But this post is not intended to provide a detailed analysis of these rules. You can get that by clicking through all the various hyperlinks above. Indeed, my focus is in the state and local tax area, and this is not an issue I’ve come across with any regularity yet, at least on the state income tax side. But recently questions have been posed to me on the sales-tax side of this. Specifically, I’m being asked whether the changes here could affect the capital improvement distinctions that are often made for state sales tax purposes. More specifically, if a company is allowed by virtue of these new regulations to treat capital expenditures as repairs, for instance, does that also mean that the sales tax status as a capital improvement also has to change?
The short answer is no. I don’t think that anything in these regulations should change the way a sales tax auditor determines whether or not work qualifies as a capital improvement. Those rules, especially in New York, are spelled out in specific detail in Tax Law § 1105(c)(5). And under these rules, the term “capital improvement” is defined as any “addition or alternation” to real property that:
(i) substantially adds to the value of or appreciably prolongs the useful life of the real property;
(ii) becomes part of the real property or is permanently affixed to the real property so that removal would cause damage to the property or article itself; and
(iii) is intended to become a permanent installation.
Those tests are based largely on concepts from the law of fixtures, which governs when a person (that is, a tenant) surrenders items of property by making them a permanent part of the real property. For sales tax purposes, a contractor completing a capital improvement is not viewed as selling individual items of tangible personal property to its customer along with the labor to install them; rather, the contractor is viewed as selling the end result of its services; that is, new real property, something that falls outside the scope of the sales tax. More on New York’s test can be found in this great article by two of my favorite lawyers.
The IRS also has somewhat of a three-part “improvement” test, but it’s not the same test. The final regulations generally require a taxpayer to capitalize its expenditures to "improve" a pre-existing unit of property. For this purpose, a unit of property is improved if the expenditures result in 1) a betterment to or 2) restoration of the unit of property, or 3) adapt the unit of property to a new or different use.
To some extent, the IRS rules are broader, meaning that it might be easier for work to qualify as a capital improvement for federal purposes than it would be for state sales tax purposes. But let’s not concern ourselves with such mental exercises. When faced with the question of whether or not something is a repair or a capital expenditure in a sales tax audit, taxpayers and their practitioners need to be focusing on the sales tax rules only. Believe me, it’s hard enough dealing with those rules, since they don't work all that well anyway! So it doesn’t matter that for federal tax purposes under the new regulations a different answer might be had. We still need to turn the focus to the sales tax rules only to make a proper determination as to capital improvement status for sales tax purposes.
Still, however, I certainly can envision confusion on audit since often a sales tax auditor will look to depreciation schedules to determine the distinction between capital assets and expenses. And if a company takes a position for sales tax purposes that a certain project is a capital improvement but is required for federal tax purposes to treat such project as a repair, certainly this will at least require a conversation with a sales tax auditor as to the nuanced distinction between federal and state tax rules. I don’t look forward to such a conversation, and it’s certainly possible that a state sales tax auditor could take a different view if it resulted in more sales tax revenue. But I really think that this is a practical problem, not a legal issue. For substantive legal purposes, when determining whether or not a project qualifies as a capital improvement, we must look to the state and sales tax rules to make that determination.
