Start-up Costs_ing For And Tax Treatment_100610 4o6b11

ing for and Tax Treatment of StartStart-up and Development Costs Tim Wilhelmy Deloitte & Touche LLP

Rupesh Vadapalli Deloitte Tax LLP

Agenda • ing Treatment of Start-up Start up and Development Costs • Tax Treatment of Start-up and Development Costs – – – – –

Overview of Project Development Activities Start-up Costs O Organizational i ti l and dS Syndication di ti C Costs t Expansion Costs Transaction Costs

ing g Treatment of Start-up and Development Costs

Start-up and Development Costs Acco nting Treatment ing • Start Start-up up costs are specifically addressed by ASC 720-15 (formerly Statement of Position 98-5, Reporting on the Cost of Start-Up Activities) – Other literature addressing start-up costs includes ASC 835-20, ASC 360-20, ASC 970-10 and ASC 805 (formerly FASB Statements 34 34, 66 66, 67 and141 and141, respectively) – ASC SC 720-15 0 5 requires equ es sstart-up a up cos costss to o be e expensed pe sed as incurred

Start-up and Development Costs Acco nting Definition ing • Start Start-up up activities are defined broadly as activities related to any of the following: – – – –

Opening p g a new facility y Introducing a new product or service Conducting business in a new territory Conducting business with an entirely new class of customers or beneficiary

Start p and De Start-up Development elopment Costs • Start Start-up up activities include activities related to organizing a new entity • Start-up p activities also include costs related to performing feasibility studies and should be expensed as incurred

Start p and De Start-up Development elopment Costs Start up activities do not include: Start-up • Routine ongoing efforts to refine, enrich, or p upon p the q qualities of an existing g otherwise improve product, service, process or facility • Costs of acquiring or constructing long-lived assets and getting them ready for their intended uses • Costs of acquiring or producing inventory Note: This list is not meant to be inclusive of all activities ti iti th thatt are nott considered id d start-up t t activities ti iti

Start up and Development Costs End of Capitali Capitalization ation Period • Issue Issue- When does a cost cease to exhibit the characteristics of a start-up cost? • Answer: Determining g whether a cost is a start-up p activity or a development or construction activity is a matter of judgment based upon case specific f t and facts d circumstances i t

ing for Start-up and De elopment Costs – Overview Development O er ie • Project costs should be capitalized when management believes a specific project is probable (i.e., 50% likelihood) of completion – Conclusion on probability should be based on achievements of milestones or a combination of milestones and a company’s company s historical experience. experience Examples may include: ece p o of go governmental e e a app approval o a o or pe permits s • Receipt • Execution of power purchase agreement (unless merchant facility) • Agreement for acquisition of significant plant components

Business Initiation Costs Acco nting Treatment ing • Costs incurred in the normal course of starting a business or project • Business initiation costs must be expensed p p prior to indentifying a feasible project

Examples of Business Initiation Costs Acco nting Treatment ing • Bid preparation • Internal costs for analysis, legal research and early g engineering g g stage • Costs of a development office • Organizational g costs of new legal g entities

Development Costs Acco nting Treatment ing • Costs incurred prior to initiating an acquisition or construction of a project, but after initiation • If not related to a specific p p property p y these costs should be expensed • If related to a specific project which management has concluded is probable of completion, costs should be capitalized as project development cost

Development Costs Acco nting Examples ing E amples • Property acquisition fees • Cost of permits and licenses • Legal and other professional fees • Internal costs related to contract negotiation

Start p and De Start-up Development elopment Costs • Construction costs – Costs incurred which are necessary to get the asset y for its intended use ready – Substantially all costs incurred in the construction phase are capitalizable – Capitalization should cease at commercial operations date

Construction of Power Plants E amples of Constr Examples Construction ction Period Costs • EPC contractor fees • Interest paid to third parties • Test power costs (and related income) (for short periods of time) • Internal costs directlyy related to the p project j • Property tax incurred during the construction period • Bonuses to development p team • Development fees (under certain circumstances)

Late Stage Development Costs Acco nting Treatment and E ing Examples amples • Late stage development costs are not capitalized for financial reporting purposes • Examples: p – Costs to train employees and contractors (unless complex and unique facilities – Costs incurred to fine tune equipment after commercial operations date – Costs incurred to negotiate contracts related to operations

Construction of Power Plants Capitali ation Iss Capitalization Issues es • Should costs be capitalized or expensed/deducted currently? • If costs are capitalized, p , are theyy a separate p intangible or part of the grant/ITC-eligible plant basis? • What is the amortization period of any intangible assets created during the start-up period?

Tax Treatment: Overview of Project Development Activities

Timeline of Project Development Acti ities Activities

Start-up Phase • PPA negotiation • Land option negotiations • Research and development of technologies

Development Phase • Design and engineering of plant • Site and groundwork • Construction of facilities

Operational Phase • Placing facility in service • Producing power for sale under PPA • Ongoing maintenance activities

Start p Phase O Start-up Overview er ie • Start Start-up up phase – Deductible costs are capitalized as start-up costs p y is not engaged g g in under Section 195 if the Company active trade or business • Unless expressly deductible – There may be certain costs that are properly capitalizable to the basis of tangible or intangible assets under Sections 263 and 263A • Tangible assets (e.g., land) g assets ((e.g., g PPA, certain licenses)) • Intangible

De elopment Phase O Development Overview er ie • Development phase – If the Company is engaged in active trade or phase, ordinary y and necessary y business at this p business expenses are deductible under Section 162 – Majority of costs typically are related to construction of project and capitalized to basis of tangible or g assets under Sections 263 and 263A intangible • Direct costs (e.g., materials, labor) • Indirect costs (e.g., overheads, engineering) • Interest capitalization

Operational Phase O Overview er ie • Operational phase – Company is engaged in active trade or business and y and necessaryy business expenses p are ordinary deductible under Section 162 (e.g., repairs and maintenance costs) – If company is constructing other projects projects, the costs attributable to the intangible basis of those projects p under Sections 263 and 263A are capitalized

Other Common De Development elopment Acti Activities ities • Companies developing alternative energy projects also commonly engage in other activities for which the associated costs have a specific tax treatment – – – –

Organization of business Syndication of partnership Expansion of existing business Acquisition or reorganization of existing business

Tax Treatment: Start-Up Costs

Tax Treatment of Start-up Costs O er ie Overview • In general, general no deduction is allowed for start-up start up expenditures • Taxpayer p y may y elect to deduct in the yyear that active trade or business begins the lesser of: – Start-up expenditures, or – $5,000, reduced by the amount of start-up expenditures in excess of $50,000

• If start-up t t expenditures dit are nott ffully ll d deductible d tibl iin the year active trade or business begins, remainder is capitalized and amortized ratably over 180 months

Tax Treatment of Start-up Costs Stat tor Construction Statutory Constr ction • Section 195(a) provides, in general, that no deduction shall be allowed for start-up expenditures • Section 195(b)(1) provides that a taxpayer may elect to ded ct in the ta deduct taxable able year ear that the acti active e trade or b business siness begins the lesser of: 1)) Its start-up p expenditures p or 2) $5,000, reduced (but not below zero) by the amount by which such start-up expenditures exceed $50,000, and to deduct the remainder of such start start-up up expenditures ratably over the 180-month period beginning with the month in which the active trade or business begins

Tax Treatment of Start-up Costs Stat tor Construction Statutory Constr ction • Section 195(c)(1) defines “start-up start up expenditure” expenditure as any amount paid or incurred in connection with: 1) Investigating the creation or acquisition of an active trade or business 2) Creating an active trade or business business, or 3) Any activity engaged in for profit and for the production of income before the day on which the active trade or business begins, in anticipation of such activity becoming an active trade or business, to the extent that the amount, if paid or incurred in connection with the operation of an existing active trade or business, would be allowable as a deduction for the taxable year in which paid or incurred.

• Section 195(c)(1) further provides that the term “start start-up up expenditure” does not include any amount with respect to which a deduction is allowable under Sections 163(a) (interest), 164 (taxes), or 174 (research and experimental expenditures)

What Constitutes a Start-up Cost? Ta Criteria Tax • Any amount paid or incurred in connection with: – Investigating the creation or acquisition of an active trade or business – Creating an active trade or business, or – Any for-profit activity engaged in by the taxpayer in anticipation of such activity becoming an active trade or business, provided such amounts would be deductible if the trade or business was active

• The amounts must be otherwise deductible (i.e., not capitalized items if incurred in an existing trade or business)

Examples of Start-up Costs for Tax P rposes Purposes • Advertising • Salaries and wages paid to employees who are g trained and their instructors being • Travel expenses • Salaries and fees p paid or incurred for executives,, consultants and similar professional services

Costs Not Subject to Capitalization as Start p Costs for Tax Start-up Ta P Purposes rposes • Amounts that are allowable as a deduction may not be capitalized and amortized as start-up costs – Interest – Taxes – Research & experimental expenditures

• Depreciation expense on fixed assets may not treated as a start-up cost eligible for capitalization and d amortization ti ti – TAM 9235004

• Business expansion costs

What Constitutes Active Conduct of Trade or B Business siness • Facts and circumstances analysis based on the corporation beginning the business when it starts the business operations for which it was organized – Does not mean “in existence”

• Key factors in analysis include: – Acquisition of all necessary assets – Revenue-producing operations commenced with th those assets t

• Does not necessarily coordinate with the “start of trade or business” business under Sections 248 248, 709 or 355

What Constitutes Active Conduct of Trade or B Business siness • Generally the courts use the tests of Richmond Television Corp., 345 F2d 901 (4th Cir. 1965) – Costs incurred by y the taxpayer p y for training g in yyears prior to receipt of its FCC broadcasting license are not ordinary business expenses – Trade T d or business b i d deemed d tto b begin i b by th the courtt when the taxpayer begins to function as a going performs those activities for which it concern and p was organized

• When active conduct of trade or business commences, start-up costs are no longer l iincurred d

Making a Valid Section 195 Election • Taxpayer is not required to make affirmative election – Attached election statement not necessary y – Election is irrevocable – Election applies to all start-up expenditures

• Taxpayer may choose to forgo the deemed election by clearly capitalize its start-up expenditures

Partners and Partnerships Ta Treatment of Start Tax Start-up p Costs • Generally in a partnership entity entity, the test of active trade or business is applied at the entity level – Partners may y have been engaged g g in active trade or business apart from the flow-through entity

• Madison Gas & Electric decision provided that a j i t venture t t by b severall utilities tiliti was a partnership, t hi requiring capitalization of the start-up costs of the t venture – t venture was not an expansion of the existing business of the utilities

Failed Start Start-up p Costs • Costs of investigating trade or businesses that do not commence are not start-up costs – Costs are deductible as a loss under Section 165 – Determination is based on available facts and circumstances

• In the case of a technical termination of a partnership, the trade or business may be considered to be disposed • Loss deductions in excess of $10M (corporations) or $2M (partnership) may require reporting on Form 8886

ITC or Treas Treasury r Grant Eligibilit Eligibility • Capitalized start-up start up costs are not tangible property and are not depreciable • Costs eligible g for Treasury y Grant or ITC must be: – Tangible personal property – Other tangible g property y

Tax Treatment: T T t t g and Organizational Syndication Costs

Organi ational Costs Tax Organizational Ta Treatment • Rules similar to those for start-up start up costs re applicable for organizational costs under IRC Sections 248 and 709 that are: – Incident to creation of a corporation or partnership, – Chargeable to a capital , AND – Of a character which would be amortizable over a limited life, if the entity had a limited life

• Amounts are generally capitalized and amortized pursuant to election by taxpayer – If election is foregone foregone, amounts are permanently capitalized

Organizational Costs Making a Valid Ta Tax Election • Taxpayer is not required to make affirmative election – Attached election statement not necessary y – Election is irrevocable – Election applies to all organizational expenditures

S ndication Costs Tax Syndication Ta Treatment • Syndication costs are capital costs related to syndicating a partnership and its related investment units – Cost of marketing of the actual units – Cost of production of any offering memorandums or promotional ti l materials t i l – Sales commissions

• Syndication costs are capitalized under Section 709 – Capitalized amounts are not subject to amortization

Tax Treatment: Expansion Costs

B siness Expansion Business E pansion Costs • Ordinary and necessary costs incurred in connection with expanding an existing trade or business are deductible under Section 162 – Facts and circumstances analysis has faced different interpretations by Courts and IRS

• In I Briarcliff B i liff C Candy d C Corp., the th courtt ruled l d th thatt costs t incurred to pursue marketing operations in a different locale and of a different type are deductible – A separate p and distinct asset was not created

B siness Expansion Business E pansion Costs • In Colorado Springs Nat'l Nat l Bank vv. U U.S., S the court ruled that costs incurred to enter the credit card business by banks that were previously engaged in retail loan making were deductible • In FMR Corp. v. Comr., the court ruled the mutual f d group was required fund i d tto capitalize it li th the costs t associated with the development of the marketing plan development of the management contract plan, contract, formation and registration of 82 new mutual funds – Taxpayer p y expected p significant g future benefit from the new funds

Tax Treatment: Transaction Costs

O er ie Overview • Transaction costs that facilitate a restructuring or reorganization of a business entity or a transaction involving the acquisition of capital, such as stock issuance, borrowing, or recapitalization, are capitalized

T o prong R Two-prong Rule le • First prong requires capitalization of costs that facilitate the taxpayer’s acquisition, creation, or enhancement of intangible asset • Second prong requires capitalization of costs that facilitate the taxpayer’s restructuring or reorganization i ti off a b business i entity tit or ffacilitate ilit t a transaction involving the acquisition of capital – Including stock issuance, issuance borrowing borrowing, or recapitalization

Facilitate Rule R le • An amount facilitates a transaction if it is paid in the process of pursuing the transaction, as determined under a facts and circumstances analysis • The fact that an amount would not have been incurred but for the transaction is relevant but not d t determinative i ti

Inherentl Facilitati Inherently Facilitative e • Certain amounts are considered inherently facilitative and must be capitalized without regard to the date such costs are incurred – Determining the value of target (i.e., securing valuation or formal written evaluation) – Negotiating N ti ti or structuring t t i th the ttransaction ti – Preparing and reviewing transactional documents or regulatory filings – Obtaining regulatory approval for the transaction – Securing advice on the tax consequences of the transaction

“Co ered Transactions” “Covered • An amount paid in the process of investigating or otherwise pursuing a “covered transaction” facilitates the transaction only if it relates to activities performed on or after the earlier of the date on which: – A letter l tt off intent, i t t exclusivity l i it agreement, t or similar i il written communication (other than a confidentiality g ) is executed by y both the acquirer q and agreement) target; or – The material of the transaction are authorized or approved db by th the ttaxpayer’s ’ b board d off di directors t

“Co ered Transactions” (cont.) “Covered ( t) • A “Covered Covered Transaction Transaction” means/includes: – A taxable acquisition of assets that constitute a trade or business – A taxable acquisition of a controlling interest in a business entity – An “A,” “B,” “C,” or acquisitive “D” reorganization

• A “Covered Transaction” does not mean/include: – Di Divisive i i “D” reorganizations i ti under d S Section ti 355 355, Section 351 transactions, “G” reorganizations – LBOs, LBOs Redemptions Redemptions, Recapitalizations Recapitalizations, Stock Issuances,

Effect on Covered Co ered Transactions • Deduction or amortization of investigatory costs is only possible in covered transactions • All transaction costs in non-covered transactions must be capitalized

Simplif ing Conventions Simplifying Con entions • Salaries and Overhead – The regulations provide an assumption that p y compensation p and overhead costs do not employee facilitate the acquisition, creation or enhancement of an intangible asset

• De Minimis Costs – The regulations provide that de minimis transaction costs do not facilitate a capital transaction and are not required to be capitalized • De minimis costs are defined as costs that do not exceed $5,000

Special R Rules les • Borrowing Costs – An amount paid to facilitate a borrowing does not facilitate another transaction other than the borrowing

• Asset Sales – An amount paid to facilitate a sale of unwanted assets does not facilitate another transaction other than the asset sale

Questions?

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