
put of the shop compared to the condition of the shop
prior to the storm, nor did it adapt the shop to a new
or different use. Therefore, the amounts paid by X to
reshingle the roof with wooden shingles do not mate-
rially increase the value of the shop. X is not required
to capitalize as an improvement under paragraph (e)
of this section amounts paid to replace the shingles.
Example 12.Not a material increase in value; re-
placement with comparable part.Assumethesame
factsasinExample 11, except that wooden shingles
are not available on the market. X decides to re-
place all the wooden shingles with comparable as-
phalt shingles. The amounts paid by X to reshingle
the roof with asphalt shingles do not materially in-
crease the value of the shop, even though the asphalt
shingles may be an improvement over the wooden
shingles. Because the wooden shingles could not
practicably be replaced with new wooden shingles,
the replacement of the old shingles with comparable
asphalt shingles does not, by itself, result in an im-
provement to the shop. X is not required to capitalize
as an improvement under paragraph (e) of this section
amounts paid to replace the shingles.
Example 13.Betterment; replacement with im-
proved parts. Assume the same facts as inExample
11, except that, instead of replacing the wooden shin-
gles with asphalt shingles, X decides to replace all the
wooden shingles with shingles made of lightweight
composite materials that are maintenance-free and do
not absorb moisture. The new shingles have a 50-year
warranty and a Class A fire rating. X must capitalize
as an improvement amounts paid to reshingle the roof
because they result in a betterment to the shop.
Example 14.Material increase in capacity.X
owns a factory building with a storage area on the
second floor. In 2008, Xreplaces the columns and
girders supporting the second floor to permit storage
of supplies with a gross weight 50 percent greater
than the previous load-carrying capacity of the stor-
age area. For purposes of thisExample 14, assume
the factory building and its structural components are
the appropriate unit of property. X must capitalize as
an improvement amounts paid for the columns and
girders because they resultin a material increase in
the load-carrying capacity of the building. The com-
parison rule in paragraph (e)(3) of this section does
not apply to these amounts paid because the expendi-
ture was not necessitated by a particular event.
Example 15.Material increase in capacity.In
2008, X purchased harbor facilities consisting of a
slip for the loading and unloading of barges and a
channel leading from the slip to the river. At the time
of purchase, the channel was 150 feet wide, 1,000
feet long, and 10 feet deep. To allow for ingress and
egress and for the unloading of its barges, X needed
to deepen the channel to a depth of 20 feet. X hired a
contractor to dredge the channel to the required depth.
For purposes of thisExample 15, assume the channel
is the appropriate unit of property. X must capital-
ize as an improvement amounts paid for the dredging
because it resulted in a material increase in the capac-
ity of the channel. The comparison rule in paragraph
(e)(3) of this section does not apply to these amounts
paid because the expenditure was not necessitated by
a particular event.
Example 16.Not a material increase in capac-
ity. Assume the same facts as inExample 15, except
that the channel was susceptible to siltation and, by
2009, the channel depth had been reduced to 18 feet.
X hired a contractor to redredge the channel to a depth
of 20 feet. The event necessitating the expenditure
was the siltation of the channel. Both prior to the sil-
tation and after the redredging, the depth of the chan-
nel was 20 feet. Therefore, the amounts paid by X for
redredging the channel did not materially increase the
capacity of the unit of property. X is not required to
capitalize as an improvement under paragraph (e) of
this section amounts paid to redredge.
Example 17.Not a material increase in capacity.
X owns a building used in its trade or business. The
first floor has a drop-ceiling. X decides to remove
the drop-ceiling and repaint the original ceiling. For
purposes of thisExample 17, assume the building and
its structural components are the appropriate unit of
property. The removal of the drop-ceiling does not
create additional capacity in the building that was not
there prior to the removal. Therefore, the amounts
paid by X to remove the drop-ceiling and repaint the
original ceiling did not materially increase the capac-
ity of the unit of property. X is not required to capital-
ize as an improvement under paragraph (e) of this sec-
tion amounts paid related to removing the drop-ceil-
ing. The comparison rule in paragraph (e)(3) of this
section does not apply to these amounts paid because
the expenditure was not necessitated by a particular
event.
(f)Restoration—(1)In general.Atax-
payer must capitalize amounts paid that re-
store a unit of property. Amounts paid re-
store property if the amounts paid substan-
tially (as defined in paragraph (f)(3) of this
section) prolong the economic useful life
of the unit of property.
(2)Economic useful life—(i)Taxpayers
with an applicable financial statement.
For taxpayers with an applicable finan-
cial statement (as defined in paragraph
(f)(2)(iii) of this section), the economic
useful life of a unit of property generally
is presumed to be the same as the useful
life used by the taxpayer for purposes of
determining (at the time the property is
originally acquired or produced by the
September 25, 20065602006–39 I.R.B.

taxpayer) depreciation in its applicable
financial statement, regardless of any
salvage value of the property. A tax-
payer may rebut this presumption only
if there is a clear and convincing basis
that the economic useful life (as defined
in paragraph (f)(2)(ii) of this section for
taxpayers without an applicable financial
statement) of the unit of property is signif-
icantly different than the useful life used
by the taxpayer for purposes of determin-
ing depreciation in its applicable financial
statement. If a taxpayer does not have
an applicable financial statement at the
time the property was originally acquired
or produced, but does have an applicable
financial statement at some later date, the
economic useful life of the unit of prop-
erty must be determined under paragraph
(f)(2)(ii) of this section. Further, if a tax-
payer treats amounts paid for a unit of
property as an expense in its applicable
financial statement on a basis other than
the property having a useful life of one
year or less, the economic useful life of
the unit of property must be determined
under paragraph (f)(2)(ii) of this section.
For example, if a taxpayer has a policy
of treating as an expense on its applica-
ble financial statement amounts paid for
property costing less than a certain dollar
amount, notwithstanding that the property
has a useful life of more than one year, the
economic useful life of the property must
be determined under paragraph (f)(2)(ii)
of this section.
(ii)Taxpayers without an applicable fi-
nancial statement. For taxpayers that do
not have an applicable financial statement
(as defined in paragraph (f)(2)(iii) of this
section), the economic useful life of a unit
of property is not necessarily the useful
life inherent in the property but is the pe-
riod over which the property may reason-
ably be expected to be useful to the tax-
payer or, if the taxpayer is engaged in a
trade or business or an activity for the pro-
duction of income, the period over which
the property may reasonably be expected
to be useful to the taxpayer in its trade or
business or for the production of income,
as applicable. This period is determined
by reference to the taxpayer’s experience
with similar property, taking into account
present conditions and probable future de-
velopments. Factors to be considered in
determining this period include, but are not
limited to—
(A) Wear and tear and decay or decline
from natural causes;
(B) The normal progress of the art, eco-
nomic changes, inventions, and current de-
velopments within the industry and the
taxpayer’s trade or business;
(C) The climatic and other local con-
ditions peculiar to the taxpayer’s trade or
business; and
(D) The taxpayer’s policy as to repairs,
renewals, and replacements.
(iii)Definition of “applicable financial
statement”. The taxpayer’s applicable
financial statement is the taxpayer’s fi-
nancial statement listed in paragraphs
(f)(2)(ii)(A) through (C) of this section
that has the highest priority (including
within paragraph (f)(2)(ii)(B) of this sec-
tion). The financial statements are, in
descending priority —
(A) A financial statement required to
be filed with the Securities and Exchange
Commission (SEC) (the 10-K or the An-
nual Statement to Shareholders);
(B) A certified audited financial state-
ment that is accompanied by the report of
an independent CPA (or in the case of a
foreign entity, by the report of a similarly
qualified independent professional), that is
used for—
(1) Credit purposes,
(2) Reporting to shareholders, partners,
or similar persons; or
(3) Any other substantial non-tax pur-
pose; or
(C) A financial statement (other than
a tax return) required to be provided to
the Federal or a state government or any
Federal or state agencies (other than the
SEC or the Internal Revenue Service).
(3)Substantially prolonging economic
useful life—(i)In general.Anamountpaid
substantially prolongs the economic useful
life of the unit of property if it extends the
period over which the property may rea-
sonably be expected to be useful to the tax-
payer in its trade or business or for the pro-
duction of income, as applicable (or, if the
taxpayer is not engaged in a trade or busi-
ness or an activity for the production of
income, the period over which the prop-
erty may reasonably be expected to be use-
ful to the taxpayer) beyond the end of the
taxable year immediately succeeding the
taxable year in which the economic use-
ful life of the unit of property was orig-
inally expected to cease, or if the prop-
erty’s economic useful life was previously
prolonged (as determined under this para-
graph (e)(3)(i)), the end of the taxable year
immediately succeeding the taxable year
in which the prolonged economic useful
life was expected to cease.
(ii)Replacements. Amounts paid will
be deemed to substantially prolong the
economic useful life of the unit of prop-
erty if a major component or a substantial
structural part of the unit of property is re-
placed with either a new part or a part that
has been restored to like-new condition as
described in paragraph (f)(3)(iii) of this
section. Thus, the replacement of a part
with another part that is not new or is not
in like-new condition (for example, a used
or reconditioned part) does not constitute
the replacement of a major component or
substantial structural part of the unit of
property under this paragraph (f)(3)(ii).
Further, replacement of a relatively minor
portion of the physical structure of the unit
of property or a relatively minor portion of
any of its major parts, even if those parts
are new, does not constitute the replace-
ment of a major component or substantial
structural part of the unit of property.
(iii)Restoration to like-new condition.
Amounts paid will be deemed to substan-
tially prolong the economic useful life of
the unit of property if they result in the unit
of property or a major component or sub-
stantial structural part of the unit of prop-
erty being restored to a like-new condi-
tion (including bringing the unit of prop-
erty or a major component or substantial
structural part of the property to the status
of new, rebuilt, remanufactured, or simi-
lar status under the terms of any Federal
regulatory guidelineor the manufacturer’s
original specifications).
(iv)Restoration after a casualty loss.
Amounts paid will be deemed to substan-
tially prolong the useful life of the unit of
property if the taxpayer properly deducts
a casualty loss under section 165 with
respect to the unit of property and the
amounts paid restore the unit of property
to a condition that is the same or better
than before the casualty.
(4)Examples. The following examples
illustrate the rules of this paragraph (f) and,
except as otherwise provided, assume that
the amounts paid would not be required to
be capitalized under any other provision of
this section (paragraph (e), for example):
Example 1.Prolonged economic useful life.X
is a Class I railroad that owns a fleet of locomotives.
2006–39 I.R.B.561September 25, 2006

In 1989, X purchased a newlocomotive with an eco-
nomic useful life (as defined in paragraph (f)(2) of
this section) of 22 years (from 1989 - 2011). X per-
forms substantially the same cyclical maintenance on
its locomotives approximately every 6 years. X per-
formed cyclical maintenance on the locomotive in
1995, in 2001, and in 2007. Assume that the loco-
motive (which includes the engine) is the appropriate
unit of property and that none of the cyclical main-
tenance projects resulted in a restoration under para-
graph (f)(3)(ii) or (f)(3)(iii) of this section. Amounts
paid for cyclical maintenance in 1995 and 2001 do
not substantially prolong the economic useful life of
the locomotive. However, the cyclical maintenance
performed in 2007 will prolong the economic use-
ful life of the locomotive to 2013, which is beyond
the end of the next succeeding taxable year after the
economic useful life of the locomotive ceases (2011).
Therefore, under paragraphs (f)(1) and (f)(3)(i) of
this section, X must capitalize as an improvement to
the locomotive amounts paid for the cyclical main-
tenance performed in 2007, regardless of whether X
was required to capitalize the amounts paid in previ-
ous years for cyclical maintenance.
Example 2.Economic useful life not prolonged.
Assume the same facts as inExample 1, except that
in 2009, X replaces a filter in the locomotive engine.
X generally replaces this type of filter every 4 years.
Although the filter itself would last beyond the end
of the locomotive’s economic useful life in 2011, the
amount paid for the filter does not substantially pro-
long the economic useful life of the locomotive be-
cause the filter will not extend beyond 2009 the pe-
riod over which the locomotive may reasonably be
expected to be useful to X in its trade or business.
Additionally, although the filter is a necessary com-
ponent of the locomotive, the filter is not a substantial
structural part or major component of the locomotive.
Therefore, the amount paid to replace the filter does
not substantially prolong the economic useful life of
the locomotive.
Example 3.Minor part replacement. X owns a
small retail shop. In 2008, a storm damaged the roof
of X’s shop by displacing numerous wooden shin-
gles. X decides to replace all the wooden shingles
on the roof and hires a contractor to replace all the
shingles on the roof with new wooden shingles. No
part of the sheathing, rafters, or joists was replaced.
ForpurposesofthisExample 3, assume the shop and
its structural components are the appropriate unit of
property. The replacement of the shingles did not
extend the useful life of the shop under paragraph
(f)(3)(i) of this section. The portion of the roof re-
placed is not a substantial structural part of the shop,
nor does the replacement of the shingles restore to a
like-new condition a major component or substantial
structural part of the shop. Therefore, the amounts
paid by X to reshingle the roof with wooden shingles
do not substantially prolong the economic useful life
of the shop.
Example 4.Major component or substantial
structural part. Assume the same facts as inExam-
ple 3, except that when the contractor began work on
the shingles, the contractor discovered that a major
portion of the sheathing had rotted, and the rafters
were weakened as well. The contractor replaced all
the sheathing and a significant portion of the rafters.
The roof (including the shingles, sheathing, rafters,
and joists) is a substantial structural part of a build-
ing. The replacement of theshingles, sheathing, and
rafters restored to a like-new condition a substantial
structural part of the shop. Therefore, under para-
graphs (f)(1) and (f)(3)(iii) of this section, X must
capitalize as an improvement to the shop amounts
paid to replace the roof of the shop.
Example 5.Not a major component or structural
part. X uses a car in providing a taxi service. X pur-
chased the car in 2008. Assume that the unit of prop-
erty is the car. The car has an economic useful life
of 5 years. In 2011, the battery dies and X takes the
car to a repair shop, which replaces the battery. Al-
though the battery itself may last beyond the end of
the car’s economic useful life, the amount paid for the
battery does not substantially prolong the economic
useful life of the car because the battery will not ex-
tend beyond 2013 the period over which the car may
reasonably be expected to be useful to X in its trade
or business. Although the battery is a necessary com-
ponent of the car, the battery is not a substantial struc-
tural part or major component of the car. Therefore,
the amount paid to replace the battery does not sub-
stantially prolong the economic useful life of the car.
Example 6.Major component or structural part.
AssumethesamefactsasExample 5, except rather
than the battery dying, the car overheats and causes
so much damage that the engine has to be rebuilt. The
engine is a major component of the car. Therefore, X
is required to capitalize asan improvement to the car
under paragraphs (f)(1) and (f)(3)(iii) of this section
the amounts paid to rebuild the engine.
Example 7.Repair performed during an improve-
ment; coordination with section 263A. Assume the
same facts asExample 6, except that X has a bro-
ken taillight fixed at the same time that the engine
was rebuilt. The repair to the taillight was not in-
curred because the engine was rebuilt, nor did it ben-
efit the rebuild of the engine. The repair of the bro-
ken taillight is a deductible expense under §1.162–4.
Under section 263A, all indirect costs, including oth-
erwise deductible repair and maintenance costs that
directly benefit or are incurred by reason of the im-
provement must be capitalized as part of the improve-
ment. Therefore, all amounts paid that are incurred
by reason of the engine being rebuilt must be capital-
ized, including, for example, amounts paid for activi-
ties that would usually be deductible maintenance ex-
penses, such as refilling the engine with oil and radia-
tor fluid. Amounts paid to repair the broken taillight,
however, are not incurred byreason of the engine be-
ing rebuilt, nor do the amounts paid directly benefit
the engine rebuild, despite being repaired at the same
time. Thus, X is not required to capitalize to the im-
provement of the car (the rebuild of the engine) the
amounts paid to repair the broken taillight.
Example 8.Related amounts to replace major
component or structural part. (i) X owns a retail
gasoline station, consisting of a paved area used for
automobile access to the pumps and parking areas, a
building used to market gasoline, and a canopy cov-
ering the gasoline pumps. The premises also consists
of underground storage tanks (USTs) that are con-
nected by piping to the pumps and are part of the
machinery used in the immediate retail sale of gas.
The pumps also are connected to a monitoring unit
in the building that allows the sales clerk to monitor
the gasoline sales. To comply with regulations issued
by the Environmental Protection Agency, X is re-
quired to remove and replace leaking USTs. In 2008,
X hires a contractor to perform the removal and re-
placement, which consists of removing the old tanks
and installing new tanks with leak detection systems.
The removal of the old tanks includes removing the
paving material covering the tanks, excavating a hole
large enough to gain access to the old tanks, discon-
necting any strapping and pipe connections to the old
tanks, and lifting the old tanks out of the hole. Instal-
lation of the new tanks includes placement of a liner
in the excavated hole, placement of the new tanks,
installation of a leak detection system, installation of
an overfill system, connection of the tank to the pipes
leading to the pumps, backfilling of the hole, and re-
placement of the paving. X is also required to pay a
permit fee to the county to undertake the installation
of the new tanks.
(ii) X pays the permit fee to the county on October
15, 2008. The contractor performs all of the required
work and, on November 1, 2008, bills X for the costs
of removing the old USTs. On November 15, 2008,
the contractor bills X for the remainder of the work.
Assume the fuel distribution system is the appropriate
unit of property. The USTs are major components of
the fuel distribution system. Therefore, under para-
graphs (f)(1) and (f)(3)(ii) of this section, X must cap-
italize as an improvement to the fuel distribution sys-
tem the aggregate of related amounts paid to replace
the USTs, which related amounts include the amount
paid to the county, the amount paid to remove the old
USTs, and the amount paid to install the new USTs
(regardless that the amounts were separately invoiced
and paid to two different parties).
Example 9.Major component or substantial
structural part. X is a common carrier that owns
a fleet of petroleum hauling trucks. In 2008, X
replaces the existing engine, cab, and petroleum tank
of a truck with a new engine, cab, and tank. Assume
the tractor of the truck (which includes the cab and
the engine) is a separateunit of property from the
rest of the truck. Also assume that the trailer (which
contains the petroleum tank) is a separate unit of
property from the truck. The engine and the cab
are major components of the truck tractor, and the
petroleum tank is a major component of the trailer.
Therefore, under paragraphs (f)(1) and (f)(3)(ii) of
this section, X must capitalize as an improvement to
the tractor amounts paid to replace the engine and
cab, and must capitalize as an improvement to the
trailer amounts paid to replace the petroleum tank.
Example 10.Restoration of major component to
like-new condition. (i) X is a towboat operator that
owns and leases a fleet of towboats. In 2008, X re-
places an existing towboat engine with a rebuilt en-
gine. A towboat engine is rebuilt through a series of
steps designed to put the engine in like-new operat-
ing condition to the maximum extent possible. En-
gines in a towboat nearing the end of its useful life or
engines that have been removed from towboats due
to a catastrophic malfunction are likely candidates
for the rebuilding process. The goal of the rebuild-
ing process is to bring each of an engine’s compo-
nent parts to the manufacturer’s original dimensional
specifications for new parts.
(ii) Replacement of the existing towboat engine
with a rebuilt engine involves dry-docking the tow-
boat. The rebuilding and replacement process takes
approximately 3 to 5 months. The process requires
the removal of the engine from the towboat and
the removal of all of the moving and nonmoving
September 25, 20065622006–39 I.R.B.

components from the engine as well. The engine’s
crankcase and oil pan are separated, and every part of
the engine is cleaned, inspected using intense illumi-
nation, machined, and treated with special materials
to restore the engine to like-new operating condition.
The engine crankcase and oil pan are extensively ma-
chined and welded, and numerous dimensional tests
and checks are performed to ensure that the engine is
returned to a like-new condition through the rebuild-
ing process. In addition, a reconditioned crankshaft
and camshaft normally are installed in the engine
during the rebuilding process. The power packs are
completely rebuilt with a large number of new parts
during the rebuilding process. The oil pumps, water
pumps, engine turbochargers, and governors are
normally removed and exchanged for rebuilt parts
during the rebuilding process. The accessory drive
gears, all of the piping on the front and aft ends of the
engine, the governor drive gear, and the turbocharger
drive gears are removed and normally exchanged for
rebuilt parts during the rebuilding process. The goal
of the rebuilding process is to bring each of an en-
gine’s component parts to the engine manufacturer’s
original dimensional specifications for new parts.
Assume the towboat (which includes the engine) is
the appropriate unit of property. The work done on
the towboat engine constitutes a remanufacture or
rebuild of the engine, which is a major component
of the towboat. Therefore, under paragraphs (f)(1)
and (f)(3)(iii) of this section, X must capitalize as an
improvement to the towboat amounts paid to rebuild
the towboat engine.
Example 11.Repairs performed during an im-
provement; coordination with section 263A. Assume
the same facts as inExample 10, except that while
the towboat is in dry-dock to have the engine rebuilt,
X also makes repairs to the hull and rudders that are
not by themselves an improvement under this sec-
tion. The amounts paid to repair the hull and rud-
ders do not directly benefit nor are incurred by rea-
son of the engine rebuild. Under section 263A, all
indirect costs, including otherwise deductible repair
costs that directly benefit or are incurred by reason
of the improvement must be capitalized as part of the
improvement. Therefore, all amounts paid that are
incurred by reason of the engine being rebuilt must
be capitalized to the improvement, including, for ex-
ample, amounts paid for activities such as cleaning
and inspecting the engine, which usually would be
deductible maintenance costs. Amounts paid to re-
pair the hull and rudders, however, are not incurred by
reason of the engine being rebuilt, nor do the amounts
paid directly benefit the engine rebuild, despite being
incurred at the same time. Thus, in accordance with
paragraph (d)(5)(i) of this section, X is not required
to capitalize to the towboat amounts paid to repair the
hull and rudders to the improvement.
Example 12.Restoration to like-new condition;
coordination with section 263A. Assume the same
facts asExample 10, except that while the towboat
is in dry-dock, X also makes substantial improve-
ments to the propulsion systems and the mechani-
cal systems, including rebuilding large sections of
the hull, and rebuilding, replacing, or upgrading the
steering systems, shafting systems, and electrical sys-
tems, such that almost the entire towboat is restored
to like-new condition. This process constitutes a re-
manufacture or rebuild of the towboat. Under sec-
tion 263A, all indirect costs, including otherwise de-
ductible repair costs that directly benefit or are in-
curred by reason of the improvement must be capi-
talized as part of the improvement. Therefore, under
paragraph (d)(5)(i) of this section, X must capital-
ize to the improvement of the towboat (the rebuild)
amounts paid that otherwise would be deductible re-
pair costs that directly benefit or are incurred by rea-
son of the improvement.
Example 13.Restoration to like-new condition.
X is a Class I railroad that owns a fleet of freight
cars. Approximately every 10 years, X rebuilds its
freight cars. The rebuild includes a complete dis-
assembly, inspection, and reconditioning and/or re-
placement of components of the suspension and draft
systems, trailer hitches, and other special equipment.
Modifications are made to the car to upgrade various
components to the latest engineering standards. The
freight car essentially is stripped to the frame, with
all of its substantial components either reconditioned
or replaced. The frame itself is the longest-lasting
part of the car and is reconditioned. The walls of
the freight-train car are replaced or are sandblasted
and repainted. New wheels typically are installed
on the car. All the remaining components of the car
are restored before they are reassembled. At the end
of the rebuild, the freight cars have been restored to
like-new condition. Assume the freight car is the
appropriate unit of property. The work done to the
freight car constitutes a remanufacture or rebuild of
the freight car. Therefore, under paragraphs (f)(1) and
(f)(3)(iii) of this section, X must capitalize as an im-
provement to the freight car amounts paid to rebuild
the freight car.
Example 14.Restoration of major component to
like-new condition. X owned a factory that it ac-
quired in 1997. In 2008, the factory roof began to
leak. These leaks on occasion resulted in damage to
X’s products and prevented the use of certain portions
of the factory. X decided to reroof the entire factory
and hired a contractor to perform the reroofing. The
structure of the roof, including substantial portions
of the rafters and joists, was restored to a like-new
condition. Assume the factory building and its struc-
tural components are the appropriate unit of property.
The roofing process constitutes a remanufacture or
rebuild of the roof, which is a substantial structural
part of the factory. Therefore, under paragraphs (f)(1)
and (f)(3)(iii) of this section, X must capitalize as an
improvement to the factory amounts paid to reroof the
factory.
Example 15.Minor part replacement; coordina-
tion with section 263A. X is in the business of smelt-
ing aluminum. X’s aluminum smelting facility in-
cludes a plant where molten aluminum is poured into
molds and allowed to solidify. Because of the poten-
tial of fire from a molten metal explosion, the plant’s
roof must be made of fire-resistant material. The roof
must also be without leaks because rain water hitting
the molten aluminum could cause an explosion. The
roof of the plant was made of roofing material and
corrugated sheet metal decking, which supports the
roofing material. During 2008, X removed and re-
placed a minor portion of the plant’s roof decking
and roofing material. At the time of the replacement,
the pattern of the original metal support decking was
not available. Therefore, X used comparable fire re-
sistant wood decking to replace the corrugated metal
decking. For purposes of thisExample 15, assume
the plant building and its structural components are
the appropriate unit of property and that the amount
paid does not prolong the economic useful life of the
plant under paragraph (f)(3)(i) of this section. The
portion of the roof structure being replaced is not a
substantial structural part of the plant, nor does the
work performed return to like-new condition a major
component or substantial structural part of the plant.
Further, because X could not practicably replace the
roof material with the same type of material, the re-
placement of the original roof material with an im-
proved, but comparable, material does not, by itself,
result in an improvement. Therefore, the amount paid
to remove and replace a minor part of the plant’s roof
decking and roofing materially does not substantially
prolong the economic useful life of the plant. How-
ever, under section 263A, all indirect costs, includ-
ing otherwise deductible costs, that directly benefit or
are incurred by reason of the taxpayer’s manufactur-
ing activities must be capitalized to the property pro-
duced for sale. Therefore, because the amounts paid
for the roof decking and materials are incurred by
reason of X’s manufacturing operations, the amounts
paid must be capitalized under section 263A to the
property produced for sale by X.
Example 16.Minor part replacement.(i)Xisa
commercial airline engaged in the business of trans-
porting passengers and freight throughout the United
States and abroad. To conduct its business, X owns
or leases various types of aircraft. As a condition of
maintaining its airworthiness certification for these
aircraft, X is required by the Federal Aviation Ad-
ministration (FAA) to establish and adhere to a con-
tinuous maintenance program for each aircraft within
its fleet. These programs, which are designed by
X and the aircraft’s manufacturer and approved by
the FAA are incorporated into each aircraft’s main-
tenance manual. The maintenance manuals require
a variety of periodic maintenance visits at various
intervals during the operating lives of each aircraft.
One type of maintenance visit is an engine shop visit
(ESV), which is performed onX’s aircraft engines ap-
proximately every 4 years.
(ii) In 2004, X purchased a new aircraft and en-
gine. In 2008, X performs its first ESV on the air-
craft engine. The ESV includes some or all of the fol-
lowing activities: disassembly, cleaning, inspection,
repair, replacement, reassembly, and testing. Dur-
ing the ESV, the engine is removed from the aircraft
and shipped to an outside vendor who performs the
ESV. When the engine arrives at the vendor, the en-
gine is cleaned and externally inspected. Regard-
less of condition, it is thoroughly inspected visually
and, as appropriate, further inspected using a number
of non-destructive testing procedures. The engine is
then disassembled into major parts and, if necessary,
into smaller parts. If inspection or testing discloses
a discrepancy in a part’s conformity to the specifi-
cations in X’s maintenance program, the part is re-
paired, or if necessary, replaced with a new or used
serviceable part conforming to the specifications. If
a part can be repaired, but not in time to be returned to
the engine with which the part had arrived, the ven-
dor first attempts to replace the part with a similar part
from customer stock (used parts from X’s aircraft that
were replaced or exchanged and repaired during an
earlierESVandthenstoredforfutureuseonX’sair-
craft). If a part is not available from customer stock,
the part is exchanged with a used, serviceable part in
the vendor’s inventory. A part is replaced (generally
2006–39 I.R.B.563September 25, 2006

with a used serviceable part) only if the part removed
from X’s engine cannot be repaired timely. Although
many minor parts may be replaced during the ESV,
the ESV does not return the engine to a like-new con-
dition.
(iii) For purposes of thisExample 16, assume the
aircraft engine is the appropriate unit of property. The
ESV does not result in the replacement of the engine
nor does it restore the engine to a like-new condition.
Therefore, the amount paid for the ESV does not sub-
stantially prolong the economic useful life of the en-
gine.
Example 17.Repairs performed during an
improvement; coordination with section 263A.(i)
Assume the same facts as inExample 16, except that
X purchased the aircraft in 1986 and, in addition to
the continuous maintenance program for engines,
X adheres to a continuous maintenance program
for its aircraft airframes. One type of maintenance
visit is a heavy maintenance visit (HMV), which is
performed on X’s aircraft airframes approximately
every 8 years. In 2008, X decided to make substan-
tial modifications to the airframe, which resulted in
the restoration of the airframe to like-new condition.
The modifications included removing all the belly
skin panels on the aircraft’s fuselage and replacing
them with new skin panels; replacing the metal
supports under the lavatories and galleys; removing
the wiring in the leading edges of both wings and
replacing it with new wiring; removing the fuel tank
bladders, harnesses, wiring systems, and connectors
and replacing them with new components; opening
every lap joint on the airframe and replacing the
epoxyandrivetsusedtosealthelapjointswitha
non-corrosive sealant and larger rivets; reconfiguring
and upgrading the avionics and the equipment in the
cockpit; replacing all the seats, overhead bins, side-
wall panels, partitions, carpeting, windows, galleys,
lavatories, and ceiling panels with new items; in-
stalling a cabin smoke and fire detection system, and
a ground proximity warning system; and painting
the exterior of the aircraft. In addition, X performed
much of the same work that would be performed
duringanHMV.
(ii) For purposes of thisExample 17, assume the
aircraft airframe is the appropriate unit of property.
The amounts paid to modify the airframe are required
to be capitalized as an improvement to the airframe
under paragraph (f) of this section because the mod-
ifications restored the airframe to a like-new condi-
tion. Assume the amounts paid for the HMV are
not required to be capitalized as a separate improve-
ment to the airframe. Under section 263A, all indi-
rect costs, including otherwise deductible repair costs
that directly benefit or are incurred by reason of the
improvement must be capitalized as part of the im-
provement. Therefore, X must capitalize to the im-
provement of the airframe (the restoration) amounts
paid that usually would be ordinary and necessary re-
pair costs, including any amounts paid for the HMV
that directly benefit or are incurred by reason of the
improvement to the airframe. X is not required, how-
ever, to capitalize to the improvement of the airframe
any amounts paid for the HMV that do not directly
benefit or are not incurred by reason of the improve-
ment to the airframe.
Example 18.Restoration of major component to
like-new condition; coordination with section 263A.
(i) X is a Class I railroad that owns a fleet of locomo-
tives. In 1994, X purchased a new locomotive (Lo-
comotive A) with an economic useful life (as defined
in paragraph (f)(2) of this section) of 20 years (from
1994 - 2014). X performed cyclical maintenance on
Locomotive A in 2000, and again in 2008. In 2000,
X replaced the power cylinders on Locomotive A’s
engine, and performed work on other components of
Locomotive A. In 2008, X removed the engine and re-
placed it with one it had previously remanufactured to
the manufacturer’s original specifications, and again
performed work on other components of Locomotive
A. The engine that X removed from Locomotive A
in 2008 was remanufactured to the manufacturer’s
original specifications and installed on Locomotive
B later in 2008.
(ii) Assume the locomotive (which includes the
engine) is the appropriate unit of property. The re-
placement of the power cylinders and the other work
performed on Locomotive A in 2000 did not prolong
the economic useful life of Locomotive A under para-
graph (f)(3) of this section. However, the amounts
paid in 2008 to remove the engine and replace it with
a previously manufactured engine must be capitalized
under paragraph (f)(3)(ii) of this section. Assume the
amounts paid in 2008 to perform work on other com-
ponents of Locomotive A are not required to be cap-
italized as a separate improvement to Locomotive A.
Under section 263A, all indirect costs, including oth-
erwise deductible repair costs that directly benefit or
are incurred by reason of the improvement must be
capitalized as part of the improvement. Therefore,
X must capitalize to the improvement of Locomo-
tive A (the installation of the remanufactured engine)
amounts paid that usually would be ordinary and nec-
essary repair costs, including any amounts paid for
work on other components that directly benefit or are
incurred by reason of the improvement to Locomo-
tive A. X is not required, however, to capitalize to the
improvement of Locomotive A any amounts paid for
work performed on other components that do not di-
rectly benefit or are not incurred by reason of the im-
provement to Locomotive A. Further, X must capital-
ize to the improvement of Locomotive B (the instal-
lation of remanufactured engine) the amounts paid to
remanufacture the engineremoved from Locomotive
A and amounts paid to install the remanufactured en-
gine on Locomotive B.
(g)Repair allowance method—(1)In
general. This paragraph (g) provides an
optional simplified method (the repair al-
lowance method) for determining whether
amounts paid to repair, maintain, or im-
prove certain tangible property are to be
treated as deductible expenses or capital
expenditures. A taxpayer that elects to
use the repair allowance method described
in paragraph (g)(3) of this section may
use that method instead of determining
whether amounts paid to repair, maintain,
or improve property are capital expendi-
tures or deductible expenses under the gen-
eral principles of sections 162(a), 212, and
263(a). Thus, except for the rules in para-
graph (d)(2) of this section for determining
the appropriate unit of property, the cap-
italization rules in §1.263(a)–3(d) do not
applytopropertyforwhichthetaxpayer
uses the repair allowance method under
this paragraph (g). See section 263A for
the scope of costs required to be capital-
ized to property produced by the taxpayer
or to property acquired for resale.
(2)Election of repair allowance
method. In the case of repair allowance
property (as defined in paragraph (g)(6)
of this section), a taxpayer may elect to
use the repair allowance method described
in paragraph (g)(3) of this section. See
paragraph (g)(9) of this section for the
manner of electing the repair allowance.
A taxpayer that elects to use the repair
allowance method must use that method
for all of its repair allowance property
in all MACRS classes (including prop-
erty classified into a MACRS class for
purposes of the repair allowance method
under paragraph (g)(6)(ii) of this section).
A taxpayer electing the repair allowance
method must use that method consistently
for all future years unless the taxpayer
revokes the election in accordance with
paragraph (g)(10) of this section.
(3)Application of repair allowance
method. Under the repair allowance
method, a taxpayer must treat all amounts
paid (other than amounts paid for ex-
cluded additions, as defined in paragraph
(g)(7) of this section) for materials and
labor to repair, maintain, or improve all
the repair allowance property in a particu-
lar MACRS class as deductible expenses
under section 162 for the taxable year, up
to the repair allowance amount (as deter-
mined in paragraph (g)(4) of this section)
for that MACRS class, and treat the excess
of all amounts paid to repair, maintain, or
improve all the repair allowance prop-
erty in that MACRS class (the capitalized
amount) in accordance with paragraph
(g)(5) of this section.
(4)Repair allowance amount—(i)In
general. Except as provided in paragraph
(g)(4)(iv) of this section (with regard to
buildings), under the repair allowance
method for a particular taxable year, the
repair allowance amount for a particular
MACRS class consisting of repair al-
lowance property is an amount equal to
the average unadjusted basis (as defined
in paragraph (g)(4)(ii) of this section) of
repair allowance property in the MACRS
class multiplied by the repair allowance
September 25, 20065642006–39 I.R.B.

percentage in effect for the MACRS class
for the taxable year.
(ii)Average unadjusted basis. For pur-
poses of this section, average unadjusted
basis is the average of the unadjusted basis
(as defined in paragraph (g)(4)(iii) of this
section) of all repair allowance property in
the MACRS class at the beginning of the
taxable year and the unadjusted basis of all
repair allowance property in the MACRS
class at the end of the taxable year.
(iii)Unadjusted basis. For purposes
of this section, unadjusted basis is the ba-
sis as determined under section 1012, or
other applicable sections of subchapter O,
and subchapters C (relating to corporate
distributions and adjustments), K (relating
to partners and partnerships), and P (re-
lating to capital gains and losses). Un-
adjusted basis is determined without re-
gard to any adjustments described in sec-
tion 1016(a)(2) or (3) or to amounts for
which the taxpayer has elected to treat as
an expense (for example, under section
179, 179B, or 179C), but with regard to ba-
sis reductions which are required because
of credits taken on the property (for exam-
ple, under section 44, 45G, 45H, or 50(c)).
Unadjusted basis also must reflect the re-
duction in basis for the percentage of the
taxpayer’s use of property for the taxable
year other than for use in the taxpayer’s
trade or business (or for the production of
income).
(iv)Buildings. In the case of buildings
and structural components that are repair
allowance property, the repair allowance
method is applied separately with respect
to each unit of property.
(5)Capitalized amount—(i)In general.
Under the repair allowance method for
a particular taxable year, the capitalized
amount is the excess of all amounts paid to
repair, maintain, or improve all the repair
allowance property in a MACRS class
over the repair allowance amount for that
MACRS class. In addition, the capitalized
amount includes all of the indirect costs of
producing the repair allowance property
in the MACRS class, which must be cap-
italized in accordance with the taxpayer’s
method of accounting for section 263A
costs. Except as provided in paragraphs
(g)(5)(iv), (g)(5)(v), and (g)(5)(vi) of this
section, a taxpayer may choose to treat
the capitalized amount as a single asset
under paragraph (g)(5)(ii) of this section
or, alternatively, may choose to allocate
the capitalized amount to specific repair
allowance property in the MACRS class
in accordance with paragraph (g)(5)(iii) of
this section.
(ii)Single asset treatment of capital-
ized amount. In general, the capitalized
amount for a particular MACRS class may
be treated by the taxpayer as a separate
single asset and depreciated in accordance
with that MACRS class. The single asset
is treated as a section 168(i)(6) improve-
ment and is treated as placed in service by
the taxpayer on the last day of the first half
of the taxable year in which the amount
is paid, before application of the conven-
tion under section 168(d). Except for a
sale of assets constituting a trade or busi-
ness, no gain or loss is recognized on cap-
italized amounts treated as a single asset
under this paragraph (g)(5)(ii) upon dispo-
sition of any repair allowance property to
which the capitalized amounts are related.
A disposition includes the sale, exchange,
retirement, physical abandonment, or de-
struction of property. Taxpayers must con-
tinue to depreciate the single asset over the
remainder of the MACRS applicable re-
covery period.
(iii)Allocation treatment of capitalized
amount. Instead of treating the capitalized
amount as a single asset under paragraph
(g)(5)(ii) of this section, a taxpayer may al-
locate the capitalized amount for a partic-
ular MACRS class to all repair allowance
property in the particular MACRS class in
proportion to the unadjusted basis of the
property in that MACRS class as of the be-
ginning of the taxable year. The capital-
ized amount allocated to repair allowance
property is treated as a section 168(i)(6)
improvement to the underlying repair al-
lowance property and is treated as placed
in service by the taxpayer on the last day
of the first half of the taxable year in which
the amount is paid, before application of
the convention under section 168(d).
(iv)Section 168(g) repair allowance
property. If any repair allowance property
in a particular MACRS class as of the
beginning of the taxable year is depre-
ciated under section 168(g) pursuant to
section 168(g)(1)(A) through (D) or other
provisions of the Internal Revenue Code,
the portion of the capitalized amount for
that MACRS class that is attributable to
all section 168(g) repair allowance prop-
erty in that MACRS class (section 168(g)
total capitalized amount) is determined
by multiplying the capitalized amount for
that MACRS class (as determined under
paragraph (g)(5)(i) of this section) by a
percentage that is equal to the unadjusted
basis of all section 168(g) repair allowance
property in that MACRS class as of the be-
ginning of the taxable year divided by the
unadjusted basis of all repair allowance
property in that MACRS class as of the
beginning of the taxable year. The section
168(g) total capitalized amount for a par-
ticular MACRS class then is allocated to
each section 168(g) repair allowance prop-
erty in that MACRS class by multiplying
the section 168(g) total capitalized amount
for that MACRS class by a percentage
that is equal to the unadjusted basis of the
particular section 168(g) repair allowance
property in that MACRS class as of the
beginning of the taxable year divided by
the unadjusted basis of all section 168(g)
repair allowance property in that MACRS
class as of the beginning of the taxable
year. The capitalized amount allocated
to each section 168(g) repair allowance
property is depreciated in accordance with
section 168(g), is treated as a section
168(i)(6) improvement to the underlying
repair allowance property, and is treated
as placed in service by the taxpayer on the
lastdayofthefirsthalfofthetaxableyear
in which the amount is paid, before ap-
plication of the convention under section
168(d).
(v)Section 168(g) election.Ifatax-
payer makes an election under section
168(g)(7) for a particular MACRS class
with respect to property placed in service
in the current taxable year, the election
applies to the capitalized amount for that
MACRS class. If such an election is made,
the taxpayer must allocate the capitalized
amount for that MACRS class to all repair
allowance property in the MACRS class
in proportion to the unadjusted basis of
the property in that MACRS class as of
the beginning of the taxable year. The
capitalized amount is treated as a section
168(i)(6) improvement to the underlying
repair allowance property and is treated as
placed in service by the taxpayer on the
lastdayofthefirsthalfofthetaxableyear
in which the amount is paid, before ap-
plication of the convention under section
168(d). The depreciation of the capital-
ized amount allocated to repair allowance
property must be determined under section
168(g) whether or not the repair allowance
2006–39 I.R.B.565September 25, 2006

property in the MACRS class as of the be-
ginning of the taxable year is depreciated
under section 168(g).
(vi)Public utility property.Ifanyre-
pair allowance property in a particular
MACRS class is public utility property
(as defined in section 168(i)(10) or for-
mer section 167(l)(3)(A)), the portion of
the capitalized amount for that MACRS
class that is attributable to all public util-
ity property in that MACRS class (public
utility property totalcapitalized amount)
is determined by multiplying the capital-
ized amount for that MACRS class (as
determined under paragraph (g)(5)(i) of
this section) by a percentage that is equal
to the unadjusted basis of all public utility
property in that MACRS class as of the be-
ginning of the taxable year divided by the
unadjusted basis of all repair allowance
property in that MACRS class as of the
beginning of the taxable year. The public
utility property total capitalized amount
for a particular MACRS class then is sub-
tracted from the unadjusted basis of all
repair allowance property in that MACRS
class as of beginning of the taxable year
to determine the non-public utility prop-
erty total capitalized amount. A taxpayer
may choose to treat the public utility
property total capitalized amount for a
particular MACRS class as a single asset
in accordance with paragraph (g)(5)(ii)
of this section, and the non-public utility
property total capitalized amount for that
MACRS class as another single asset in
accordance with paragraph (g)(5)(ii) of
this section. Alternatively, the taxpayer
may choose to allocate the public utility
property total capitalized amount for a
particular MACRS class in proportion to
the unadjusted basisof the public utility
property in that MACRS class as of the
beginning of the taxable year in accor-
dance with paragraph (g)(5)(iii) of this
section, and allocate the non-public util-
ity property total capitalized amount for
a particular MACRS class in proportion
to the unadjusted basis of the non-public
utility property in that MACRS class as
of the beginning of the taxable year in
accordance with paragraph (g)(5)(iii) of
this section. In either case, the public
utility property total capitalized amount
for a particular MACRS class is subject to
the normalization requirements of section
168(i)(9).
(6)Repair allowance property—(i)In
general. Except as provided in paragraph
(g)(6)(iii) of this section, repair allowance
property means real or personal property
subject to section 168 of the Internal Rev-
enue Code of 1986, or treated as subject
to section 168 under paragraph (g)(6)(ii) of
this section, that is used in the taxpayer’s
trade or business or for the production of
income.
(ii)Certain property not subject to sec-
tion 168. Repair allowance property in-
cludes tangible depreciable property not
otherwise in a MACRS class if the tax-
payer classifies the property, only for pur-
poses of the repair allowance method in
paragraph (g)(4) of this section, to deter-
mine the appropriate MACRS class and
either the taxpayer placed the property in
service before the effective date of section
168 of the Internal Revenue Code of 1986
or the taxpayer properly elected out of sec-
tion 168 with regard to the property.
(iii)Exclusions from repair allowance
property. Repair allowance property
does not include any property for which
the taxpayer has elected to use the as-
set guideline class repair allowance in
§1.167(a)–11(d)(2); the method of ac-
counting provided in section 263(d) (with
regard to certain railroad rolling stock);
the method of accounting provided in Rev.
Proc. 2001–46, 2001–2 C.B. 263, or Rev.
Proc. 2002–65, 2002–2 C.B. 700 (with re-
gard to railroad track) (see §601.601(d)(2)
of this chapter); or any other property or
method of accounting that is designated in
guidance published in theFederal Regis-
teror the Internal Revenue Bulletin (see
§601.601(d)(2) of this chapter).
(7)Excluded additions—(i)In general.
Excluded additionmeans any amount
paid—
(A) For the acquisition or production of
a specific unit of property;
(B) For work that ameliorates a condi-
tion or defect that either existed prior to the
taxpayer’s acquisition of the unit of prop-
erty or arose during the production of the
unit of property, whether or not the tax-
payer was aware of the condition or defect
at the time of acquisition or production;
(C) For work performed prior to the
date the unit of property is placed in ser-
vice by the taxpayer (without regard to
any applicable convention under section
168(d));
(D) That adapts the unit of property to
a new or different use; or
(E) That increases the cubic or square
space of a building.
(ii)Treatment of excluded additions.
Any amount paid for an excluded addition
is treated as a capital expenditure under
sections 263(a) and 263A.
(8)Repair allowance percentage.Ex-
cept as provided in any future guidance
published in theFederal Registeror the
Internal Revenue Bulletin, the repair al-
lowance percentage in effect for each
MACRS class for a particular taxable year
is as follows:
MACRS ClassMACRS Recovery
Period
Repair Allowance
Percentage
3-year property3 years16.5
5-year property5 years10
7-year property7 years7.14
10-year property10 years5
15-year property15 years3.33
20-year property20 years2.5
Water utility property25 years2
Residential rental property27.5 years1.82
Nonresidental rental property39 years1.28
Railroad grading or tunnel bore50 years1
September 25, 20065662006–39 I.R.B.

(9)Manner of election.[Reserved]
(10)Manner of revoking election.A
taxpayer may revoke an election made un-
der the repair allowance method only by
obtaining the Commissioner’s consent to
revoke the election. An election must be
revoked prospectively and may not be re-
voked through the filing of an amended
Federal income tax return. A taxpayer that
revokes an election may not re-elect the
repair allowance method for a period of
at least five taxable years, beginning with
the year of the revocation unless, based on
a showing of unusual and compelling cir-
cumstances, consent is specifically granted
by the Commissioner to re-elect the repair
allowance at an earlier time.
(11)Examples. The following exam-
ples illustrate the rules of this paragraph
(g) and assume that none of the rules in
paragraph (g)(5)(iv) or (g)(5)(v) of this
section applies:
Example 1. X elects the repair allowance method
described in this paragraph (g). X’s total unadjusted
basis of all of its MACRS 10-year property as of Jan-
uary 1, 2008 is $10 million. X’s total unadjusted ba-
sis of all MACRS 10-year property as of December
31, 2008 is $15 million (computed without regard to
amounts capitalized under this repair allowance pro-
vision). During 2008, X pays $1,000,000 to repair,
maintain, or improve MACRS 10-year property. As-
sume that none of X’s property is an excluded ad-
dition as defined in paragraph (g)(7) of this section.
The repair allowance percentage for MACRS 10-year
property is 5 percent. X’s repair allowance amount
and capitalized amount are computed as follows:
(i) X determines its average unadjusted ba-
sis of MACRS 10-year property: ($10,000,000 +
$15,000,000)/2 = $12,500,000.
(ii) X multiplies its average unadjusted basis of
MACRS 10-year property bythe prescribed repair
allowance percentage for MACRS 10-year property
to arrive at the repair allowance amount: $12,500,000
x 5% = $625,000.
(iii) Because X’s amounts paid to repair,
maintain, or improve MACRS 10-year property
($1,000,000) exceed the repair allowance amount
for MACRS 10-year property ($625,000), X deducts
under section 162(a) amounts paid to the extent of the
repair allowance amount ($625,000) and capitalizes
the amounts paid in excess of the repair allowance
amount ($1,000,000 - $625,000 = $375,000).
(iv) The capitalized amount ($375,000) is treated
as an improvement under section 168(i)(6). The im-
provement is depreciatedas 10-year property under
section 168 and is considered placed in service on the
last day of the first half of 2008.
Example 2. X elects the repair allowance method
described in this paragraph (g). X uses a car in
providing a taxi service. X’s unadjusted basis in
the car is $25,000. Assume that the unit of prop-
erty (as determined under paragraph (d)(2) of this
section) is the car. In 2008, X incurs various costs
to maintain, repair, and improve the car, including:
$4,500 for gasoline; $550 for car washes and de-
tailing, $2,200 for scheduled maintenance such as
oil changes, tire rotation, new brakes, minor parts,
and fluid replacements, etc.; $80 for new headlights;
$250 for new tires; and $4,800 to rebuild the engine
after the car overheated. Assume that none of X’s
expenditures are an excluded addition as defined in
paragraph (g)(7) of this section. The car is classified
as MACRS 5-year property. Assume that X has no
other MACRS 5-year property. The repair allowance
percentage for MACRS 5-year property is 10 per-
cent. X’s repair allowance amount and capitalized
amount are computed as follows:
(i) X determines its average unadjusted basis of
MACRS 5-year property is $25,000.
(ii) X multiplies its average unadjusted basis of
MACRS 5-year property by the prescribed repair al-
lowance percentage for MACRS 5-year property to
arrive at the repair allowance amount: $25,000 x 10%
= $2,500.
(iii) Because X’s amounts to repair, maintain, or
improve MACRS 5-year property ($2,200 + $80 +
$250 + $4,800 = $7,330) exceed the repair allowance
amount for MACRS 5-year property ($2,500), X
treats $2,500 as an otherwise deductible ordinary
and necessary expenditure under section 162(a) and
capitalizes $4,830 as the amounts paid in excess of
the repair allowance amount.
(iv) The capitalized amount ($4,830) is treated as
an improvement under section 168(i)(6). The im-
provement is depreciated as 5-year property under
section 168 and is considered placed in service on the
lastdayofthefirsthalfof2008.
(h)Treatment of capital expenditures.
Amounts required to be capitalized un-
der this section are capital expenditures
and must be taken into account through
a charge to capital account or basis, or in
the case of property that is inventory in
the hands of a taxpayer, through inclusion
in inventory costs. See section 263A for
the treatment of amounts referred to in
this section as well as other amounts paid
in connection with the production of real
property and personal property, includ-
ing films, sound recordings, video tapes,
books, or similar properties.
(i)Recovery of capitalized amounts.
Amounts that are capitalized under this
section are recovered through deprecia-
tion, cost of goods sold, or by an adjust-
ment to basis at the time the property is
placed in service, sold, used, or otherwise
disposed of by the taxpayer. Cost recovery
is determined by the applicable Internal
Revenue Code and regulation provisions
relating to the use, sale, or disposition of
property.
(j)Effective date. The rules in this sec-
tion apply to taxable years beginning on or
after the date of publication of the Treasury
decision adopting these rules as final reg-
ulations in theFederal Register.
(k)Accounting method changes.[Re-
served]
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on August 18,
2006, 8:45 a.m., and published in the issue of the Federal
Register for August 21, 2006, 71 F.R. 48590)
Notice of Proposed
Rulemaking and Notice of
Public Hearing
User Fees Relating to
Enrollment
REG–145154–05
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
and notice of public hearing.
SUMMARY: This document contains pro-
posed amendments to the regulations re-
lating to user fees for the special enroll-
ment examination to become an enrolled
agent, the application for enrollment of en-
rolled agents, and the renewal of this en-
rollment. The charging of user fees is au-
thorized by the Independent Offices Ap-
propriations Act (IOAA) of 1952. This
document also contains a notice of public
hearing on these proposed regulations.
DATES: Written or electronically-gen-
erated comments must be received by
September 28, 2006. Outlines of topics to
be discussed at the public hearing sched-
uled for September 29, 2006, must be
received by September 28, 2006.
ADDRESSES: Comments are encour-
aged to be submitted to: CC:PA:LPD:PR
(REG–145154–05), room 5203, Inter-
nal Revenue Service, P.O. Box 7604,
Ben Franklin Station, Washington, DC
20044. Submissions may be sent elec-
tronically via the IRS Internet site at
www.irs.gov/regsor via the Federal eRule-
making Portal atwww.regulations.gov
(IRS–REG–145154–05).
FOR FURTHER INFORMATION
CONTACT: Concerning submissions
of comments and/or to be placed
2006–39 I.R.B.567September 25, 2006

on the building access list to at-
tend the hearing, Richard Hurst at
Richard.A.Hurst@irscounsel.treas.gov
or at (202) 622-7180; concerning cost
methodology, Eva Williams at (202)
622–6400; concerning the proposed
regulations, Matthew Cooper at (202)
622–4940 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
Section 330 of Title 31 of the United
States Code authorizes the Secretary of the
Treasury to regulate practice before the
Treasury Department. Pursuant to section
330 of Title 31, the Secretary has published
regulations governing practice before the
IRS in 31 CFR part 10 and reprinted them
as Treasury Department Circular No. 230
(Circular 230). These regulations are ad-
ministered by the IRS Office of Profes-
sional Responsibility (OPR).
Section 10.3 of Circular 230 generally
authorizes attorneys, certified public ac-
countants, enrolled agents and enrolled ac-
tuaries to practice before the IRS. An en-
rolled agent is defined as an individual en-
rolled as an agent pursuant to the provi-
sions of Circular 230. The provisions of
Circular 230 provide that an individual de-
siring to become an enrolled agent is eligi-
ble for enrollment through either the suc-
cessful passing of a written examination
or through demonstration of sufficient ex-
pertise in tax administration based on for-
mer employment with the IRS. Specifi-
cally, section 10.4(a) authorizes the Direc-
tor of OPR to grant enrollment to an ap-
plicant who demonstrates special compe-
tence in tax matters by passing a written
examination administered by, or adminis-
tered under the oversight of, the Director
of OPR and who has not engaged in any
conduct that would justify the censure, sus-
pension, or disbarment of any practitioner
under the provisions of Circular 230. Ac-
cordingly, every year OPR develops and
administers a Special Enrollment Exami-
nation (SEE) that is given to all applicants
desiring to become enrolled agents so that
they can practice before the IRS. The IRS
charged applicants a user fee of $55 ($45
if taking the examination in part) in order
to take the 2005 SEE.
Section 10.4(b) authorizes the Director
of OPR to grant enrollment for former IRS
employees if the former employee meets
certain requirements, including length of
employment with the IRS and substantive
tax expertise. Application for enrollment
based on former employment with the IRS
must be made within three years from the
date of separation from such employment.
Once eligible for enrollment, by either
passing the examination or because of for-
mer employment with the IRS, an appli-
cant must file an application for enroll-
ment on Form 23, “Application for Enroll-
ment to Practice Before the Internal Rev-
enue Service,” with the Director of OPR.
As part of the application for enrollment
process, the applicant must enclose a check
or money order payable to the IRS in the
amount set forth on Form 23, which consti-
tutes a fee charged to each applicant for en-
rollment. The fee is nonrefundable regard-
less of whether the applicant is granted en-
rollment. The current user fee for enroll-
ment on the Form 23 (Rev. February 2005)
is $80. The Director of OPR will act upon
an application for enrollment and issue an
enrollment card to each individual whose
application for enrollment to practice be-
fore the IRS is approved.
Pursuant to section 10.6(d), each indi-
vidual, once enrolled, is required to renew
the enrollment every three years to main-
tain an active enrollment to practice before
the IRS. In order to qualify for renewal,
an applicant must certify the completion of
the continuing professional education re-
quirements set forth in section 10.6(e) of
Circular 230. A nonrefundable user fee of
$80 is currently charged for each applica-
tion for renewal of enrollment filed with
the Director of OPR on Form 8554, “Appli-
cation for Renewal of Enrollment to Prac-
tice Before the Internal Revenue Service.”
Contracting Out of Special Enrollment
Examination
OPR has recently contracted out certain
functions pertaining to the SEE to a pri-
vate contractor. The contractor will fur-
nish the resources, facilities, and services
necessary to administer the entire SEE pro-
gram, which includesexamination devel-
opment, administration of SEE, notifica-
tion to IRS of candidates who took the ex-
amination, and the results of the exami-
nation. The contractor will receive pay-
ment for its services by charging a fee to
exam applicants. OPR will, nonetheless,
still maintain an oversight role with respect
to the SEE. The contractor will collect a
user fee on behalf of the IRS based on the
full costs incurred by the IRS. These pro-
posed regulations only establish a user fee
with respect to the government costs for
overseeing the SEE anddonotincludeany
fee that the contractor may charge for its
services. Accordingly, while the user fee
imposed pursuant to these regulations is
less than the user fee that applicants were
charged in 2005, the total fee that appli-
cants will be charged is greater. The IRS
estimates that by using a contractor, how-
ever, the total fees incurred will be less
than the total fees that would otherwise be
charged by the IRS in order to recover the
full cost of the IRS administering all as-
pects of the SEE.
User Fees for Special Enrollment
Examination, Enrollment, and Renewal
of Enrollment
The user fee that the IRS currently
charges applicants in order to take the SEE
is being modified to reflect the change in
IRS costs of administering the exam pro-
gram as a result of the contracting out
of the exam. The user fees that the IRS
currently charge applicants for the enroll-
ment and renewal of enrollment process
are less than the actual cost of oversee-
ing the enrollment process. The IRS is
proposing new user fees to take the SEE to
become an enrolled agent, the application
for enrollment and the renewal of such
enrollment.
Proposed section 300.4 establishes an
$11 per part user fee for the SEE. Proposed
sections 300.5 and 300.6 establish separate
$125 user fees for the enrollment and re-
newal of enrollment process.
Authority
The IOAA of 1952 (31 U.S.C. 9701)
authorizes agenciesto prescribe regula-
tions that establish charges for services
provided by the agency. The charges must
be fair and be based on the costs to the
Government, the value of the service to
the recipient, the public policy or inter-
est served, and other relevant facts. The
IOAA of 1952 provides that regulations
implementing user fees are subject to poli-
cies prescribed by the President, which are
currently set forth in OMB Circular A–25,
September 25, 20065682006–39 I.R.B.

58 FR 38142 (July 15, 1993) (the OMB
Circular).
The OMB Circular encourages user
fees for Government-provided services
that confer benefits on identifiable re-
cipients over and above those benefits
received by the general public. Under the
OMB Circular, an agency that seeks to
impose a user fee for Government-pro-
vided services must calculate its full cost
of providing those services. In general,
a user fee should be set at an amount in
order for the agency to recover the cost of
providing the special service, unless the
Office of Management and Budget grants
an exception. Pursuant to the guidelines
in the OMB Circular, the IRS has calcu-
lated its cost of providing services under
the enrolled agents program. The IRS has
determined that the full cost to the IRS
of overseeing the SEE is $11 per part per
applicant. The IRS has determined that
the full cost of administering the enroll-
ment and renenrollment process is $125
per enrolled agent.
The proposed user fees will be imple-
mented under the authority of the IOAA of
1952 and the OMB Circular.
Proposed E
ffective Date
These regulations are proposed to apply
thirty days after the date of publication in
theFederal Registerof the final regula-
tions.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant
regulatory action as defined in Executive
Order 12866. Therefore, a regulatory as-
sessment is not required. It is hereby cer-
tified that these regulations will not have a
significant economic impact on a substan-
tial number of small entities. Accordingly,
a regulatory flexibility analysis is not re-
quired. This certification is based on the
information that follows. The economic
impact of these regulations on any small
entity would result from a small entity, in-
cluding a sole proprietor, being required
to pay a fee prescribed by these regula-
tions in order to obtain a particular service.
The dollar amount of the fee is not, how-
ever, substantial enough to have a signif-
icant economic impactonanyentitysub-
ject to the fee. Moreover, payment of the
fee is voluntary. The only persons sub-
ject to the fee are those who elect to take
the special enrollment exam. Persons who
elect to take the exam will have determined
that it is in their economic interest to do
so. Pursuant to section 7805(f) of the In-
ternal Revenue Code, this notice of pro-
posed rulemaking will be submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
its impact.
Comments and Public Hearing
Before these proposed regulations are
adopted as final regulations, consideration
will be given to any written (a signed origi-
nal and eight (8) copies) or electronic com-
ments that are submitted timely to the IRS.
The IRS and Treasury Department request
comments on the substance of the pro-
posed regulations, as well as on the clarity
of the proposed rules and how they can be
made easier to understand. All comments
will be available for public inspection and
copying.
A public hearing has been scheduled
for September 29, 2006, at 10 a.m. in
the 11
th
floor conference room at 1901 S.
Bell Street, Arlington, VA 22202. Due to
building security procedures, all visitors
must present photo identification to enter
the building. Because of access restric-
tions, visitors will not be admitted beyond
the immediate entrance area more than 30
minutes before the hearing starts. For in-
formation about having your name placed
on the building access list to attend the
hearing, see the “FOR FURTHER INFOR-
MATION CONTACT” section of this pre-
amble.
The rules of 26 CFR 601.601(a)(3) ap-
ply to the hearing. Persons who wish to
present oral comments at the hearing must
submit electronic or written comments and
an outline of the comments to be discussed
and the time to be devoted to each topic
(signed original and eight (8) copies) by
September 28, 2006. A period of ten (10)
minutes will be allotted to each person for
making comments. An agenda showing
the scheduling of the speakers will be pre-
pared after the deadline for receiving out-
lines has passed. Copies of the agenda will
be available free of charge at the hearing.
Drafting Information
The principal author of these regula-
tions is Matthew S. Cooper of the Office
of the Associate Chief Counsel (Procedure
& Administration), Administrative Provi-
sions & Judicial Practice Division.
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR Part 300 is pro-
posed to be amended as follows:
PART 300—USERS FEES
Paragraph 1. The authority citation for
part 300 continues to read as follows:
Authority: 31 U.S.C. 9701.
Par. 2. Section 300.0 is amended as
follows:
1. Paragraphs (b)(4), (5), and (6) are
added.
2. Paragraph (c) is revised.
The additions and revision read as fol-
lows:
§300.0 User fees, in general.
*****
(b) * * *
(4) Taking the special enrollment exam-
ination to become anenrolled agent.
(5) Enrolling an enrolled agent.
(6) Renewing the enrollment of an en-
rolled agent.
(c)Effective Date. This part 300 is ap-
plicable March 16, 1995, except that the
user fee for processing offers in compro-
mise is applicable November 1, 2003, and
the user fee for the special enrollment ex-
amination, enrollment, and renewal of en-
rollment for enrolled agents is applicable
thirty days after the date of publication in
theFederal Registerof the final regula-
tions.
Par. 3. Section 300.4 is added to read
as follows:
§300.4 Special enrollment examination
fee.
(a)Applicability. This section applies
to the special enrollment examination to
become an enrolled agent pursuant to 31
CFR 10.4(a).
(b)Fee. The fee for taking the special
enrollment examination is $11.00 per part.
2006–39 I.R.B.569September 25, 2006

(c)Person liable for the fee. The person
liable for the special enrollment examina-
tion fee is the applicant taking the exami-
nation.
Par. 4. Section 300.5 is added to read
as follows:
§300.5 Enrollment of enrolled agent fee.
(a)Applicability. This section applies
to the initial enrollment of enrolled agents
with the IRS Office of Professional Re-
sponsibility pursuant to 31 CFR 10.5(b).
(b)Fee. The fee for initially enrolling
as an enrolled agent with the IRS Office of
Professional Responsibility is $125.00.
(c)Person liable for the fee. The per-
son liable for the enrollment fee is the ap-
plicant filing for enrollment as an enrolled
agent with the IRS Office of Professional
Responsibility.
Par. 5. Section 300.6 is added to read
as follows:
§300.6 Renewal of enrollment of enrolled
agent fee.
(a)Applicability. This section applies
to the renewal of enrollment of enrolled
agents with the IRS Office of Profes-
sional Responsibility pursuant to 31 CFR
10.6(d)(6).
(b)Fee. The fee for renewal of enroll-
ment as an enrolled agent with the IRS
Office of Professional Responsibility is
$125.00.
(c)Person liable for the fee. The person
liable for the renewal of enrollment fee is
the person renewing their enrollment as
an enrolled agent with the IRS Office of
Professional Responsibility.
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on August 25,
2006, 12:09 p.m., and published in the issue of the Federal
Register for August 29, 2006, 71 F.R. 51179)
Notice of Proposed
Rulemaking by
Cross-Reference to
Temporary Regulations
Determination of Interest
Expense Deduction of Foreign
Corporations
REG–120509–06
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking
by cross-reference to temporary regula-
tions.
SUMMARY: In this issue of the Bulletin,
the IRS is issuing temporary regulations
(T.D. 9281) under sections 882 and 884
relating to the determination of the inter-
est expense deduction of foreign corpora-
tions engaged in a trade or business within
the United States. These regulations up-
date the 1996 final interest expense allo-
cation rules for foreign corporations and
take into account changes in the foreign
banking industry. The rule changes are
necessary to conform the final regulations
more closely to current operating condi-
tions in the foreign banking industry, and
to harmonize the deemed earnings repa-
triation from a foreign corporation’s trade
or business within the United States, with
the manner in which dividends are repatri-
ated from U.S. resident companies to their
foreign shareholders. These regulations
are expected to simplify compliance bur-
dens for many foreign corporations that al-
locate interest expense to effectively con-
nected income and provide greater latitude
to taxpayers in determining when their ef-
fectively connectedearnings are treated as
remitted. The text of these regulations also
serves as the text of these proposed regu-
lations.
DATES: Written or electronic comments
and requests for a public hearing must be
received by November 15, 2006.
ADDRESSES: Send submissions to:
CC:PA:LPD:PR (REG–120509–06), In-
ternal Revenue Service, PO Box 7604,
Ben Franklin Station, Washington, DC
20044. Submissions may be sent elec-
tronically, via the IRS Internet site at
www.irs.gov/regsor via the Federal eRule-
making Portal atwww.regulations.gov
(IRS REG–120509–06).
FOR FURTHER INFORMATION
CONTACT: Concerning the regula-
tions, Gregory Spring or Paul Epstein,
(202) 622–3870, concerning submis-
sions of comments, Richard A. Hurst,
Richard.A.Hurst@irscounsel.treas.gov,or
(202) 622–7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information contained
in this notice of proposed rulemaking has
been submitted to the Office of Manage-
ment and Budget for review in accordance
with the Paperwork Reduction Act of 1995
(44 U.S.C. 3507(d)). Comments on the
collection of information should be sent to
theOffice of Management and Budget,
Attn: Desk Officer for the Department of
Treasury, Office of Information and Reg-
ulatory Affairs, Washington, DC 20503,
with copies to theInternal Revenue Ser-
vice, Attn: IRS Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC
20224. Comments on the collection of in-
formation should be received by October
16, 2006. Comments are requested specif-
ically concerning:
Whether the proposed collection of in-
formation is necessary for the proper per-
formance of the functions of the Internal
Revenue Service, including whether the
information will have practical utility;
The accuracy of the estimated burden
associated with the proposed collection of
information (see below);
How the quality, utility, and clarity of
the information to be collected may be en-
hanced;
How the burden of complying with the
proposed collection of information may be
minimized, including through the appli-
cation or automated collection techniques
or other forms of information technology;
and
Estimates of capital or start-up costs
and costs of operation, maintenance, and
purchase of service to provide information.
The collections of information
in these proposed regulations are
in§§1.882–5T(d)(5)(ii)(B)and
1.884–1T(e)(3)(iv).This collection
of information is required to facilitate
September 25, 20065702006–39 I.R.B.

administrability of reporting of allocable
expense from without the United States.
Section 1.882–5T(d)(5)(ii)(B) provides
a simplified procedure for taxpayers to
calculate an allocable amount of U.S. dol-
lar denominated interest expense booked
by foreign banks in foreign locations.
The collection of information provides
certainty of application and immediate
verification in the advance review and
resolution of such treatment on examina-
tion. Section 1.884–1T(e)(3)(iv) provides
the identical collection of information that
was promulgated in final regulations in
T.D. 8432, 1992–2 C.B. 157. The rule
provides an election to reduce liabilities
for purposes of treating effectively con-
nected earnings and profits as reinvested.
It also requires that U.S. connected
liabilities be reduced for purposes of
determining the allocation of interest
expense to effectively connected income.
The collection of information facilitates
identification andverification of the
coordinated treatment of the sections 882
and 884 provisions in accordance with
the time, place and manner restrictions
for making the election. The collections
of information are mandatory. The likely
respondents are foreign banks.
Estimated total annual reporting bur-
den: 37.5.
Estimated average annual burden hours
per respondent:
1
/2hour.
Estimated number of respondents: 75.
Estimated annual frequency of re-
sponses: annually.
An agency may not conduct or sponsor,
and a person is not required to respond to, a
collection of information unless it displays
a valid control number assigned by the Of-
fice of Management and Budget.
Books and records relating to a collec-
tion of information must be retained as
long as their contents may become mate-
rial in the administration of any internal
revenue law. Generally, tax returns and tax
return information are confidential, as re-
quired by 26 U.S.C. 6103.
Background
In this issue of the Bulletin, the IRS is
issuing temporary regulations under sec-
tions 882 and 884 relating to the determi-
nation of the interest expense deduction of
foreign corporations engaged in a trade or
business within the United States. The text
of those regulations published in this issue
of the Bulletin also serves as the text of
these proposed regulations. The preamble
to those temporary regulations explains the
temporary regulations and these proposed
regulations.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a signifi-
cant regulatory action as defined in Exec-
utive Order 12866. Therefore, a regula-
tory assessment is not required. It has also
been determined that section 553(b) of the
Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these reg-
ulations, and because the regulations do
not impose a collection of information on
small entities, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply.
Pursuant to section 7805(f) of the Code,
this regulation has been submitted to the
Chief Counsel for Advocacy of the Small
Business Administration for comment on
its impact on small business.
Comments and Requests for Public
Hearing
Before these proposed regulations are
adopted as final regulations, considera-
tion will be given to any written (a signed
original and eight (8) copies) or electronic
comments that are submitted timely to the
IRS. The IRS and the Treasury Depart-
ment specifically request comments on
the clarity of the proposed regulations and
how they can be made easier to under-
stand. All comments will be available for
public inspection and copying. A public
hearing will be scheduled if requested by
any person who timely submits comments.
If a public hearing is scheduled, notice of
the date, time and place for the hearing
will be published in theFederal Register.
Drafting Information
The principal authors of these
regulations are Paul S. Epstein and
Gregory A. Spring of the Office of As-
sociate Chief Counsel(International).
*****
Proposed Amendments to the
Regulations
Accordingly, 26 CFR 1 is proposed to
be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority:26U.S.C.7805***
Par. 2. Section 1.882–5 is amended to
read as follows:
1.Paragraphs (a)(1), (a)(1)(i),
(a)(1)(ii), (a)(1)(ii)(A), (a)(1)(ii)(B),
(a)(2), (a)(7), (a)(7)(i), (a)(7)(ii),
(b)(2)(ii)(A), (b)(3), (c)(2)(iv), (c)(4),
(d)(2)(ii)(A)(2),(d)(2)(ii)(A)(3),
(d)(2)(iii)(A), and (d)(5)(ii) are re-
vised.
2. Paragraph (d)(6) Example 5 is added.
The revisions and addition read as fol-
lows:
§1.882–5 Determination of interest
deduction.
(a) * * *
(a)(1) through (a)(2) [The text of this
proposed amendment is the same as the
text of §1.882–5T(a)(1) through (a)(2)
published elsewhere in this issue of the
Bulletin].
*****
(a)(7) [The text of this proposed
amendment is the same as the text of
§1.882–5T(a)(7) published elsewhere in
this issue of the Bulletin].
*****
(b) * * *
(2) * * *
(ii) * * *
(b)(2)(ii)(A) [The text of this proposed
amendment is the same as the text of
§1.882–5T(b)(2)(ii)(A) published else-
where in this issue of the Bulletin].
*****
(b)(2)(iv) [The text of this proposed
amendment is the same as the text of
§1.882–5T(b)(2)(iv)published elsewhere
in this issue of the Bulletin].
*****
(b)(3) [The text of this proposed
amendment is the same as the text of
§1.882–5T(b)(3) published elsewhere in
this issue of the Bulletin].
*****
2006–39 I.R.B.571September 25, 2006

(c) * * *
(2) * * *
(c)(2)(iv) [The text of this proposed
amendment is the same as the text of
§1.882–5T(c)(2)(iv) published elsewhere
in this issue of the Bulletin].
*****
(c)(4) [The text of this proposed
amendment is the same as the text of
§1.882–5T(c)(4) published elsewhere in
this issue of the Bulletin].
*****
(d) * * *
(2) * * *
(ii) * * *
(A) * * *
(d)(2)(ii)(A)(2) through (3)[Thetextof
these proposed amendments are the same
as the text of §1.882–5T(d)(2)(ii)(A)(2)
through (3) published elsewhere in this is-
sue of the Bulletin].
*****
(d)(2)(iii)(A) [The text of this proposed
amendment is the same as the text of
§1.882–5T(d)(2)(iii)(A) published else-
whereinthisissueoftheBulletin].
*****
(5) * * *
(i) * * *
(d)(5)(ii) [The text of this proposed
amendment is the same as the text of
§1.882–5T(d)(5)(ii)published elsewhere
in this issue of the Bulletin].
*****
(d)(6)Example 5[The text of this pro-
posed amendment is the same as the text
of §1.882–5T(d)(6)Example 5published
elsewhere in this issue of the Bulletin].
*****
Par. 3. Section 1.884–1 is amended
by revising the entries for paragraphs
§1.884–1(e)(3)(ii), (e)(3)(iv) and (e)(5)
Example 2to read as follows:
§1.884–1 Determination of interest
deduction
*****
(e) * * *
(3) * * *
(e)(3)(ii) [The text of this proposed
amendment is the same as the text of
§1.884–1T(e)(3)(ii) published elsewhere
in this issue of the Bulletin].
*****
(e)(3)(iv) [The text of this proposed
amendment is the same as the text of
§1.884–1T(e)(3)(iv) published elsewhere
in this issue of the Bulletin].
*****
(5) * * *
(e)(5)Example 2[The text of this pro-
posed amendment is the same as the text
of §1.884–1T(e)(5)Example 2published
elsewhere in this issue of the Bulletin].
*****
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
(Filed by the Office of the Federal Register on August 15,
2006, 8:45 a.m., and published in the issue of the Federal
Register for August 17, 2006, 71 F.R. 47459)
Announcement of Disciplinary Actions Involving
Attorneys, Certified Public Accountants, Enrolled Agents,
and Enrolled Actuaries — Suspensions, Censures,
Disbarments, and Resignations
Announcement 2006-57
Under Title 31, Code of Federal Regu-
lations, Part 10, attorneys, certified public
accountants, enrolled agents, and enrolled
actuaries may not accept assistance from,
or assist, any person who is under disbar-
ment or suspension from practice before
the Internal Revenue Service if the assis-
tance relates to a matter constituting prac-
tice before the Internal Revenue Service
and may not knowingly aid or abet another
person to practice before the Internal Rev-
enue Service during a period of suspen-
sion, disbarment, or ineligibility of such
other person.
To enable attorneys, certified public
accountants, enrolled agents, and enrolled
actuaries to identify persons to whom
these restrictions apply, the Director, Of-
fice of Professional Responsibility, will
announce in the Internal Revenue Bulletin
their names, their city and state, their pro-
fessional designation, the effective date
of disciplinary action, and the period of
suspension. This announcement will ap-
pear in the weekly Bulletin at the earliest
practicable date after such action and will
continue to appear in the weekly Bulletins
for five successive weeks.
September 25, 20065722006–39 I.R.B.

Consent Suspensions From Practice Before the Internal
Revenue Service
Under Title 31, Code of Federal Regu-
lations, Part 10, an attorney, certified pub-
lic accountant, enrolled agent, or enrolled
actuary, in order to avoid the institution
or conclusion of a proceeding for his or
her disbarment or suspension from prac-
tice before the Internal Revenue Service,
may offer his or her consent to suspension
from such practice. The Director, Office
of Professional Responsibility, in his dis-
cretion, may suspend an attorney, certified
public accountant, enrolled agent, or en-
rolled actuary in accordance with the con-
sent offered.
The following individuals have been
placed under consent suspension from
practice before the Internal Revenue Ser-
vice:
NameAddressDesignationDate of Suspension
Crane, StephenPalm Springs, CAEnrolled AgentMay 4, 2006
to
August 3, 2007
Cohen, Ronald J.Newburgh, NYAttorneyIndefinite
from
June 21, 2006
Layson, David A.Corydon, INAttorneyApril 7, 2006
to
October 6, 2007
Brough, Donald L.Salem, INCPAJuly 1, 2006
to
June 30, 2010
Gulian, YervantGreat Neck, NYCPAApril 17, 2006
to
December 16, 2007
Rivera-Smith, DawnBrick, NJCPAMay 30, 2006
to
November 29, 2008
Eckstein, MatthewWoodbury, NYCPAJune 15, 2006
to
March 14, 2007
Hecht, Jodee L.Clifton, VACPAIndefinite
from
June 19, 2006
Finch, Phillip W.Yorktown, VACPAIndefinite
from
June 22, 2006
Troese Jr., Henry A.Clarion, PAEnrolled AgentIndefinite
from
June 22, 2006
Robbins, Ronald E.Pittsford, VTCPAJune 24, 2006
to
June 23, 2008
Shapiro, Sidney C.West Palm Beach, FLCPAIndefinite
from
July 1, 2006
2006–39 I.R.B.573September 25, 2006

NameAddressDesignationDate of Suspension
Martini, AnthonyStamford, CTCPAJune 18, 2006
to
December, 17, 2007
Cunningham, WilliamPhiladelphia, PACPAJuly 1, 2006
to
March 31, 2007
Simontacchi, Joseph F.Morris Plains, NJCPAIndefinite
from
July 1, 2006
Carroccio, Ronald P.Staten Island, NYCPAIndefinite
from
July 1, 2006
Miller, Walter P.Roanoke, VACPAIndefinite
from
July 1, 2006
Aneji, PatrickHouston, TXCPAIndefinite
from
June 22, 2006
Rosenbloom, Mark L.Chicago, ILAttorneyAugust 15, 2006
to
August 14, 2007
Viener, Ira S.Fort Lee, NJCPAIndefinite
from
August 1, 2006
Ganz, Sheldon M.Great Neck, NJCPAIndefinite
from
August 1, 2006
Tomasulo, MariaWantagh, NYCPAIndefinite
from
August 7, 2006
Galpern, Joel G.North Miami, FLCPAIndefinite
from
September 1, 2006
September 25, 20065742006–39 I.R.B.

Expedited Suspensions From Practice Before the Internal
Revenue Service
Under Title 31, Code of Federal Regu-
lations, Part 10, the Director, Office of Pro-
fessional Responsibility, is authorized to
immediately suspend from practice before
the Internal RevenueService any practi-
tioner who, within five years from the date
the expedited proceeding is instituted (1)
has had a license to practice as an attor-
ney, certified public accountant, or actuary
suspended or revoked for cause or (2) has
been convicted of certain crimes.
The following individuals have been
placed under suspension from practice be-
fore the Internal Revenue Service by virtue
of the expedited proceeding provisions:
NameAddressDesignationDate of Suspension
Dolan Jr., John L.Memphis, TNAttorneyIndefinite
from
April 3, 2006
St. Mary, Randall L.Snohomish, WAAttorneyIndefinite
from
April 3, 2006
Theriault, Michael J.Bel Air, MDAttorneyIndefinite
from
April 3, 2006
Smith, Bernard P.Marblehead, MAAttorneyIndefinite
from
April 3, 2006
Bradley, Phillip M.West Point, VAAttorneyIndefinite
from
April 3, 2006
Haefele, Richard J.Wayzata, MNAttorneyIndefinite
from
April 3, 2006
Decker, William E.Mandeville, LAAttorneyIndefinite
from
April 3, 2006
Arbour, John J.Monroe, LAAttorneyIndefinite
from
April 3, 2006
Keller, John S.Martin Kenner, LAAttorneyIndefinite
from
April 3, 2006
Fallon, Charles D.Neptune, NJAttorneyIndefinite
from
April 3, 2006
Agresti, Thomas J.Centennial, COAttorneyIndefinite
from
April 3, 2006
Kirsch, Craig F.Pittsburgh, PACPAIndefinite
from
April 3, 2006
2006–39 I.R.B.575September 25, 2006

NameAddressDesignationDate of Suspension
Hall, Lenny G.McDowell, KYCPAIndefinite
from
April 11, 2006
Hultgren, Jerry R.Fresno, CAAttorneyIndefinite
from
April 11, 2006
Loutos, Peter A.Chicago,ILAttorneyIndefinite
from
April 11, 2006
Smith III, Frank L.Bushnell, FLAttorneyIndefinite
from
April 11, 2006
Morley, Michael J.Springfield, PACPAIndefinite
from
April 11, 2006
Waters, Richard W.Smithfield, UTCPAIndefinite
from
April 11, 2006
Hartgraves, Travis M.Abilene, TXAttorneyIndefinite
from
April 14, 2006
Dunn, George T.Lockhart, TXAttorneyIndefinite
from
April 14, 2006
Adkins, Thomas R.Houston, TXAttorneyIndefinite
from
April 14, 2006
Hairston, John W.Sugar Land, TXAttorneyIndefinite
from
April 26, 2006
Marcone, Frank J.Upper Providence, PAAttorneyIndefinite
from
May 1, 2006
Fraley, Donald J.Minneapolis, MNAttorneyIndefinite
from
May 3, 2006
Tooke, S. JuddShreveport, LAAttorneyIndefinite
from
May 3, 2006
Reilly, Michael G.Council Bluffs, IAAttorneyIndefinite
from
May 3, 2006
Faneuil, Robert A.Newton, MAAttorneyIndefinite
from
May 3, 2006
September 25, 20065762006–39 I.R.B.

NameAddressDesignationDate of Suspension
Maignan, Peter R.Upper Marlboro, MDAttorneyIndefinite
from
May 3, 2006
Son, DavidPhoenix, AZAttorneyIndefinite
from
May 5, 2006
Susman, Warren I.New York, NYAttorneyIndefinite
from
May 8, 2006
Wurst, JeromeArlington, TXAttorneyIndefinite
from
May 8, 2006
O’Shea, Joseph G.Jackson Heights, NYAttorneyIndefinite
from
May 8, 2006
Biegelson, AlanBrooklyn, NYAttorneyIndefinite
from
May 8, 2006
Leonard, Robert K.Winston-Salem, NCAttorneyIndefinite
from
May 8, 2006
Cassidy, Michael M.Madison, WIAttorneyIndefinite
from
May 8, 2006
Dobkin, Daniel B.New Hyde Park, NYAttorneyIndefinite
from
May 8, 2006
Nealy, Joseph L.Sugarland, TXAttorneyIndefinite
from
May 16, 2006
Conmey, Edwin W.Oconomowoc, WIAttorneyIndefinite
from
May 16, 2006
Knott Jr., Robert T.Los Angeles, CAAttorneyIndefinite
from
May 16, 2006
Diamond, Howard S.Mendham, NJAttorneyIndefinite
from
May 16, 2006
Fitzgerald, Bill L.Lubbock, TXAttorneyIndefinite
from
May 16, 2006
Brubaker, Gregory A.San Francisco, CAAttorneyIndefinite
from
May 18, 2006
Dodenbier, Robert F.Lehi, UTAttorneyIndefinite
from
May 18, 2006
2006–39 I.R.B.577September 25, 2006

NameAddressDesignationDate of Suspension
Young, Paul J.Taft, CAAttorneyIndefinite
from
June 8, 2006
Dahodwala, FatemaAndover, MAAttorneyIndefinite
from
June 8, 2006
Mendola, Joseph E.Monessen, PACPAIndefinite
from
June 8, 2006
Rooney, Edward F.Minneapolis, MNAttorneyIndefinite
from
June 8, 2006
Long, Rebecca L.Wichita,KSAttorneyIndefinite
from
June 8, 2006
West, Clifton C.Fayetteville, NCAttorneyIndefinite
from
June 8, 2006
Silva, Zoilo I.City Island, NYAttorneyIndefinite
from
June 8, 2006
Tyler Jr., Earle S.Bangor, MEAttorneyIndefinite
from
June 12, 2006
Horneber, Alice S.Sioux City, IAAttorneyIndefinite
from
June 12, 2006
Donnelly, Christine M.Blue Springs, MOAttorneyIndefinite
from
June 12, 2006
Driscoll Jr., PeterColumbia, MDAttorneyIndefinite
from
June 12, 2006
Souza, John C.Pocatello, IDAttorneyIndefinite
from
June 12, 2006
Crockett, Kevin J.Midvale, UTAttorneyIndefinite
from
June 12, 2006
White, Debra M. WyattNavasota, TXCPAIndefinite
from
June 12, 2006
Wilkins, Daniel J.Chelmsford, MAAttorneyIndefinite
from
June 12, 2006
Merica, Chad L.Murray, UTCPAIndefinite
from
June 12, 2006
September 25, 20065782006–39 I.R.B.

NameAddressDesignationDate of Suspension
Wintroub, David S.Omaha,NEAttorneyIndefinite
from
June 12, 2006
Smith, Roderick E.Kansas City, MOAttorneyIndefinite
from
June 12, 2006
Guida, Joseph M.Aberdeen, MDAttorneyIndefinite
from
June 12, 2006
Sonibare, NashSt. Paul, MNCPAIndefinite
from
June 12, 2006
Braun, Marc W.St. Louis, MOAttorneyIndefinite
from
June 12, 2006
Coffey, John J.Rye, NHAttorneyIndefinite
from
June 12, 2006
Whitehead, H. AllenNew York, NYAttorneyIndefinite
from
June 12, 2006
Lansky, SidneyMattapoisett, MAAttorneyIndefinite
from
June 12, 2006
Pazniokas, Paul M.Norwood, MAAttorneyIndefinite
from
June 12, 2006
Bajgrowicz, James J.Santa Rosa, CAAttorneyIndefinite
from
June 12, 2006
Davis, Bret J.Los Angeles, CAAttorneyIndefinite
from
June 12, 2006
McAvoy, TimothyChicago, ILAttorneyIndefinite
from
June 12, 2006
Loffadelli, Thomas C.Studio City, CAAttorneyIndefinite
from
June 12, 2006
Emeziem, Kelechi C.Antioch, CAAttorneyIndefinite
from
June 12, 2006
Pugh, William C.Wayzata,MNAttorneyIndefinite
from
June 12, 2006
Lamanna, Eugene C.Reading, PAAttorneyIndefinite
from
June 12, 2006
2006–39 I.R.B.579September 25, 2006

NameAddressDesignationDate of Suspension
Bartels, John R.St. Paul, MNAttorneyIndefinite
from
June 12, 2006
Shapiro, Kenneth S.Bala Cynwyd, PACPAIndefinite
from
June 14, 2006
Stone, Jerry W.Austin, TXAttorneyIndefinite
from
June 21, 2006
Vanriper, Philip E.Binghamton, NYAttorneyIndefinite
from
June 21, 2006
Simuro, Valerie T.Gardiner, NYAttorneyIndefinite
from
June 21, 2006
Simms, William K.Brooklyn, NYAttorneyIndefinite
from
June 21, 2006
Weaver, Terring M.Clarksburg, WVCPAIndefinite
from
July 1, 2006
Norman, ClarenceBrooklyn, NYAttorneyIndefinite
from
August 3, 2006
Knight, John G.Winston-Salem, NCAttorneyIndefinite
from
August 3, 2006
Kronegold, Sheldon H.Englewood, NJAttorneyIndefinite
from
August 3, 2006
Foushee, Wayne H.Winston-Salem, NCAttorneyIndefinite
from
August 3, 2006
Suspensions From Practice Before the Internal Revenue
Service After Notice and an Opportunity for a Proceeding
Under Title 31, Code of Federal Reg-
ulations, Part 10, after notice and an op-
portunity for a proceeding before an ad-
ministrative law judge, the following indi-
viduals have been placed under suspension
from practice before the Internal Revenue
Service:
NameAddressDesignationEffective Date
Kahn, HaroldHollis, NYCPAJune 26, 2006
to
June 25, 2010
September 25, 20065802006–39 I.R.B.

Disbarments From Practice Before the Internal Revenue
Service After Notice and an Opportunity for a Proceeding
Under Title 31, Code of Federal Regu-
lations, Part 10, after notice and an oppor-
tunity for a proceeding before an adminis-
trative law judge, the following individu-
als have been disbarred from practice be-
fore the Internal Revenue Service:
NameAddressDesignationEffective Date
Gailey, James N.Huntersville, NCCPAJune 5, 2006
Censure Issued by Consent
Under Title 31, Code of Federal Reg-
ulations, Part 10, in lieu of a proceeding
being instituted or continued, an attorney,
certified public accountant, enrolled agent,
or enrolled actuary, may offer his or her
consent to the issuance of a censure. Cen-
sure is a public reprimand.
The following individuals have con-
sented to the issuance of a Censure:
NameAddressDesignationDate of Censure
Williams, Daniel S.Carlsbad, CAAttorneyMarch 29, 2006
Azan, Reinaldo L.Miami Beach, FLCPAJuly 24, 2006
Golub, Stephen B.Norwalk, CTCPAAugust 3, 2006
2006–39 I.R.B.581September 25, 2006

Definition of Terms
Revenue rulings and revenue procedures
(hereinafter referred to as “rulings”) that
have an effect on previous rulings use the
following defined terms to describe the ef-
fect:
Amplifieddescribes a situation where
no change is being made in a prior pub-
lished position, but the prior position is be-
ingextendedtoapplytoavariationofthe
fact situation set forth therein. Thus, if
an earlier ruling held that a principle ap-
plied to A, and the new ruling holds that the
same principle also applies to B, the earlier
ruling is amplified. (Compare withmodi-
fied,below).
Clarifiedis used in those instances
where the language in a prior ruling is be-
ing made clear because the language has
caused, or may cause, some confusion.
It is not used where a position in a prior
ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.
Modifiedis used where the substance
of a previously published position is being
changed. Thus, if a prior ruling held that a
principle applied to A but not to B, and the
new ruling holds that it applies to both A
and B, the prior ruling is modified because
it corrects a published position. (Compare
withamplifiedandclarified, above).
Obsoleteddescribes a previously pub-
lished ruling that is not considered deter-
minative with respect to future transac-
tions. This term is most commonly used in
a ruling that lists previously published rul-
ings that are obsoleted because of changes
in laws or regulations. A ruling may also
be obsoleted because the substance has
been included in regulations subsequently
adopted.
Revokeddescribes situations where the
position in the previously published ruling
is not correct and the correct position is
beingstatedinanewruling.
Supersededdescribes a situation where
the new ruling does nothing more than re-
state the substance and situation of a previ-
ously published ruling (or rulings). Thus,
the term is used to republish under the
1986 Code and regulations the same po-
sition published under the 1939 Code and
regulations. The term is also used when
it is desired to republish in a single rul-
ing a series of situations, names, etc., that
were previously published over a period of
time in separate rulings. If the new rul-
ing does more than restate the substance
of a prior ruling, a combination of terms
is used. For example,modifiedandsu-
persededdescribes a situation where the
substance of a previously published ruling
is being changed in part and is continued
without change in part and it is desired to
restate the valid portion of the previously
published ruling in a new ruling that is self
contained. In this case, the previously pub-
lished ruling is first modified and then, as
modified, is superseded.
Supplementedis used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and that
list is expanded by adding further names in
subsequent rulings. After the original rul-
ing has been supplemented several times, a
new ruling may be published that includes
the list in the original ruling and the ad-
ditions, and supersedes all prior rulings in
the series.
Suspendedis used in rare situations
to show that the previous published rul-
ings will not be applied pending some
future action such as the issuance of new
or amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.
Abbreviations
The fol
lowing abbreviations in current use
and for
merly used will appear in material
publis
hedintheBulletin.
A—Individual.
Acq.—A
cquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank
.
B.T.A.—Board of Tax Appeals.
C—Individual.
C.B.—Cu
mulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Coo
perative.
Ct.D.—Court Decision.
CY—County.
D—Decede
nt.
DC—Dummy Corporation.
DE—Donee.
Del. Order
—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Emp
loyer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduc
iary.
FC—Foreign Country.
FICA—Federal Insurance Contributions Act.
FISC—Fo
reign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Fed
eral Unemployment Tax Act.
FX—Foreign corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grante
e.
GP—General Partner.
GR—Grantor.
IC—Insura
nce Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited
Partner.
LR—Lessor.
M—Minor.
Nonacq.—No
nacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Persona
l Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Pa
rtnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Re
al Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsi
diary.
S.P.R.—Statement of Procedural Rules.
Stat.—Statutes at Large.
T—Target
Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Trans
feree.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpay
er.
TR—Trust.
TT—Trustee.
U.S.C.—Uni
ted States Code.
X—Corporation.
Y—Corporation.
Z—Corporat
ion.
September 25, 2006i2006–39 I.R.B.

Numerical Finding List
1
Bulletins 2006–27 through 2006–39
Announcements:
2006-42, 2006-27 I.R.B.48
2006-43, 2006-27 I.R.B.48
2006-44, 2006-27 I.R.B.49
2006-45, 2006-31 I.R.B.121
2006-46, 2006-28 I.R.B.76
2006-47, 2006-28 I.R.B.78
2006-48, 2006-31 I.R.B.135
2006-49, 2006-29 I.R.B.89
2006-50, 2006-34 I.R.B.321
2006-51, 2006-32 I.R.B.222
2006-52, 2006-33 I.R.B.254
2006-53, 2006-33 I.R.B.254
2006-54, 2006-33 I.R.B.254
2006-55, 2006-35 I.R.B.342
2006-56, 2006-35 I.R.B.342
2006-57, 2006-35 I.R.B.343
2006-58, 2006-36 I.R.B.388
2006-59, 2006-36 I.R.B.388
2006-60, 2006-36 I.R.B.389
2006-61, 2006-36 I.R.B.390
2006-62, 2006-37 I.R.B.444
2006-63, 2006-37 I.R.B.445
2006-64, 2006-37 I.R.B.447
2006-65, 2006-37 I.R.B.447
2006-66, 2006-37 I.R.B.448
2006-67, 2006-38 I.R.B.509
2006-68, 2006-38 I.R.B.510
2006-69, 2006-37 I.R.B.449
Notices:
2006-56, 2006-28 I.R.B.58
2006-57, 2006-27 I.R.B.13
2006-58, 2006-28 I.R.B.59
2006-59, 2006-28 I.R.B.60
2006-60, 2006-29 I.R.B.82
2006-61, 2006-29 I.R.B.85
2006-62, 2006-29 I.R.B.86
2006-63, 2006-29 I.R.B.87
2006-64, 2006-29 I.R.B.88
2006-65, 2006-31 I.R.B.102
2006-66, 2006-30 I.R.B.99
2006-67, 2006-33 I.R.B.248
2006-68, 2006-31 I.R.B.105
2006-69, 2006-31 I.R.B.107
2006-70, 2006-33 I.R.B.252
2006-71, 2006-34 I.R.B.316
2006-72, 2006-36 I.R.B.363
2006-73, 2006-35 I.R.B.339
2006-74, 2006-35 I.R.B.339
2006-75, 2006-36 I.R.B.366
2006-76, 2006-38 I.R.B.459
Notices— Continued:
2006-82, 2006-39 I.R.B.529
Proposed Regulations:
REG-135866-02, 2006-27 I.R.B.34
REG-146893-02, 2006-34 I.R.B.317
REG-159929-02, 2006-35 I.R.B.341
REG-148864-03, 2006-34 I.R.B.320
REG-168745-03, 2006-39 I.R.B.532
REG-109512-05, 2006-30 I.R.B.100
REG-145154-05, 2006-39 I.R.B.567
REG-112994-06, 2006-27 I.R.B.47
REG-118775-06, 2006-28 I.R.B.73
REG-118897-06, 2006-31 I.R.B.120
REG-120509-06, 2006-39 I.R.B.570
REG-124152-06, 2006-36 I.R.B.368
REG-125071-06, 2006-36 I.R.B.375
Revenue Procedures:
2006-29, 2006-27 I.R.B.13
2006-30, 2006-31 I.R.B.110
2006-31, 2006-27 I.R.B.32
2006-32, 2006-28 I.R.B.61
2006-33, 2006-32 I.R.B.140
2006-34, 2006-38 I.R.B.460
2006-35, 2006-37 I.R.B.434
2006-36, 2006-38 I.R.B.498
2006-37, 2006-38 I.R.B.499
2006-38, 2006-39 I.R.B.530
Revenue Rulings:
2006-35, 2006-28 I.R.B.50
2006-36, 2006-36 I.R.B.353
2006-37, 2006-30 I.R.B.91
2006-38, 2006-29 I.R.B.80
2006-39, 2006-32 I.R.B.137
2006-40, 2006-32 I.R.B.136
2006-41, 2006-35 I.R.B.331
2006-42, 2006-35 I.R.B.337
2006-43, 2006-35 I.R.B.329
2006-44, 2006-36 I.R.B.361
2006-45, 2006-37 I.R.B.423
2006-46, 2006-39 I.R.B.511
2006-47, 2006-39 I.R.B.511
2006-48, 2006-39 I.R.B.516
Treasury Decisions:
9265, 2006-27 I.R.B.1
9266, 2006-28 I.R.B.52
9267, 2006-34 I.R.B.313
9268, 2006-30 I.R.B.94
9269, 2006-30 I.R.B.92
9270, 2006-33 I.R.B.237
9271, 2006-33 I.R.B.224
9272, 2006-35 I.R.B.332
9273, 2006-37 I.R.B.394
Treasury Decisions— Continued:
9274, 2006-33 I.R.B.244
9275, 2006-35 I.R.B.327
9276, 2006-37 I.R.B.424
9277, 2006-33 I.R.B.226
9278, 2006-34 I.R.B.256
9279, 2006-36 I.R.B.355
9280, 2006-38 I.R.B.450
9281, 2006-39 I.R.B.517
9282, 2006-39 I.R.B.512
1
A cumulative list of all revenue rulings, revenueprocedures, Treasury decisions, etc., publishedin Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin
2006–26, dated June 26, 2006.
2006–39 I.R.B.iiSeptember 25, 2006

Finding List of Current Actions on
Previously Published Items
1
Bulletins 2006–27 through 2006–39
Announcements:
2005-59
Updated and superseded by
Ann. 2006-45, 2006-31 I.R.B.121
Notices:
2002-45
Amplified by
Rev. Rul. 2006-36, 2006-36 I.R.B.353
2006-20
Supplemented and modified by
Notice 2006-56, 2006-28 I.R.B.58
2006-53
Modified by
Notice 2006-71, 2006-34 I.R.B.316
Proposed Regulations:
REG-135866-02
Corrected by
Ann. 2006-65, 2006-37 I.R.B.447
Ann. 2006-64, 2006-37 I.R.B.447
REG-134317-05
Corrected by
Ann. 2006-47, 2006-28 I.R.B.78
Revenue Procedures:
2002-9
Modified and amplified by
Notice 2006-67, 2006-33 I.R.B.248
2004-63
Superseded by
Rev. Proc. 2006-34, 2006-38 I.R.B.460
2005-41
Superseded by
Rev. Proc. 2006-29, 2006-27 I.R.B.13
2005-49
Superseded by
Rev. Proc. 2006-33, 2006-32 I.R.B.140
2006-12
Modified by
Rev. Proc. 2006-37, 2006-38 I.R.B.499
Revenue Rulings:
81-35
Amplified and modified by
Rev. Rul. 2006-43, 2006-35 I.R.B.329
81-36
Amplified and modified by
Rev. Rul. 2006-43, 2006-35 I.R.B.329
Revenue Rulings— Continued:
87-10
Amplified and modified by
Rev. Rul. 2006-43, 2006-35 I.R.B.329
2002-41
Amplified by
Rev. Rul. 2006-36, 2006-36 I.R.B.353
2003-43
Amplified by
Notice 2006-69, 2006-31 I.R.B.107
2005-24
Amplified by
Rev. Rul. 2006-36, 2006-36 I.R.B.353
Treasury Decisions:
9254
Corrected by
Ann. 2006-44, 2006-27 I.R.B.49
Ann. 2006-66, 2006-37 I.R.B.448
9258
Corrected by
Ann. 2006-46, 2006-28 I.R.B.76
9260
Corrected by
Ann. 2006-67, 2006-38 I.R.B.509
9262
Corrected by
Ann. 2006-56, 2006-35 I.R.B.342
9264
Corrected by
Ann. 2006-46, 2006-28 I.R.B.76
9272
Corrected by
Ann. 2006-68, 2006-38 I.R.B.510
1
A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2006–1 through 2006–26 is in Internal Revenue Bulletin 2006–26, dated June 26, 2006.
September 25, 2006iii2006–39 I.R.B.

INDEX
Internal Revenue Bulletins 2006–27 through
2006–39
The abbreviation and number in parenthesis following the index entry
refer to the specific item; numbers in roman and italic type following
the parenthesis refers to the Internal Revenue Bulletin in which the item
may be found and the page number on which it appears.
Key to Abbreviations:
AnnAnnouncement
CDCourt Decision
DODelegation Order
EOExecutive Order
PLPublic Law
PTEProhibited Transaction Exemption
RPRevenue Procedure
RRRevenue Ruling
SPRStatement of Procedural Rules
TCTax Convention
TDTreasury Decision
TDOTreasury Department Order
EMPLOYEE PLANS
Anti-cutback rules, section 411(d)(6) protected benefits (TD
9280) 38,450
Disaster relief, additional postponement under section 7508A for
filing certain 2004 and 2005 individual tax returns by certain
taxpayers affected by Hurricane Katrina (Notice 56) 28,58
Employee stock ownership plan (ESOP), disallowance of deduc-
tion for reacquisition payments (TD 9282) 39,512
Exempt organization employees, minimum coverage require-
mentsofsection410(b)(TD9275)35,327
Full funding limitations, weighted average interest rate:
For July 2006 (Notice 66) 30,99
For August 2006 (Notice 74) 35,339
Pension Protection Act of 2006 modifications (Notice 75) 36,
366
Nonbank trustee and nonbank custodian, approval list (Ann 45)
31,122
Qualified retirement plans:
Government pick-up plans, employer contributions (RR 43)
35,329
Prohibited transaction excise tax, amount involved in elective
deferral (RR 38) 29,80
Regulations:
26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ-
ees of 501(c)(3) organizations in 401(k) and 401(m) plans
(TD 9275) 35,327
26 CFR 1.411(a)–8, amended; 1.411(d)–3, amended; section
411(d)(6) protected benefits (TD 9280) 38,450
26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividends
paid deduction for stock held in employee stock ownership
plan (TD 9282) 39,512
Roth IRAs, distributions of designated Roth contributions, public
hearing on REG–146459–05 (Ann 42) 27,48
EMPLOYMENT TAX
Controlled services transactions under section 482, treatment, al-
location of income and deductions from intangibles, and stew-
ardship expense (TD 9278) 34,256; (REG–146893–02) 34,
317
Disaster relief:
Additional postponement under section 7508A for filing cer-
tain 2004 and 2005 individual tax returns by certain taxpay-
ers affected by Hurricane Katrina (Notice 56) 28,58
Leave-sharing plans (Notice 59) 28,60
Disclosure of return information, Bureau of Economic Analysis
(TD 9267) 34,313; (REG–148864–03) 34,320
Federal Insurance Contributions Act (FICA), application to pay-
ments made for certain services (TD 9266) 28,52
Offers in compromise, nonrefundable down payments required
(Notice 68) 31,105
Proposed Regulations:
26 CFR 31.3121(s)–1, amended; treatment of services under
section 482, allocation of income and deductions from in-
tangibles, stewardship expense (REG–146893–02) 34,317
26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
turn information to the Bureau of Economic Analysis
(REG–148864–03) 34,320
Regulations:
26 CFR 31.3102–1, amended; 31.3121(a)–2, (a)(7)–1,
(a)(8)–1, (i)–1, amended; 31.3121(a)(10)–1, revised; ap-
plication of the Federal Insurance Contributions Act to
payments made for certain services (TD 9266) 28,52
26 CFR 31.3121(s)–1, amended; 31.3121(s)–1T, added; treat-
ment of services under section 482, allocation of income
and deductions from intangibles, stewardship expense (TD
9278) 34,256
26 CFR 31.3401(a)–1, –4, amended; 31.3402(g)–1, amended;
31.3402(j)–1, amended; 31.3402(n)–1, revised; flat rate
supplemental wage withholding (TD 9276) 37,423
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
added; disclosure of return information to the Bureau of
Economic Analysis (TD 9267) 34,313
Supplemental wages, withholding (TD 9276) 37,423
Tip reporting, Attributed Tip Income Program (ATIP) (RP 30)
31,110
ESTATE TAX
Disaster relief, additional postponement under section 7508A for
filing certain 2004 and 2005 individual tax returns by certain
taxpayers affected by Hurricane Katrina (Notice 56) 28,58
Disclosure of return information, Bureau of Economic Analysis
(TD 9267) 34,313; (REG–148864–03) 34,320
Offers in compromise, nonrefundable down payments required
(Notice 68) 31,105
Proposed Regulations:
26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
turn information to the Bureau of Economic Analysis
(REG–148864–03) 34,320
2006–39 I.R.B.ivSeptember 25, 2006

ESTATE TAX—Cont.
Regulations:
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
added; disclosure of return information to the Bureau of
Economic Analysis (TD 9267) 34,313
EXCISE TAX
Disaster relief, additional postponement under section 7508A for
filing certain 2004 and 2005 individual tax returns by certain
taxpayers affected by Hurricane Katrina (Notice 56) 28,58
Disclosure of return information, Bureau of Economic Analysis
(TD 9267) 34,313; (REG–148864–03) 34,320
Disclosure requirements with respect to prohibited tax shelter
transactions to which tax-exempt entities are parties (Notice
65) 31,102
Excise taxes with respect to prohibited tax shelter transactions to
which tax-exempt entities are parties (Notice 65) 31,102
Health Savings Accounts (HSAs) under section 4980G, em-
ployer comparable contributions (TD 9277) 33,226
Offers in compromise, nonrefundable down payments required
(Notice 68) 31,105
Proposed Regulations:
26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
turn information to the Bureau of Economic Analysis
(REG–148864–03) 34,320
Regulations:
26 CFR 54.4980G–0 thru –5, added; employer comparable
contributions to Health Savings Accounts under section
4980G (TD 9277) 33,226
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
added; disclosure of return information to the Bureau of
Economic Analysis (TD 9267) 34,313
EXEMPT ORGANIZATIONS
Disaster relief, additional postponement under section 7508A for
filing certain 2004 and 2005 individual tax returns by certain
taxpayers affected by Hurricane Katrina (Notice 56) 28,58
Disclosure requirements with respect to prohibited tax shelter
transactions to which tax-exempt entities are parties (Notice
65) 31,102
Excise taxes with respect to prohibited tax shelter transactions to
which tax-exempt entities are parties (Notice 65) 31,102
List of organizations classifiedas private foundations (Ann 51)
32,222
Revocations (Ann 48) 31,136; (Ann 54) 33,254;(Ann55)35,
342; (Ann 60) 36,389; (Ann 69) 37,449
GIFT TAX
Disaster relief, additional postponement under section 7508A for
filing certain 2004 and 2005 individual tax returns by certain
taxpayers affected by Hurricane Katrina (Notice 56) 28,58
Disclosure of return information, Bureau of Economic Analysis
(TD 9267) 34,313; (REG–148864–03) 34,320
GIFT TAX—Cont.
Offers in compromise, nonrefundable down payments required
(Notice 68) 31,105
Proposed Regulations:
26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
turn information to the Bureau of Economic Analysis
(REG–148864–03) 34,320
Regulations:
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
added; disclosure of return information to the Bureau of
Economic Analysis (TD 9267) 34,313
INCOME TAX
Accounting methods:
Advance consent to change procedures (RP 37) 38,499
Revised instructions for Form 3115, Application for Change
inAccountingMethod(Ann52)33,254
Capitalization of amounts paid to acquire, produce, or improve
tangible property (REG–168745–03) 39,532
Collection, IRS’s use of private collection agencies (PCAs) in
2006 (Ann 63) 37,445
Computer software, domestic production activities deduction un-
der section 199(c)(5)(B):
Change in hearing location for REG–111578–06 (Ann 53) 33,
254
Correction to TD 9262 (Ann 56) 35,342
Conservation Security Program (CSP), cost-share payments (RR
46) 39,511
Consolidated returns, basis reallocation, loss suspension, and ex-
piration of losses on certain stock dispositions, correction to
TD 9254 (Ann 44) 27,49; correction (Ann 66) 37,448
Controlled services cost method under section 482 regulations,
identification of specified eligible covered services (Ann 50)
34,321
Controlled services transactions under section 482, treatment, al-
location of income and deductions from intangibles, and stew-
ardship expense (TD 9278) 34,256; (REG–146893–02) 34,
317
Corporations:
Attribution of earnings and profits to stock of controlled
foreign corporations (REG–135866–02) 27,34; correction
(Ann 64) 37,447; additional corrections (Ann 65) 37,447
Distributions of interests in a loss corporation from qualified
trusts (TD 9269) 30,92
Foreign corporation interest expense allocations, branch prof-
its tax election, branch profits tax liability reduction (TD
9281) 39,517; (REG–120509–06) 39,570
Information returns required with respect to certain foreign
corporations and certain foreign-owned domestic corpora-
tions (TD 9268) 30,94; (REG–109512–05) 30,100
Inversions, surrogate foreign corporations (Notice 70) 33,252
Look-through treatment of dividends from noncontrolled sec-
tion 902 corporations, correction to TD 9260 (Ann 67) 38,
509
September 25, 2006v2006–39 I.R.B.

INCOME TAX—Cont.
Surrogate foreign corporation status for purposes of section
7874 (TD 9265) 27,1; (REG–112994–06) 27,47
Credits:
Enhanced oil recovery credit, 2006 inflation adjustment (No-
tice 62) 29,86
For income, war profits, excess profits taxes paid to foreign
country or U.S. possession (REG–124152–06) 36,368
Low-income housing credit:
Carryovers to qualified states, 2006 National Pool (RP 38)
39,530
Satisfactory bond, “bond factor” amounts for the period:
January through September 2006 (RR 37) 30,91
New markets tax credit, low-income community business
(Notice 60) 29,82
Nonbusiness energy property, siding not component specifi-
cally and primarily designed to reduce heat loss or gain of
dwelling (Notice 71) 34,316
Work opportunity and welfare-to-work tax credits (Ann 49)
29,89
Debit cards used to reimburse participants in self-insured medical
reimbursement plans and dependent care assistance programs
(Notice 69) 31,107
Disaster relief:
Additional postponement under section 7508A for filing cer-
tain 2004 and 2005 individual tax returns by certain taxpay-
ers affected by Hurricane Katrina (Notice 56) 28,58
Casualty and theft loss deductions attributable to Hurricanes
Katrina, Rita, and Wilma, safe harbor methods for individ-
uals, personal-use residential real property and certain per-
sonal belongings (RP 32) 28,61
Depreciation, Gulf Opportunity (GO) Zone additional first
year depreciation deduction (Notice 67) 33,248
Leave-sharing plans (Notice 59) 28,60
Disciplinary actions involving attorneys, certified public accoun-
tants, enrolled agents, and enrolled actuaries (Ann 57) 35,343
Disclosure of return information:
Bureau of Economic Analysis (TD 9267) 34,313;
(REG–148864–03) 34,320
By certain officers and employeesfor investigative purposes
(TD 9274) 33,244
E-file, guidance necessary to facilitate business electronic filing
and burden reduction, correction to TD 9264 (Ann 46) 28,76;
correction to REG–134317–05 (Ann 47) 28,78
Effect of elections in certain multi-step transactions (TD 9271)
33,224
Employee stock ownership plan (ESOP), disallowance of deduc-
tion for reacquisition payments (TD 9282) 39,512
Exempt organization employees, minimum coverage require-
mentsofsection410(b)(TD9275)35,327
Fast Track Settlement (FTS) for SB/SE taxpayers to expedite
case resolution (Ann 61) 36,390
Forms:
1042-S, Foreign Person’s U.S. Source Income Subject to
Withholding, specificationsfor filing electronically or
magnetically (RP 34) 38,460
INCOME TAX—Cont.
1098, 1099, 5498 and W-2G, requirements for filing electron-
ically or magnetically (revised 8-2006) (RP 33) 32,140
3115, Application for Change in Accounting Method, instruc-
tions revised May 2006 (Ann 52) 33,254
8027, Employer’s Annual Information Return of Tip Income
and Allocated Tips, specifications for filing electronically
or magnetically (RP 29) 27,13
8802, Application for United States Residency Certification,
user fees for processing (RP 35) 37,434
8830, Enhanced Oil Recovery Credit, credit phased out for
2006 (Ann 62) 37,444
8840, Closer Connection Exception Statement for Aliens, re-
vision (Notice 73) 35,339
8898, Statement for Individuals Who Begin or End Bona Fide
Residence in a U.S. Possession, postponement of filing date
for tax years 2001 through 2005 (Notice 57) 27,13; revision
(Notice 73) 35,339
Health reimbursement arrangements, taxable benefits of benefi-
ciaries (RR 36) 36,353
Health Savings Accounts (HSAs) under section 4980G, em-
ployer comparable contributions (TD 9277) 33,226
Indian tribal governments, limitation on issuance of tax-ex-
empt bonds, advance notice of proposed rulemaking
(REG–118788–06) (Ann 59) 36,388
Information reporting:
For payments to attorneys, reporting of gross proceeds pay-
ments (TD 9270) 33,237
Requirements for qualified tuition and related expenses (No-
tice 72) 36,363
Insurance companies:
Life-nonlife tacking rule, correction to TD 9258 (Ann 46) 28,
76
Recomputed differential earnings rate for 2004 (RR 45) 37,
423
Interest:
Investment:
Federal short-term, mid-term, and long-term rates for:
July 2006 (RR 35) 28,50
August 2006 (RR 39) 32,137
September 2006 (RR 44) 36,361
Portfolio interest rules as appliedtopaymentsmadetopart-
nerships and simple or grantor trusts (REG–118775–06) 28,
73; hearing rescheduled (Ann 58) 36,388
Inventory:
LIFO, price indexes used by department stores for:
May 2006 (RR 40) 32,136
June 2006 (RR 41) 35,331
July 2006 (RR 48) 39,516
Involuntary conversions, livestock sold on account of drought,
extension of replacement period (Notice 82) 39,529
Levy, use of superpriority lien arguments as a defense to (RR 42)
35,337
Marginal production rates, 2006 (Notice 61) 29,85
Nonqualified deferred compensation, permitted accelerated pay-
ment (Notice 64) 29,88
2006–39 I.R.B.viSeptember 25, 2006

INCOME TAX—Cont.
Offers in compromise, nonrefundable down payments required
(Notice 68) 31,105
Partnerships, portfolio interest rules as applied to payments made
to partnerships and simple or grantor trusts (REG–118775–06)
28,73
Postponement of filing date for Form 8898, Statement for Indi-
viduals Who Begin or End Bona Fide Residence in a U.S. Pos-
session, for tax years 2001 through 2005 (Notice 57) 27,13
Private foundations, organizations now classified as (Ann 51) 32,
222
Procedures for requesting specialstatistical studies and compila-
tions involving return information (RP 36) 38,498
Proposed Regulations:
26 CFR 1.162–4, revised; 1.263(a)–0, amended; 1.263(a)–1
thru –3, revised; guidance regarding deduction and cap-
italization of expenditures related to tangible property
(REG–168745–03) 39,532
26 CFR 1.367(b)–2, –4, revised; 1.1248–1, –2, –3, –7, re-
vised; 1.1248–8, added; section 1248 attribution principles
(REG–135866–02) 27,34; correction (Ann 64) 37,447;ad-
ditional corrections (Ann 65) 37,447
26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–9,
added; 1.861–8, amended; 1.6038A–3(a)(3), amended;
1.6662–6, amended; treatment of services under section
482, allocation of income and deductions from intangibles,
stewardship expense (REG–146893–02) 34,317
26 CFR 1.671–5, amended; reporting rules for widely held
fixed investment trusts (REG–125071–06) 36,375
26 CFR 1.706–1, amended; 1.901–2, revised; definition of
taxpayer for purposes of section 901 and related matters
(REG–124152–06) 36,368
26 CFR 1.860A–1, amended; 1.860G–3, amended; 1.863–1,
amended; 1.1441–2, amended; REMIC residual interests-
accounting for REMIC net income (including any excess
inclusions (foreign holders) (REG–159929–02) 35,341
26 CFR 1.871–14, amended; 1.881–2, amended; revisions to
regulations relating to repeal of tax on interest of nonres-
ident alien individuals and foreign corporations received
from certain portfolio debt investments (REG–118775–06)
28,73; hearing rescheduled (Ann 58) 36,388
26 CFR 1.882–5, amended; 1.884–1, amended; determina-
tion of interest expense deduction of foreign corporations
(REG–120509–06) 39,570
26 CFR 1.985–3, amended; United States dollar approximate
separate transactions method (REG–118897–06) 31,121
26 CFR 1.6038–2, amended; 1.6038A–2, amended; informa-
tion returns required with respect to certain foreign cor-
porations and certain foreign-owned domestic corporations
(REG–109512–05) 30,100
26 CFR 1.7874–2, added; guidance regarding expatriated en-
tities and their foreign parents (REG–112994–06) 27,47
26 CFR 300.0, amended; 300.4, .5, .6, added; user fees relat-
ing to enrollment (REG–145154–05) 39,567
26 CFR 301.6103(j)(1)–1, amended; disclosure of re-
turn information to the Bureau of Economic Analysis
(REG–148864–03) 34,320
INCOME TAX—Cont.
Publications:
1187, Specifications for Filing Form 1042-S, Foreign Per-
son’s U.S. Source Income Subject to Withholding, Elec-
tronically or Magnetically, revised (RP 34) 38,460
1220, Specifications for Filing Forms 1098, 1099, 5498 and
W-2G Electronically or Magnetically, 2006 revision (RP
33) 32,140
1239, Specifications for Filing Form 8027, Employer’s An-
nual Information Return of TipIncome and Allocated Tips,
Electronically or Magnetically, revised (RP 29) 27,13
Real Estate Investment Trust (REIT) income tests, rents from real
property (Notice 58) 28,59
Real Estate Mortgage Investment Conduit (REMIC), allocation
of income to foreign persons by certain entities (TD 9272) 35,
332; correction (Ann 68) 38,510; (REG–159929–02) 35,341
Record retention requirements for tax-exempt bonds (Notice 63)
29,87
Regulations:
26 CFR 1.162(k)–1, added; 1.404(k)–3, added; dividends
paid deduction for stock held in employee stock ownership
plan (TD 9282) 39,512
26 CFR 1.199–3T, –8T, amended; computer software under
section199(c)(5)(B),correctiontoTD9262(Ann56)35,
342
26 CFR 1.338–3, amended; 1.338(h)(10)–1, amended;
1.338(h)(10)–1T, removed; effect of elections in certain
multi-step transactions (TD 9271) 33,224
26 CFR 1.367(b)–0 thru –3, amended; 1.367(b)–6, revised;
1.367(b)–7, –8, –9, added; 1.381(a)–1, revised; stock trans-
fer rules, carryover of earnings and taxes (TD 9273) 37,394
26 CFR 1.382–1, amended; 1.382–10, added; 1.382–10T, re-
moved; distributions of interests in a loss corporation from
qualified trusts (TD 9269) 30,92
26 CFR 1.410(b)–0, –6, –10, amended; exclusion of employ-
ees of 501(c)(3) organizations in 401(k) and 401(m) plans
(TD 9275) 35,327
26 CFR 1.482–0, –1, –2, –4, –6, –8, amended; 1.482–0T, –1T,
–2T, –4T, –6T, –8T, –9T, added; 1.861–8, –8T, amended;
1.6038–3(a)(3), amended; 1.6038A–3T, added; 1.6662–6,
amended; 1.6662–6T, added; treatment of services under
section 482, allocation of income and deductions from in-
tangibles, stewardship expense (TD 9278) 34,256
26 CFR 1.671–5, amended; 1.671–5T, added; reporting rules
for widely held fixed investment trusts (TD 9279) 36,355
26 CFR 1.860A–0, –1, amended; 1.860A–1T, added;
1.860G–3, amended; 1.860G–3T, added; 1.863–0, –1,
amended; 1.863–1T, added; 1.1441–0, –2, amended;
1.1441–2T, added; REMIC residual interests-accounting
for REMIC net income (including any excess inclusions)
(foreign holders) (TD 9272) 35,332; correction (Ann 68)
38,510
26 CFR 1.882–0, –5, amended; 1.882–5T, added; 1.884–1,
amended; 1.884–1T, added; 602.101, amended; determina-
tion of interest expense deduction of foreign corporations
(TD 9281) 39,517
September 25, 2006vii2006–39 I.R.B.

INCOME TAX—Cont.
26 CFR 1.904–4, amended; application of separate limitations
to dividends from noncontrolled section 902 corporations,
correctiontoTD9260(Ann67)38,509
26 CFR 1.1502–35, amended; suspension of losses on certain
stock dispositions, correction to TD 9254 (Ann 44) 27,49;
correction (Ann 66) 37,448
26 CFR 1.1502–76T, amended; 1.1563–1, amended; 602.101,
amended; amendment of tacking rule requirements of life-
nonlife consolidated regulations, and guidance necessary to
facilitate business electronic filing and burden reduction,
correction to TD 9258 and TD 9264 (Ann 46) 28,76
26 CFR 1.6038–2, –2T, amended; 1.6038A–2, –2T, amended;
602.101(b), amended; information returns required with re-
spect to certain foreign corporations and certain foreign-
owned domestic corporations (TD 9268) 30,94
26 CFR 1.6041–1, –3, amended; 1.6045–5, added; reporting
of gross proceeds payments to attorneys (TD 9270) 33,237
26 CFR 1.7874–2T, added; guidance regarding expatriated
entities and their foreign parents (TD 9265) 27,1
26 CFR 54.4980G–0 thru –5, added; employer comparable
contributions to Health Savings Accounts under section
4980G (TD 9277) 33,226
26 CFR 301.6103(j)(1)–1, amended; 301.6103(j)(1)–1T,
added; disclosure of return information to the Bureau of
Economic Analysis (TD 9267) 34,313
26 CFR 301.6103(k)(6)–1, added; 301.6103(k)(6)–1T, re-
moved; disclosure of return information by certain officers
and employees for investigative purposes (TD 9274) 33,
244
Revocations, exempt organizations (Ann 48) 31,136;(Ann54)
33,254;(Ann55)35,342; (Ann 60) 36,389;(Ann69)37,449
Revoking an election under section 83(b) (RP 31) 27,32
Standard Industry Fare Level (SIFL) formula (RR 47) 39,511
Stock transfer rules, carryover of earnings and taxes (TD 9273)
37,394
Tax Exempt Bond (TEB) Mediation Pilot Program, one-year re-
newal (Ann 43) 27,48
Tuition and related expenses, qualified, information reporting re-
quirements (Notice 72) 36,363
United States dollar approximate separate transactions method
(DASTM) (REG–118897–06) 31,121
U.S. possessions, examples for determining whether income is
U.S. possession source or effectively connected with trade or
business in U.S. possession (Notice 76) 38,459
User fees:
Enrollment examinations, enrollment of enrolled agents, re-
newal of enrollment (REG–145154–05) 39,567
Processing Form 8802, Application for United States Resi-
dency Certification (RP 35) 37,434
Widely held fixed investment trusts (WHFITs), reporting re-
quirements (TD 9279) 36,355; (REG–125071–06) 36,375
SELF-EMPLOYMENT TAX
Disaster relief, additional postponement under section 7508A for
filing certain 2004 and 2005 individual tax returns by certain
taxpayers affected by Hurricane Katrina (Notice 56) 28,58
Offers in compromise, nonrefundable down payments required
(Notice 68) 31,105
2006–39 I.R.B.viiiSeptember 25, 2006

September 25, 20062006–39 I.R.B.

2006–39 I.R.B.September 25, 2006

September 25, 20062006–39 I.R.B.

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