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Eighth Circuit affirms Honeywell decision - rotable spare parts are depreciable.

In Honeywell, Inc., 6/22/94, aff'g per curiam TC Memo 1992-453, the Eighth Circuit held that certain spare parts were considered assets subject to an allowance for depreciation rather than merchandise held for resale (inventory).

Honeywell was engaged in the business of maintaining and servicing computers sold or leased to its customers. Pursuant to maintenance agreements with its customers, Honeywell was obligated to provide the necessary labor and materials to repair malfunctioning computers.

Honeywell maintained a replacement parts pool, consisting of expendable parts and rotable parts. An expendable part was not repaired when it malfunctioned. A rotable part was repaired when it malfunctioned and, after repair, would be returned to the rotable parts pool.

Honeywell charged its customers a fixed fee based on various factors, including the cost of labor, training and overhead, the failure rates of computers, the time required to fix computers, the cost of replacement parts and the maintenance fees charged by Honeywell's competitors. Honeywell did not generally distinguish the fees charged to customers who purchased rather than leased its computers.

The IRS contended that rotable parts held for use in computers owned by Honeywell's customers (as opposed to computers leased from Honeywell) should be treated as inventory: First, the customer acquired title to the replaced rotable parts once the part was installed. Second, the Service asserted that sales of rotables were income-producing events under Regs. Sec. 1.471-1. And finally, the fixed asset method of accounting did not clearly reflect income under these circumstances.

According to the Tax Court, Honeywell was in the business of computer maintenance service and not a "mixture of service and selling parts" (as the IRS contended). Accordingly, transactions involving rotable spare parts were not an "income-producing factor." The court based its findings on the following factors:

* Honeywell and its customers viewed the transactions as a maintenance service and not a service and a product sale. Therefore, the rotable spare parts were not merchandise within the meaning of Regs. Sec. 1.471-1.

* Although the fee charged to customers pursuant to maintenance service agreements included the cost of rotable parts, no direct relationship existed between the fee that Honeywell charged to maintain the computers and the cost of the parts in their replacement parts pool.

* Expert testimony confirmed that the fixed asset method of accounting was in accordance with generally accepted accounting principles (GAAP).

* The fixed asset method was an accepted practice for accounting for spare parts in the computer industry.

The Tax Court's decision emphasized the economic reality of the transaction rather than its form.

The following facts and circumstances of Honeywell may serve as a benchmark for other taxpayers that might be eligible to use the fixed asset method:

* Honeywell and its customers viewed the agreement as a service contract.

* The maintenance service agreements did not assign a value for spare parts replaced in the customer's computer.

* Honeywell did not separately charge its customers for the cost of replaced computer rotable parts, thereby substantiating the position that it was providing a maintenance service and not a product.

* The fixed asset accounting method conformed with GAAP.

In light of the Eighth Circuit's affirmation of the Tax Court's decision, affected companies should consider the benefit of requesting an accounting method change to report these items as depreciable assets. However, it is not clear at this time whether the IRS will follow the decision.
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Author:Nii, Bradley T.
Publication:The Tax Adviser
Date:Jan 1, 1995
Words:561
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