Entertainment, Media, and Communications Tax Newsletter Volume 24/February 2015 In focus In brief

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1 Entertainment, Media, and Communications Tax Newsletter Volume 24/February 2015 Contributed by the Washington National Tax Services practice Recent IRS guidance provides safe harbor accounting methods for cable system operators In focus View EMC newsletter archives Visit us online: In brief The IRS recently released Rev. Proc , which provides several safe harbor methods of accounting for tangible property costs of cable system operators and related automatic accounting method change procedures. The new guidance is effective for tax years ending after December 31,

2 Rev. Proc addresses the following tangible property issues for a cable system operator: Deductibility and capitalization of expenditures to maintain, replace, or improve cable network assets; Deductibility and capitalization of costs for installations of customer drops and customer premises equipment (CPE); Treatment of fiber optic transfer node and trunk line used in a cable distribution network as the asset for computing depreciation (consistent with Rev. Proc ); and Primary-use classifications of cable distribution network assets performing one-way and two-way communication services for purposes of determining the appropriate depreciation class life for such assets (expanding applicability of similar test provided in Rev. Proc ). The revenue procedure provides automatic method changes for all the above items other than the primary-use tests. Those tests are treated as changes in use under the regulations that generally are effected prospectively by depreciating the asset's remaining basis over its remaining life. Note: This revenue procedure does not apply to a taxpayer that is primarily a wireline or wireless telecommunications service provider. However, the IRS indicates in the background section that it anticipates providing a safe harbor similar to the safe harbor for cable operators (described below) for a wireline telecommunications service provider to determine the primary use of assets used to provide video, highspeed internet, and voice communication services. 2 pwc

3 In detail Rev. Proc observes that cable system operators that provide video, highspeed internet, and voice over internet protocol (VOIP) phone services incur significant costs in maintaining, replacing, and improving real and personal property in performing those services for its customers. Applying capitalization principles under Section 263(a) to assets used in a cable system can be particularly difficult because the property consists of interconnected items. Consequently, the revenue procedure provides safe harbors to identify deductible repairs or units of property and to determine the treatment of costs to install customer drops and CPE. The revenue procedure also expands the applicability of Rev. Proc from cable TV network assets to all cable distribution network assets. The issues and methods addressed in Rev. Proc , each of which are discussed in more detail below, are as follows: Issue Deductibility and capitalization of expenditures to maintain, replace, or improve cable network assets Methods Network asset maintenance allowance (NAMA) method, which generally permits a taxpayer to deduct 12 percent of cable network asset additions capitalized for financial accounting purposes; or Units of property method, which provides safe harbor units of property that can be used to apply the capitalization standards. Deductibility and/or capitalization of costs for installations of customer drops and CPE Specific identification method, under which the costs of installing initial external drops must be capitalized, but the costs of installing ordinary external drop replacements and internal drops may be deducted; or Safe-harbor allocation method, under which 12 percent of total customer drops are capitalized, and 88 percent of total customer drops are deducted as long as the external drop replacements are ordinary. Treatment of CPE costs, under which the labor costs to install CPE may be deducted. Treatment of fiber optics as unit of property Primary-use classifications of cable distribution network assets performing one-way and two-way communication services Method to treat fiber optic transfer node and trunk line used in a cable distribution network as the asset for computing depreciation (i.e., consistent with Rev. Proc ). Use of any reasonable manner that is consistently applied such as gross receipts or subscriber count, but not bandwidth (consistent with Rev. Proc ), or Safe harbor method, under which primary use is determined based on a combination of revenue presumptions (where revenue from video services is deemed to be one-way, and revenue from telephony, home monitoring, and leasing of fiber optics generally is deemed to be two-way) and signal traffic data (for broadband revenue). 3 pwc

4 Expenditures to maintain, replace, or improve cable network assets Rev. Proc provides two safe harbors for determining the deductibility and capitalization of expenditures to maintain, replace, or improve cable network assets: the network asset maintenance allowance method and the units of property method. Network asset maintenance allowance (NAMA) method In general, under the NAMA method, a taxpayer may claim an additional tax deduction equal to 12 percent of adjusted cable network asset capital additions placed in service during the year for financial statement purposes. That is, the NAMA allows a deduction in addition to operation and maintenance costs that generally are deductible for both financial statement and federal tax purposes. To determine the adjusted amount of applicable additions, certain adjustments must be made, including removing customer drop costs capitalized for financial statement purposes, costs capitalized for financial statement purposes that are deducted or deferred for federal tax purposes (other than under the NAMA method, such as Section 174 costs), and the cost of cable network assets acquired in an applicable asset acquisition or in a transaction subject to a Section 338 election. After the deduction is computed, the revenue procedure requires taxpayers to allocate the allowance to each cable network asset placed in service during the year. To perform this allocation, a taxpayer generally must reduce the basis for each class of cable network assets by 12 percent (i.e., by multiplying the adjusted basis of property in each class placed in service during the year by 88 percent), and then allocate the reduction proportionally to each cable network asset in the class that is placed in service during the year. If elected, the NAMA method is the exclusive means for determining for federal tax purposes whether cable network asset costs that are capitalized for financial statement purposes are deductible or must be capitalized, except for costs of customer drops and for costs deductible under Section 174. If the NAMA method is elected, the taxpayer must use the method for all its cable network costs, including subsequent costs relating to cable network assets acquired in asset acquisitions. Observations The NAMA method allows a simplified approach to determine additional tax deductions that arguably would be available if a cable operator analyzed its book additions of cable network assets to identify amounts capitalized for books that would be allowable as a repair deduction for tax purposes under the Section 263(a) tangible property regulations. While application of the tangible property regulations could yield a larger tax deduction in some instances, the additional compliance burden to identify additional repairs on an asset-by-asset basis may outweigh the benefit. It is important to note that the NAMA amount must be allocated to individual assets in order to track when the book-tax difference will reverse, which potentially adds some complexity for cable operators with a significant number of assets. 4 pwc

5 Units of property method As an alternative safe harbor, Rev. Proc provides a units of property method that, if properly applied under the principles of Section 263(a), will not be challenged by the IRS. The units of property safe harbor method defines nine groupings of cable network assets that constitute separate units of property solely for purposes of applying the tangible property regulations under Section 263(a). The following groupings generally constitute separate units of property within an individual cable system: All programming reception equipment All towers, antenna support structures, and satellite dish support structures affixed to foundations All concrete foundations upon which a tower, antenna support structure, or satellite support structure is installed Each headend building and each hub building (including its structural components) The headend equipment All depreciable land improvements All equipment at the nodes The fiber optic distribution system The coaxial distribution system. A taxpayer is not required to use all the unit of property determinations provided in Rev. Proc However, once used, a unit of property determination applies to all assets in the unit of property grouping. The units of property safe harbor does not apply for any purpose other than for Section 263(a), including determining unit of property under other code sections (e.g., Section 263A) and determining the asset for depreciation purposes. For the purposes of the revenue procedure, cable network assests are defined as personal or real property cable network assets do not include intangible property, other than computer software used in operating plant and equipment that provides cable services. Observations The units of property as determined under the safe harbor may be different than the taxpayer's current units of property. To the extent any unit of property specified in the revenue procedure is larger than the taxpayer's current unit of property for those assets; the taxpayer may qualify for additional repair deductions under the tangible property regulations. Although the revenue procedure indicates the safe harbor units of property apply only to the determination of repairs or capital improvements, the taxpayer also should consider the potential implication on other areas of the tax law. Definition of cable network assets For purposes of the revenue procedure, cable network assets are defined as personal or real property used in a cable system that provides video, high-speed internet, and VOIP phone services (i.e., cable services) to customer premises in the US. The network assets consist of operating plant and equipment that receive signals and transmit programming from the headend (i.e., the primary location in a cable system that receives television programming signals for distribution to the customer premises through a cable distribution network) to the customer, including signalreceiving equipment, encoding and decoding devices, cables, connectors, switches, amplifiers, and distribution equipment at or near customer locations. Cable network assets do not include intangible property, other than computer software used in operating plant and equipment that provides cable services. Furthermore, cable network assets do not include any personal or real property not directly used to provide cable services to customers. Costs for installations of customer drops and CPE Rev. Proc provides two methods to determine whether costs to install customer drops may be deducted under Section 162 or must be capitalized under Section 263(a) -- the specific identification method and the safe-harbor allocation method and provides for the treatment of costs to install CPE. 5 pwc

6 Specific identification method for customer drops Under this method, taxpayers must identify the costs to install different types of customer drops and treat them as follows: Initial external drops Direct and indirect costs to install initial external drops must be capitalized, unless otherwise deductible under another provision of the code or regulations Replacement external drops Direct or indirect costs associated with ordinary replacements of external drops that do not result in a betterment or an adaptation to a new or different use may be deducted Internal drops Direct and indirect costs associated with installing or replacing internal drops may be deducted. For this purpose, external drops are defined as the cable and any associated connectors that run (aerial or underground) from the tap (i.e., equipment that is the final interconnection point within a cable distribution network and directs a signal to be delivered to a customer) to the exterior of the customer premises. Internal drops are defined as the cable and any associated connectors within the interior of the customer premises. Safe-harbor allocation method for customer drops As an alternative to the specific identification method, a taxpayer may allocate 12 percent of total customer drops for the tax year to initial external drops and treat such costs as expenditures that must be capitalized under Section 263(a). The remaining 88 percent of total customer drop costs may be treated as costs to replace external drops, or to install or replace internal drops that are deductible. However, to the extent that the replacement of any external drop factually results in a betterment or an adaptation to a new or different use, the taxpayer must capitalize the costs to install those drops. Observation Although this safe harbor presumably is intended to alleviate the compliance burden associated with identifying installation costs attributable to different types of customer drops, the method still requires a taxpayer to identify costs attributable to external drop replacements and to analyze whether such replacements factually result in an improvement under the tangible property regulations. The safe harbor therefore may not provide taxpayers with the simplification desired. Treatment of CPE costs Rev. Proc confirms that whether the costs of acquiring CPE must be capitalized is determined under the general rules of the code and regulations, such as Section 263(a) and the corresponding regulations. The labor costs associated with installing CPE, however, may be treated as expenditures that are deductible under Section 162 under the revenue procedure. For this purpose, CPE includes set-top boxes, modems, routers, and remotes used by customers to receive and select programming services. CPE also includes a customer connection box treated by the taxpayer as CPE rather than as part of a customer drop. 6 pwc

7 Observation The revenue procedure confirms the treatment of cable operators that currently are deducting the labor costs associated with installing CPE. Cable operators that currently are capitalizing the labor costs to install CPE should consider changing their method of accounting to begin deducting such costs. Treatment of fiber optic transfer node and trunk line as a unit of property Consistent with the position in Rev. Proc , Rev. Proc provides a safe harbor to treat a fiber optic transfer node and a trunk line consisting of fiber optic cable used in a cable distribution network (providing both one-way and two-way communications) as the asset for computing depreciation under Sections 167 and 168. The safe harbor in Rev. Proc considers the asset to be the fiber optic node and the fiber optic cable to that node, excluding any fiber optic cable previously considered placed in service and any optic fibers sold by the taxpayer. The safe harbor also provides that this asset is considered placed in service for depreciation purposes when in a condition or state of readiness and availability for its specifically assigned function of providing services to subscribers. Thus, when a node is connected to the equipment necessary for providing one-way or two-way communication services to subscribers, or potential subscribers, the property is considered placed in service. Rev. Proc adds that fiber optic cables may contain more optic fibers than are necessary to serve a single node; however, all optic fibers in the asset are considered placed in service when the node is ready and available for use and connected to at least one optic fiber in the fiber optic cable. The revenue procedure requires consistent treatment for fiber optic nodes and cables, as a taxpayer must apply the safe harbor, if elected, to all nodes and fiber optic cables connected to an individual headend. The taxpayer also must treat the asset consistently for all purposes under Sections 167 and 168. As a general rule, determining primary use must be performed by a taxpayer using reasonable manner that is consistently applied within a tax year to the taxpayer s tested assets. Observation Rev. Proc incorporates the safe harbor contained in Rev. Proc to determine the unit of property for fiber optic transfer nodes and trunk lines, and also expands the applicability of this safe harbor to all cable distribution network assets (as opposed to just to cable television distribution system assets). Primary use classifications of cable network assets performing one-way and two-way communication services Consistent with Rev. Proc , Rev. Proc provides a safe harbor for determining the primary use of cable distribution network assets, and also extends the application of this safe harbor beyond cable television distribution assets to all cable network assets described in asset class (CATV-Subscriber Connection and Distribution Systems) of Rev. Proc ( tested assets ). Primary use Determining primary use of tested assets is relevant to determine the appropriate asset classifications and recovery periods for purposes of calculating depreciation under Section 168. That is, to the extent tested assets are used primarily for providing one-way communication services, the property is classified as seven-year property under Section 168(e)(1), with a recovery period of seven years under the general depreciation system (GDS) and 10 years under the alternative depreciation system (ADS). However, to the extent tested assets are used primarily for providing two-way communication services, the property is classified as 15-year property under Section 168(e)(3)(E)(ii), with a recovery period of 15 years under GDS and 24 years under ADS. As a general rule, determining primary use must be performed by a taxpayer using any reasonable manner that is consistently applied within a tax year to the taxpayer's tested assets. The revenue procedure further provides certain methods that are considered reasonable, and not reasonable, as well as a safe harbor that may be used to determine primary use. 7 pwc

8 Reasonable manner Under Rev. Proc , a reasonable manner to determine primary use includes by gross receipts or subscriber count for each service within the applicable cable system, as well as the safe harbor manner described below. Determining primary use solely by bandwidth is not considered reasonable. Safe harbor manner Rev. Proc provides a safe harbor approach for determining primary use that applies solely for depreciation purposes and is applied at the cable system level to all tested assets for a tax year. Under the safe harbor, primary use is determined based on whether one-way or two-way use generates greater revenue for the cable system. For this purpose, certain categories of revenue are assigned primary use classifications, as depicted below: Revenue Video service revenue Telephony service revenue Home monitoring revenue Broadband service revenue Revenue derived from leasing or otherwise providing the right to use optical fibers or one or more fiber optic cables in the cable system Any other revenue generated by the use of tested assets identified in guidance published in the Internal Revenue Bulletin Primary use classification One-way Two-way Two-way Allocated between one-way and two-way based on signal traffic data that is either specific to the taxpayer or based on a published industry average Presumptively treated as two-way, unless taxpayer can substantiate otherwise Reserved Note: The revenue identified above includes the following sub-categories of revenue: service revenue, advertising revenue, equipment rental, installation fees, and early termination fees, but not franchise fee revenue. If total cable system revenue from one-way communication services is greater than total cable system revenue from two-way communication services for the tax year, then the primary use of the tested assets in the cable system is providing one-way communication services for that tax year. Change in primary use If a taxpayer determines that the primary use of its tested assets has changed, then the taxpayer must apply the change-in-use provisions under Section 168(i)(5) and Reg. sec (i)-4 for purposes of determining depreciation of the affected assets beginning in the year of change. In general, these change-in-use provisions require the asset s remaining basis to be depreciated over its remaining life. Observation Rev. Proc confirms that a cable operator must test the primary use of its cable distribution network assets each year. To the extent a cable operator reclassifies the primary use of its tested assets (i.e., from a one-way to two-way, or two-way to one-way), that change in characterization is not effected through a method change, presumably even if the taxpayer s facts have not changed (e.g., the taxpayer merely applies a different reasonable manner approach to determine primary use to consistent facts). Rather, a change in characterization must be effected prospectively via the tested asset's depreciation deductions. 8 pwc

9 Changes in method of accounting Rev. Proc provides guidance for qualifying taxpayers to obtain automatic consent to change to any of the methods described within the revenue procedure (not including a change in the manner of determining primary use, which is not treated as a change in method but as a change in use as described above). Consequently, the revenue procedure modifies certain sections of Rev. Proc (or successor), which provides the procedures for automatic changes in method of accounting. All the changes in method of accounting provided by Rev. Proc require a Section 481(a) adjustment. In general, the scope limitations of section 4.02 of Rev. Proc (or successor) do not apply for the first or second tax year ending after December 31, However, a taxpayer does not receive audit protection in connection with a method change if the method to be changed is an issue pending at exam or an issue under consideration by an appeals office or a federal court. The takeaway Taxpayers that are cable system operators should review the various safe harbors and methods in Rev. Proc , and consider the potential impact of the various alternatives on the treatment of their cable network assets for federal tax purposes. To the extent that one or more of the safe harbors provided would result in accelerated tax deductions, the cable operator should consider filing an application to change its method of accounting in accordance with the provisions outlined in the revenue procedure. 9 pwc

10 Let s talk For a deeper discussion of how this issue might affect your business, please contact: Peter D Avanzo, New York US Entertainment, Media, and Communications Tax Leader +1 (646) peter.davanzo@us.pwc.com Brian Goldstein, New York US Entertainment, Media, and Communications State and Local Tax Leader +1 (646) brian.goldstein@us.pwc.com Thomas Nardozzi, New York Entertainment, Media, and Communications Tax Newsletter Editor +1 (646) thomas.c.nardozzi@us.pwc.com Annette Smith, Washington, DC Leader, Federal Tax Services +1 (202) annette.smith@us.pwc.com Christine Turgeon, New York, NY FTS Leader for EMC Sector +1 (646) christine.turgeon@us.pwc.com Tom Stockdale Tax Director +1 (216) tom.stockdale@us.pwc.com SOLICITATION 2015 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers (a Delaware limited liability partnership), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. 10 pwc