Tax-exempt use property

The policy underlying the restriction on tax-exempt use property is to provide tax-reducing incentives only to those who are subject to income tax, and to deny them to tax-exempt entities, including foreign entities.

Depreciation deductions for tax-exempt use property were computed using the straight-line method and disregarding salvage value. The cost of tax-exempt use personal property was generally recovered over the longer of the asset's ADR midpoint life (12 years if the property had no ADR midpoint life) or 125 percent of the lease term. The recovery period for qualified technological property subject to these rules was five years. The recovery period for taxexempt use real property was the longer of 40 years or 125 percent of the lease term. A taxpayer could elect to recover the cost of taxexempt use property over an optional extended recovery period. The rules for tax-exempt use property overrode the rules relating to foreign-use property.

Property financed with industrial development bonds

Except in the case of property placed in service in connection with projects for residential rental property, the cost of property that was financed with tax-exempt industrial development bonds was recovered using the straight-line method over either the applicable ACRS recovery period or an optional extended recovery period.

Computation of earnings and profits

If an accelerated depreciation method were used for purposes of computing earnings and profits, the acceleration of depreciation deductions would reduce a corporation's earnings and profits, and thereby facilitate the distribution of tax-free dividends. For this reason, domestic corporations were required to compute earnings and profits using the straight-line method over recovery periods that were longer than the standard ACRS recovery periods.

The extended recovery periods used to compute earnings and profits were: (1) five years for three-year property, (2) 12 years for five-year property, (3) 25 years for 10-year property, (4) 35 years for 15-year public utility property, and (5) 40 years for 19-year real property and low-income housing.

Minimum taxes

The minimum tax provisions are designed to prevent taxpayers with substantial economic income from avoiding tax liability by using certain exclusions, deductions, and credits (referred to as "items of tax preference"). In applicable cases, the excess of ACRS deductions over depreciation deductions that would have been allowed had the taxpayer used the straight-line method over a prescribed recovery period were treated as items of tax preference. For purposes of this rule, the prescribed recovery periods were: (1) five years for three-year property, (2) eight years for five-year property, (3) 15 years for 10-year property, (4) 22 years for 15-year public utility property, (5) 15 years for low-income housing, and (6) 19 years for real property other than low-income housing. These rules ap

plied to personal property subject to a lease and 19-year real property and low-income housing (prior law sec. 57(a)(12)). Further, personal property subject to a lease was not taken into account for corporations other than personal holding companies (as defined in sec. 542).

Luxury automobiles and mixed-use property

ACRS deductions were subject to fixed limitations for automobiles and reduced for certain property (including automobiles) used for both personal and business purposes (prior law sec. 280F). For luxury automobiles, depreciation deductions were limited to $3,200 for the first year in the recovery period, and $4,800 for each succeeding year. For mixed-use property used 50 percent or more for personal purposes, capital costs-to the extent of business usewere recovered using the straight-line method of depreciation over the same recovery periods that were used for purposes of computing the earnings and profits of a domestic corporation. ACRS was available for mixed-use property used more than 50 percent for business purposes, but only with respect to the portion of the property's basis attributable to business use.

Mass asset vintage accounts

In general, taxpayers computed depreciation deductions, as well as gain or loss on disposition, on an asset-by-asset basis. A taxpayer could elect to establish mass asset vintage accounts for assets in the same recovery class and placed in service in the same taxable year. Under proposed Treasury regulations, the definition of mass assets eligible for this treatment was limited to assets (1) each of which is minor in value relative to the total value of such assets, (2) that are numerous in quantity, (3) that are usually accounted for only on a total dollar or quantity basis, and (4) with respect to which separate identification is impractical (Prop. Treas. reg. sec. 1.168-2(h)(2)).

Lessee-leasehold improvements

In general, if a lessee made improvements to property, the lessee was entitled to recover the cost of the improvement over the shorter of the ACRS recovery period applicable to the property or the portion of the term of the lease remaining on the date the property was acquired. If the remaining lease term was shorter than the recovery period, the cost was amortized over the remaining term of the lease. For purposes of these rules, under prior law section 178, if the remaining term of a lease was less than 60 percent of the improvement's ACRS recovery period, the term of a lease was treated as including any period for which the lease could be renewed pursuant to an option exercisable by the lessee, unless the lessee established that it was more probable that the lease would not be renewed. In any case, a renewal period had to be taken into account if there was a reasonable certainty the lease would be renewed. Section 178 also provided rules relating to the amortization of lease acquisition costs.

Public utility property

In general

In general, a regulatory commission allows a public utility to charge customers rates that are sufficient to recover the utility's cost of service. A public utility's cost of service includes its annual operating expense and the capital expense allocable to a year. The capital expense that can be passed through to customers consists of an annual depreciation charge for equipment and also a rate of return on the capital invested in the equipment and other property (which capital is referred to as the "rate base").

ACRS distinguished between long-lived public utility equipment and other equipment. Further, as described below, public utilities were required to use a "normalization" method of accounting for ACRS deductions.

Definition of public utility property.-In general, public utility property was defined as property used predominantly in the trade or business of furnishing or selling:

(1) electrical energy, water, or sewage disposal services,

(2) gas or steam through a local distribution system,

(3) telephone services,

(4) other communication services if furnished or sold by the Communications Satellite Corporation for purposes authorized by the Communications Satellite Act of 1962 (47 U.C.C. sec. 701), or

(5) transportation of gas or steam by pipeline,

if the rates are established or approved by certain regulatory bodies.

Normalization accounting

A public utility could use ACRS only if a "normalization" method of accounting was used for purposes of establishing the utility's cost of service and reflecting operating results in its regulated books of account. Normalization required that (1) a utility's tax expense for ratemaking purposes be computed as if the depreciation deduction were computed in the same manner as the ratemaking allowance for depreciation (which is generally based on the straight-line method over relatively long useful lives), (2) the deferred taxes (i.e., the difference between the actual tax expense computed using ACRS and that computed for ratemaking purposes) be reflected in a reserve (and thus be available for capital investment), and (3) the regulatory commission not exclude from the rate base an amount that is greater than the amount of the reserve for the period used in determining the tax expense as part of the utility's cost of service (see Treas. reg. sec. 1.167(1)-1, which interprets a similar provision of pre-ACRS law).

Normalization prevented the immediate lowering of rates charged to customers as a result of the cost savings from ACRS. Rather, current tax reductions were flowed through to customers over the period of tax deferral.

Expensing of up to $5,000 of personal property

A taxpayer (other than a trust or estate) could elect to deduct the cost of up to $5,000 of qualifying personal property in the year the property was placed in service, in lieu of recovering the cost

under ACRS (prior law sec. 179). In general, qualifying property had to be acquired by purchase for use in a trade or business, and eligible for the investment tax credit (although no investment credit was allowed for the portion of the cost expensed under this rule). The $5,000 limit was scheduled to increase to $7,500 for taxable years beginning in 1988 and 1989, and to $10,000 for years beginning after 1989.

If expensed property was converted to nonbusiness use within two years of the time the property was placed in service, the difference between the amount expensed and the ACRS deductions that would have been allowed for the period of business use was recaptured as ordinary income.

Anti-churning rules

Under rules enacted as part of ACRS, taxpayers were prevented from bringing property placed in service before January 1, 1981 under ACRS by certain post effective date transactions (referred to as "churning transactions"). In general, churning transactions include those in which either the owner or user of property before January 1, 1981 (or a related party) is the owner or user immediately after the transaction. Taxpayers subject to the anti-churning rules compute depreciation under the law in effect before 1981.

Regular investment tax credit

General rule

A credit against income tax liability was allowed for up to 10 percent of a taxpayer's investment in certain tangible depreciable property (generally, not including buildings or their structural components) (secs. 38 and 46). The amount of the regular investment credit was based on the ACRS recovery class to which the property was assigned. The 10-percent credit was allowed for eligible property in the five-year, 10-year, or 15-year public utility property class. Three-year ACRS property was eligible for a six-percent regular credit (even if the taxpayer elected to use a longer recovery period). The maximum amount of a taxpayer's investment in used property that was eligible for the regular investment credit was $125,000 per year; the limitation on used property was scheduled to increase to $150,000 for taxable years beginning after 1987.

Generally, the investment credit was claimed for the taxable year in which qualifying property was placed in service. In cases where property was constructed over a period of two or more years, an election was provided under which the credit could be claimed on the basis of qualified progress expenditures ("QPES") made during the period of construction before the property was completed and placed in service. Investment credits claimed on QPEs were subject to recapture if the property failed to qualify for the investment credit when placed in service.

The amount of income tax liability that could be reduced by investment tax credits in any year was limited to $25,000 plus 85 percent of the liability in excess of $25,000 (sec. 38(c)). Unused credits for a taxable year could be carried back to each of the three preceding taxable years and then carried forward to each of the 15 following taxable years (sec. 39).

Public utility property

Public utility property was eligible for the regular investment credit only if the tax benefits of the credit were normalized in setting rates charged by the utility to customers and in reflecting operating results in regulated books of account (sec. 46(f)). The investment credit was denied for public utility property if the regulatory commission's treatment of the credit resulted in benefits being flowed through to customers more rapidly than under either (1) the ratable flow-through method or (2) the rate base reduction method. Under the ratable flow-through method (sec. 46(f)(2)), utilities passed through to customers a pro rata portion of the credit during each year of the useful life of the asset. The regulatory commission could not require that the utility reduce its rate base by the amount of the credit. Therefore, even though the credit itself was flowed through to customers over the life of the asset, the utility's shareholders were allowed to earn a return on that amount of the cost of the equipment which had, in effect, been supplied by the Federal government through the regular investment credit.

Under the rate base reduction method (sec. 46(f)(1)), the utility's rate base was reduced by the amount of the credit, so the shareholders were prevented from earning a return on that part of the cost of the equipment which was paid for by the credit. Under this method, the regulatory commission could not require that the utility flow through to customers any part of the credit itself, or allow the utility to charge customers for the depreciation expense on the entire cost of the equipment, including the part paid for by the investment credit.

Finance leases

Overview

The law contains rules to determine who owns an item of property for tax purposes when the property is subject to an agreement that the parties characterize as a lease. Such rules are important because the owner of the property is entitled to claim tax benefits including cost recovery deductions and investment tax credits with respect to the property. These rules attempt to distinguish between true leases, in which the lessor owns the property for tax purposes, and conditional sales or financing arrangements, in which the user of the property owns the property for tax purposes. These rules generally are not written in the Internal Revenue Code. Instead they evolved over the years through a series of court cases and revenue rulings and revenue procedures issued by the Internal Revenue Service. Essentially, the law is that the economic substance of a transaction, not its form, determines who is the owner of property for tax purposes. Thus, if a transaction is, in substance, simply a financing arrangement, it is treated that way for tax purposes, regardless of how the parties choose to characterize it. Under these rules, lease transactions cannot be used solely for the purpose of transferring tax benefits; they have to have nontax economic substance.