Interest Capitalization and
Debt--Related Costs:
Debt
Accounting and Tax Requirements
Dale Jekov
Deloitte & Touche LLP
George Gans
Deloitte Tax LLP
Interest Capitalization
O er ie
Overview
• Both US GAAP and US Tax generally capitalize interest
based on the “avoided cost” concept described in ASC
835-20 (formally known as FAS 34) :
The amount of interest cost to be capitalized for qualifying
assets (designated property) is intended to be that portion of
the interest cost incurred during the assets' acquisition periods
( d ti period)
(production
i d) th
thatt theoretically
th
ti ll could
ld h
have b
been avoided
id d
if expenditures for the assets had not been made.
• Key differences in the two accounting methods arise when
determining:
– A qualifying asset vs. designated property
– The capitalization
p
p
period vs. p
production p
period
– The capitalization of land and other expenditures
Qualifying Assets vs. Designated Property
GAAP
• ASC 835
835-20
20 (formally known as FAS 34) requires
capitalization of interest costs while a qualifying
asset is being prepared for its intended use.
Qualifying assets generally are:
– Assets constructed for an entity's own use
• Includes deposits/progress payments on assets constructed by
others
– Assets intended for sale or lease that are constructed as discrete
projects (for example
example, ships or real estate developments)
developments).
– Equity method investments (equity, loans, and advances) while the
investee has qualifying activities/expenditures in progress
– That require a period of time to get them ready for their intended use
Qualifying Assets vs. Designated Property
Tax
Ta
• US Tax regulations use the term “designated
designated
property” to distinguish property that is subject to
interest capitalization, which is defined as any
property produced by the taxpayer or is produced
under a contract and is:
– Real property;
– Tangible personal property with a class life of 20 years or
more and is not inventory or held for resale by the
taxpayer;
– Tangible personal property with an estimated production
period exceeding two years; or
– Tangible personal property with an estimated production
period
i d exceeding
di one year and
d an estimated
ti t d production
d ti
cost exceeding $1 million
Capitalization vs. Production Period
GAAP
• The capitalization period shall begin when the
following three conditions are present:
– Expenditures
p
for the asset have been made
– Activities that are necessary to get the asset ready
for its intended use are in progress
– Interest cost is being incurred
– Interest capitalization shall continue as long as those
three conditions are present
Capitalization vs. Production Period
Tax
Ta
• Interest capitalization does not begin until the
production period begins, defined as:
– Real property
• Production period begins on the first day any physical
production activity is performed on the property
– Tangible personal property
• Production period begins on the first day that the
taxpayer’s incurs at least 5% of the total expenditures
– Property produced for the taxpayer under a contract –
contractor
• Production period begins on the date the contractor's
accumulated production expenditures (without any
reduction for payments from the customer) are at least
5 percent of the contractor's total estimated
accumulated production expenditures
Capitalization vs. Production Period
Ta (cont.)
Tax
(
t)
– Property produced for the taxpayer under a contract –
customer
• Production period begins on the earlier of the date the
contract is executed or the date that the customer's
customer s
accumulated production expenditures for the unit are
at least 5 percent of the customer's total estimated
production expenditures for the unit
• Election to treat the production period as beginning on
the date the sum of the APEs of the contractor(s) and
off the
h customer are at least
l
5 percent off the
h
customer's estimated production expenditures for the
unit
Land and Other E
Expenditures
pendit res
Tax
• Under tax regulations the following activities are not
considered physical work when considering the production
period for real property (not tangible personal property):
– Planning and design – soil testing,
testing preparing architectural blueprints
or models, or obtaining building permits
– Incidental repairs
– Clearing,
g, g
grading
g or excavating
g of raw land
– Construction of infrastructure – roads, sewers, sidewalks, cable,
wiring
– Landscaping activities
– Structural,
St t l mechanical,
h i l or electrical
l t i l activities
ti iti
GAAP
• Conversely, under US GAAP, activities undertaken for the
purpose off developing an asset for
f a particular use would
qualify for interest capitalization – even acquiring land
Is a Wind Farm TPP or Realty?
When Does Ta
Tax Interest Cap Begin?
• Foundation/pad
• Roadways
• Tower
• Nacelle
• Blades
• Generators
• Transformers
• Wiring
• Building – office,
office storage facility
Is a Wind Farm TPP or Realty?
When Does Ta
Tax Interest Cap Begin?
• Real property includes land
land, unsevered natural
products of land, buildings, and inherently permanent
structures
–R
Reall property
t iincludes
l d structural
t t l components
t off b
both
th
buildings and inherently permanent structures
• Inherently permanent structures include property that is
affixed to real property and that will ordinarily remain
affixed for an indefinite period of time
– Examples – roads,
roads paved parking areas
areas, fences
fences,
telephone poles, power generation and transmission
facilities, permanently installed telecommunications
cables broadcasting towers
cables,
towers, oil and gas pipelines
pipelines,
derricks and storage equipment, grain storage bins and
silos
Is a Wind Farm TPP or Realty?
When Does Ta
Tax Interest Cap Begin?
• A structure that is property in the nature of machinery or is
essentially an item of machinery or equipment is not an
inherently permanent structure and is not real property. In
the case,
case however,
however of a building or inherently permanent
structure that includes property in the nature of machinery
as a structural component, the property in the nature of
machinery is real property
property.
• A structure may be an inherently permanent structure, and
not p
property
p y in the nature of machinery
y or essentially
y an
item of machinery, even if the structure is necessary to
operate or use, supports, or is otherwise associated with,
machinery.
Suspension Period
Interest Capitali
Capitalization
ation
• Tax
– If production on the property is suspended for 120 days,
interest capitalization is suspended (ceases)
• GAAP
– If the entity suspends substantially all activities related to
acquisition of the asset, interest capitalization shall cease
until activities are resumed
– However, brief interruptions
p
in activities, interruptions
p
that are externally imposed, and delays that are inherent
in the asset acquisition process shall not require
cessation of interest capitalization
End of Production Period
GAAP Interest Capitali
Capitalization
ation
• The capitalization period shall end when the asset
is substantially complete and ready for its intended
use.
• Examples:
– Assets completed in parts, each part capable of
being used independently while work is continuing
on other parts
– Assets that must be completed in their entirety
before any part of the asset can be used
– Assets that cannot be used effectively
y until a
separate facility has been completed
Unit of Property
Ta Interest Capitali
Tax
Capitalization
ation
• Relevant in determining the production period (during which
interest is capitalized)
– When production is complete and interest capitalization
ceases depends upon how one defines “unit
unit of property”
property
• The regulations provide that “a unit of real property includes
any component of real property . . . that are functionally
interdependent and an allocable share of common features”
– Components are functionally interdependent “if the placing in
property
p y is dependent
p
upon
p the p
placing
g in
service of one p
service of the other . . .”
– Regulations provide that each lot owned by a developer and
each store held for rent by a shopping center is a single unit of
property
Unit of Property Determination
CCA 200827034 – Facts
• Taxpayer operates several processing and manufacturing
facilities and was involved in several construction projects,
including an addition of a power plant and expansion of
other generation facilities
• Taxpayer used authorization for expenditures (AFEs) as a
g
tool to document approval
pp
of expenditures
p
management
above certain cost levels and to accumulate costs
– Several AFEs were used for each location
• Taxpayer took the position that each item of tangible
personal property within each AFE was a single unit of
property for purposes of its interest capitalization calculation
Unit of Property Determination
CCA 200827034 – Holding & Anal
Analysis
sis
• Tangible personal properties that have no utility
apart from the components’ combined role in
furthering a project are “functionally
interdependent”
• All items of tangible personal property at each
l
location
ti ((comprising
i i severall AFE
AFEs)) are functionally
f
ti
ll
interdependent
• Thus,
Thus interest should have been capitalized on the
costs of all of the items of property at each location
placed in service
until all of the items were p
Accumulated Production Expenditures
GAAP Interest Capitali
Capitalization
ation
• 30-5
30 5 Reasonable approximations of net capitalized
expenditures may be used E.g. capitalized costs for an
asset may be used as a reasonable approximation of
capitalized expenditures unless the difference is material
• Capitalized ARO costs do not qualify as expenditures
• 30-6 The total amount of interest cost capitalized
p
in an
accounting period shall not exceed the total amount of
interest cost incurred by the entity in that period
– Separately issued financial statements of a parent entity
or a consolidated subsidiary and in the financial
statements (whether separately issued or not) of
unconsolidated subsidiaries
Accumulated Production Expenditures
Ta Interest Capitali
Tax
Capitalization
ation
• Costs included
– Cumulative amount of direct and indirect costs that
q
to be capitalized
p
with respect
p
to the unit
are required
of property (includes interest capitalized) PLUS
– Adjusted basis of property used to produce the
designated property
• When costs are included
– Once the production period has begun
begun, all costs are
taken into account as soon as they are recognized
under the all-events and economic performance test
Property Used To Produce Designated
Propert – TAM 200303001
Property
• Taxpayer should include adjusted basis of functionally
interdependent components of a unit of real property (a
unit of a coal-fired plant for one project and a nuclear
plant
l t in
i another)
th ) th
thatt was temporarily
t
il withdrawn
ithd
ffrom
service for improvement in the accumulated production
p
of such unit when it computed
p
amount of
expenditures
interest required to be capitalized
temporarily withdrawn from
• Unit of real property is “temporarily
service” when it is removed from its condition or state
of readiness and availability for a specifically assigned
f
function
ti
Accumulated Production Expenditures
Ta Interest Capitali
Tax
Capitalization
ation
• Property produced under contract – customer
– Include any payments under the contract that represent part of the
purchase price of the unit of designated property or, to the extent
costs are incurred earlier than payments are made (determined on a
cumulative
l ti basis
b i for
f each
h unitit off designated
d i
t d property),
t ) any partt off
such price for which the requirements of section 461 have been
satisfied
• Deposits
– The customer has made a payment under this section if the
transaction would be considered a payment by a taxpayer using the
cash receipts and disbursements method of accounting
accounting.
– The customer's accumulated production expenditures also include
any other costs incurred by the customer, such as interest, or any
other direct or indirect costs that are required to be capitalized under
section 263A(a) and the regulations thereunder with respect to the
production of the unit of designated property
Accumulated Production Expenditures
Ta Interest Capitali
Tax
Capitalization
ation
• Property produced under contract – contractor
– Treat the cumulative amount of payments made by
the customer under the contract attributable to the
unit of property as a reduction in the contractor's
APEs
– The customer has made a payment under this
section if the transaction would be considered a
payment
p
y
by
y a taxpayer
p y using
g the cash receipts
p and
disbursements method of accounting
Avoided Cost Method
Ta Interest Capitali
Tax
Capitalization
ation
• Interest must be capitalized to the extent that it would
not have been incurred during the production period if a
taxpayer had used the money spent on production
expenditures to pay down outstanding indebtedness
• Debts directly attributable to accumulated production
expenditures (APE) are capitalized first (i.e., “traced
debt”)
• Non-traced debts are treated as allocable to the
production if APE > traced debt
– Weighted average interest rate
• Interest capitalized under the avoided cost method is
determined separately
separatel for each unit
nit of designated
property produced
Capitalization Rate
GAAP Interest Capitali
Capitalization
ation
• 30-3 Amount capitalized
p
- apply
pp y the capitalization
p
rate to average
g
amount of qualifying accumulated expenditures in the period
• Capitalization rate - based on the rates applicable to borrowings
outstanding during that period
• Use judgment – objective is a reasonable measure of the cost of
financing acquisition of the asset in terms of the interest cost incurred
that otherwise could have been avoided
• If specific new borrowing for a qualifying asset - may use the rate on
that borrowing as the capitalization rate to be applied to that portion of
the average accumulated expenditures for the asset that does not
exceed the amount of that borrowing
• If average accumulated expenditures exceed the amounts of specific
new borrowings associated with the asset, the capitalization rate to be
applied to such excess shall be a weighted average of the rates
applicable to other borrowings of the entity
Eligible Debt
Ta Interest Capitali
Tax
Capitalization
ation
• Liabilities whose interest may be traced or
allocated to production or currently deducted
• Does not include:
– Reserves, deferred taxes, and income taxes
– Debt borrowed directly
y or indirectly
y from a related
person and that bears interest less than the
applicable federal rate (AFR) under section 1274(d)
– Debt,
Debt such as accounts payable and other accrued
items, that bears no interest, except to the extent
that such debt is traced debt
Eligible Debt
Ta Interest Capitalization
Tax
Capitali ation
• Non
Non-traced
traced debt
– All eligible debt on a measurement date other than any debt that is
treated as traced debt
• Excess expenditure amount
– APE in excess of traced debt on a measurement date
– A taxpayer must capitalize the excess expenditure amount
• However, an exception exists when the sum of the excess
expenditure amounts for all units of designated property exceeds
the total interest. In such as case, only a pro rata amount of such
interest must be capitalized with respect to each unit of property
– Average excess expenditure amount
• Weighted average interest rate
– Interest incurred on non-traced debt during the period divided by the
average non-traced debt for the period
Debt Issuance, Loan Modification
and Other Related Costs
Debt Issuance
Iss ance Costs
• GAAP - ASC 835
835-30-35
30 35
– Debt issuance costs accounted for in the same way as debt
discount Par 237 of FASB Concepts Statement No. 6, Elements of Financial Statements
– Capitalized and amortized over contractual life of underlying
debt on the interest or constant yield method
– Other methods of amortization may be used if results are not
materially different from interest method APB 21, paragraph 15
– Period cost capitalized into CWIP
– Debt issue costs of bridge financing should be recognized as interest
cost during the estimated interim period preceding the placement of
the p
permanent financing
g with any
y unamortized amounts charged
g to
expense if the bridge loan is repaid prior to the expiration of the
estimated period SAB TOPIC 2.A, paragraph 6 Q2
Debt Issuance
Iss ance Costs
• Tax
– Issuance cost is original issue discount (OID) and
yield method – Reg.
g
amortized over a constant y
Sec. 1.446-5
• De minimis exception – Reg. Sec. 1.1273-1(d)
• Debt issued on or after December 31, 2003
– Debt modifications – Section 1001 regulations
– Hybrid
H b id iinstruments
t
t
Debt Issuance
Iss ance Costs
X borrows $10,000,000 on January 1, 2004. Principal is repayable on
December 31, 2008. Interest payments of $500,000 are due on December
31 of each year the loan is outstanding. Debt issuance costs of $130,000 to
facilitate the borrowing.
Method
SL
Constant
Yield
Year
2004
2005
2006
2007
2008
Principal Debt Issuance Costs Interest
9,870,000
26,000
500,000
9,896,000
26,000
500,000
9,922,000
26,000
500,000
9,948,000
26,000
500,000
9 974 000
9,974,000
26 000
26,000
500 000
500,000
10,000,000
130,000
2004
2005
2006
2007
2008
9,870,000
9 893 385
9,893,385
9,918,010
9,943,941
9,971,247
10 000 000
10,000,000
23,385
24 625
24,625
25,931
27,306
28,753
130 000
130,000
500,000
500 000
500,000
500,000
500,000
500,000
Yield
5.33%
5.32%
5.30%
5.29%
5 27%
5.27%
5.30%
5 30%
5.30%
5.30%
5.30%
5.30%
Commitment and Letter of Credit Fees
• GAAP
– Period cost, generally not capitalized into CWIP
• Tax
– Capitalized and amortized over the life of the loan
– Anover Realty
y Corp.
p v. Commissioner,, 33 T.C. 671
(1960)
– Capitalization of amortization into CWIP
Loan Modification - GAAP
• ASC 470-50
470 50 provides guidance on whether an exchange of
debt constitutes an extinguishment, a modification or a
modification that should be accounted for as an
extinguishment of debt
• An exchange or modification of debt instruments with
substantially different terms should be accounted for as a
debt extinguishment
• If debt instruments are changed or modified and the present
value of the cash flows change less than 10 percent, the
debt instruments are not considered to be substantially
different (except when certain conversion options are
changed added or eliminated)
changed,
Loan Modification - GAAP (cont.)
(
t)
• If the original and new debt instruments are
substantially different, the new debt shall be
recorded at fair value and used to determine the
debt extinguishment gain or loss and the effective
interest rate of the new instrument
• If nott substantially
b t ti ll different,
diff
t then
th a new effective
ff ti
interest rate shall be determined based on the
carrying amount of the original debt instrument
Loan Modification – GAAP (cont.)
(
t)
• Debt issuance costs related to the original debt
instrument are accounted for as follows:
– Extinguishments – unamortized costs are expensed in
th period
the
i d off th
the d
debt
bt extinguishment
ti
i h
t
– Non-extinguishment modifications – costs are associated
with the modified debt and amortized over the remaining
term of the modified debt
• Costs incurred with third parties directly related to the
exchange or modification of debt (such as legal fees)
are accounted as follows:
– Extinguishments – costs are amortized over the term of
the new debt similar to debt issue costs
costs.
– Non-extinguishment modifications – costs are expensed
as incurred
Loan Modification - Tax
Ta
• “Significant
Significant Modification of Debt”
Debt is treated as a
deemed exchange of a new debt instrument that
replaces the old one – Reg. Sec. 1.1001-3
• What is a “Significant Modification”? - (e)(2) –
(e)(6)
–
–
–
–
–
Change in yield
Deferral of payments
Change in obligor
Change in recourse nature of the instrument
Change in accounting / financial covenants
• General
G
l rule
l – (e)(1)
( )(1) – Economically
E
i ll significant
i ifi
t
Loan Modification - Tax
Ta
• Consequences – new debt issued in exchange for
old debt – taxable event
• Need to determine issue p
price of new debt –
– Section 1274 – non-traded debt
– Section 1273 – traded debt
• Effect
Eff
to Issuer
I
– Compare issue price of new debt with AIP of old
debt
– COD Income – Section 108(e)(10)
• Effect to Holder
– Taxable exchange; Character?
Loan Modification - Tax
Ta
• Section 108 general rule – COD = ordinary income
– Some exceptions
• Section 108(i) election – “new” deferral provision
– Applies
pp
to business debt that was reacquired
q
between 1/1/2009 – 12/31/2010
– COD income deferred until 2014
– Ratable inclusion from 2014 - 2018
Swaps and
Hedging Transactions
Swaps
Characteristics
• Agreement between two or more counterparties to
exchange streams of cash flows over a specified
period in the future
• Payment streams based on a notional value
• Equivalent to a series of cash-settled forward
contracts
• ISDA agreements or customized/negotiated terms
• Counterparty credit risk
Hedge Req
Requirements
irements
• GAAP
– Formally designate and document at inception
– Assess eligibility
g
y of hedged
g item and hedging
g g instrument
– Assess hedge effectiveness and measure
ineffectiveness
• Tax
T
–
–
–
–
–
Identify the hedge and the hedged item(s)
In the tax records (not the tax return)
Same-day identification of hedge
Identifyy hedged
g item within 35 days
y
Must be clear and unambiguous and refer to the tax rules
GAAP Accounting
Acco nting for S
Swap
ap
• Fair value hedge:
– Swap and hedged item marked to market
– Difference between the changes in the two fair
values = ineffectiveness reported in earnings
• Cash flow hedge:
– Swap is marked to market
– For “efficient” or effective portion of hedge
• Change in the swap’s value is reported in OCI
– For “inefficient” or ineffective portion of hedge
• Change
Ch
iin th
the swap’s
’ value
l iis reported
t d iin currentt
earnings
GAAP Consideration of S
Swap
ap Gain/Loss
• ASC 815-25-35-14
815 25 35 14 precludes the capitalization of
ineffectiveness (including time value of options) in a fair
value hedge
• Also inappropriate to capitalize or defer ineffectiveness
of a cash flow hedge. None of the effects of the
derivative in a cash flow hedge will be included in
capitalized interest ASC 835-20
• However amounts recorded in AOCI (the effective
portion of realized gains and losses) should be
reclassified into earnings over the depreciable life of
the constructed asset when depreciation begins on the
constructed asset ASC 815-30-35-45
Ta Hedging Iss
Tax
Issues
es
• Character of gain or loss
– Ordinary character if properly identified
– Character whipsaw if not properly identified
• Timing
g of g
gain/loss recognition
g
– Timing of hedging instrument matches timing of
hedged item
Hedge
Ta Definition
Tax
• Covers most common business hedges
– Hedges of inventory, consumable supplies
– Hedges
edges of
o borrowings
bo o
gs a
and
da
anticipated
t c pated bo
borrowings
o
gs
• Fixed-to-floating, floating-to-fixed
– Recycled hedges
– Transactions that counteract earlier hedges
• Does not include
– Hedges of related party risk outside consolidated
group
– Partner hedges risk of partnership
– Over-hedging
Early Termination of Swaps
Ta Treatment
Tax
• Character
– Ordinary gain or loss if properly identified
• Matching
– Gain or loss realized on the swap needs to be
matched with the item or risk being hedged
– Spread the gain or loss over the remaining term of
the item or risk being hedged
Questions?
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