FedEx v. Commissioner: the continuing debate over cyclical maintenance costs.
Introduction: General Principles of Capitalization
The Internal Revenue Code provisions applicable in determining whether an expenditure is currently deductible under section 162 as a trade or business expense or instead must be capitalized under section 263(a) as a capital improvement are well known. Section 263(a) provides simply that no deduction shall be allowed for (1) any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate or (2) any amount expended in restoring property or in making good the exhaustion thereof for which an allowance is or has been made.
The applicable Treasury regulations provide little more clarity. Treas. Reg. [section] 1.162-4 permits a current deduction for the cost of incidental repairs that neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition (so long as the repair costs are not added to the property's basis). This regulation also provides that repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, must be capitalized and depreciated in accordance with section 167.
Treas. Reg. [section] 1.263(a)-1(b) provides the counterpart to Treas. Reg. [section] 1.162-4 (collectively referred to as the Repair Regulations). This section provides in general that amounts required to be capitalized include amounts paid or incurred (1) to add to the value, or substantially prolong the useful life, of property owned by the taxpayer, such as plant or equipment, or (2) to adapt property to a new or different use. Amounts paid or incurred for incidental repairs and for the maintenance of property are not capital expenditures.
Nearly every word and phrase of the Repair Regulations have been scrutinized, parsed, and debated by courts, taxpayers, and the IRS for decades. Students of capitalization can recite the litany of "repair cases" like a mantra. (3) The decades-long judicial scrutiny of the Repair Regulations has produced several general principles relevant to cyclical maintenance costs.
First, costs incurred to "keep" an asset in an ordinarily efficient operating condition generally are deductible, while those incurred to "put" an asset into such a condition generally must be capitalized. (4) This rule dates to the Board of Tax Appeals' 1926 decision in Illinois Merchants Trust. (5) The taxpayer owned a brick building located along a river. The building was partially built on wooden pilings that were in the river. Unexpectedly, the river level dropped significantly, exposing the top portion of the wooden pilings to the air, causing them to rot. This in turn caused the building to begin to collapse. To save the building, the taxpayer sawed off the wooden pilings above the water line and replaced them with concrete pillars. The taxpayer also had to shore up part of a wall that had begun to collapse. The court found that the work did not prolong the original estimated life of the building or increase its value.
The issue was whether the taxpayer was entitled to deduct the cost of the structural work that was done to the building. The taxpayer argued that the work only kept the building in an ordinarily efficient operating condition. The IRS argued that the work was in the nature of a replacement, since it arrested deterioration and appreciably prolonged the life of the building. The issue thus was framed as whether the costs simply repaired the existing building, or whether they instead replaced a significant structural component.
In holding that the costs were deductible as repairs, the Board of Tax Appeals set forth a test that remains the touchstone of any repair analysis:
In determining whether an expenditure is a capital one or is chargeable against operating income, it is necessary to bear in mind the purpose for which the expenditure was made. To repair is to restore to a sound state or to mend, while a replacement connotes a substitution. A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciable prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired. Expenditures for that purpose are distinguishable from those for replacements, alterations, improvements, or additions which prolong the life of the property, increase its value, or make it adaptable to a different use. The one is a maintenance charge, while the others are additions to capital investment which should not be applied against current earnings. (6)
This standard is routinely applied by courts trying to determine whether an expenditure is a repair--keeping an asset in an ordinarily efficient operating condition--or instead is a capital improvement--putting the asset in such a condition. (7)
Second, replacing major structural elements of an asset is not a repair, but replacing numerous, less significant components may be. Capitalization is not required if the replacements are a relatively minor portion of the physical structure of the asset, or of its major parts, such that the asset as a whole has not gained materially in value or useful life. (8) The costs of replacing a major component or a substantial structural part of the asset must be capitalized, however, where the value, life-expectancy, or uses of the asset have materially increased. (9)
Third, the tax code is not concerned with why the taxpayer undertakes the repair, only with the effect of that repair. In Swig Investment Co. v. United States, (10) for example, a landmark San Francisco hotel was required by a city ordinance to replace its historic masonry cornices and parapets with lighter weight replicas that posed less of a public hazard in the event of an earthquake. The hotel argued that the cost of installing the new cornices should be deductible because the old cornices were not damaged or deteriorated, and the hotel only replaced the old cornices because the city ordered it to. Rejecting this argument, the Federal Circuit agreed with its sister courts that what matters is what you do, not why you do it. (11)
Fourth, otherwise deductible repair costs must be capitalized if they are part of a "plan of rehabilitation." A plan of rehabilitation starts with the presumption that the asset in question is in need of "rehabilitation," in other words that there is a need to "put" the asset in an ordinarily efficient operating condition. One typically does not need to rehabilitate an asset that is in a generally sound working condition. Other than this general assumption, whether a general plan of rehabilitation exists, and whether a particular repair or maintenance item is part of it, are questions of fact. Relevant factors include the purpose, nature, extent, and value of the work done. (12) The existence of a written plan, by itself, is not sufficient to trigger the plan-of-rehabilitation doctrine. (13)
Upon finding a plan of rehabilitation, all costs that are incidental to that overall plan must be capitalized, including those that would otherwise be deductible as repairs. Capitalization, however, is only required if these erstwhile repair costs are "incidental" to the plan of rehabilitation--in other words, if they are part of and contribute to the purpose and goals of the plan of rehabilitation. It is not sufficient that the repairs simply occurred concurrently with the plan of rehabilitation. (14)
There has been some debate whether a plan of rehabilitation may consist only of otherwise deductible repairs or whether a "plan" must include at least one activity that would independently meet the definition of a capital expenditure. The general view is that at least one capital expenditure must be present in order to sweep incidental and otherwise deductible repair expenditures into a plan of rehabilitation. (15) Thus, while this is a factual inquiry, the general rule is that a plan of rehabilitation exists if there is at least one capital improvement plus related repair-type costs that are all incidental to an overall plan of putting the asset into an ordinarily efficient operating condition.
Finally, while the high cost of an activity may be probative concerning whether it is an incidental repair or a capital improvement, cost alone is not determinative. (16) Instead, the cost must be compared with, for example, the original cost of the asset and the cost of a replacement asset. (17) A $1 million expenditure may be large in absolute terms, but it may be modest in comparison to the multimillion dollar cost of replacing an aircraft that is not properly maintained and likely will have only an incidental effect on the aircraft's overall value or useful life. (18) As with everything in the capitalization area, the totality of the facts and circumstances must be considered in gauging the relevance of the dollar amount.
Cyclical Maintenance Costs
Although many industries have their tales of woe, the air transportation industry has been undergoing a particularly turbulent period during the past several years. On audit, the IRS has been aggressively requiring the capitalization of a wide variety of costs related to maintaining the airworthiness of an aircraft. At least in part, the absolute size of the costs required to maintain sophisticated aircraft appears to have attracted this scrutiny.
1. Rev. Rul. 88-57
One of the government's earliest efforts at addressing the treatment of cyclical maintenance costs looked at the costs of "rehabilitating" railroad freight cars. In Rev. Rul. 88-57, (19) a railroad established a program for "major cyclical rehabilitation" of freight-train cars. Each car was removed from service after a predetermined period (usually every 8 to 10 years) and restored to an efficient operating condition. Under the cyclical maintenance program, each freight car was stripped to the frame, each of its structural components was either reconditioned or replaced, and upgrades were made to bring various components up to the latest engineering standards. The freight cars were totally disassembled and inspected; components of the suspension and draft systems, trailer hitches, and other special equipment were reconditioned or replaced; the walls of the freight cars were replaced or were sandblasted and repainted; new wheels were installed; and all remaining components were restored before reassembly.
Before the cyclical maintenance, the freight car had a value of $8,000 and was nearing the end of its service life. Following the rehabilitation, the car had a value of $30,000 and had a service life of 12 to 14 years. A new freight car costs $45,000. With repeated cyclical rehabilitations, the cars have an aggregate service life in excess of 30 years; absent the procedures, the useful life is approximately 12 to 14 years.
On these facts, Rev. Rul. 88-57 required the railroad to capitalize its cyclical maintenance costs. First, the IRS concluded that the maintenance appreciably prolonged the useful lives of the freight cars. The ruling notes that without periodic rehabilitation the cars have a useful life of only 12 to 14 years, whereas as a result of the cyclical maintenance program the freight cars may remain in operation for more than 30 years. (20) In other words, on the facts presented in the revenue ruling, the railroad essentially uses the freight car to the point of exhaustion and then rebuilds the asset from the frame up. The railroad was "putting" rather than "keeping" the car in an ordinarily efficient operating condition or, alternatively, was replacing rather than repairing the asset.
Second, Rev. Rul. 88-57 held that the cyclical maintenance increased the value of the freight cars. The rationale for this otherwise seemingly reasonable conclusion is troubling and, fortunately, was later modified by the IRS. The ruling first states that the Tax Court's decision in Plainfield-Union (21) applies only to repairs necessitated by "sudden and unanticipated" damage. The IRS later recanted this narrow interpretation in Rev. Rul. 94-38, which modified Rev. Rul. 88-57 to the extent it implies that Plainfield-Union's value test "cannot be an appropriate test in any case other than one in which there is sudden and unanticipated damage to an asset." Rev. Rul. 88-57 also concludes, however, that because the freight car was worth $8,000 before the cyclical maintenance and $30,000 afterward, the maintenance materially added to the value of the asset. Result aside, this standard is plainly incorrect. The Tax Court in Plainfield-Union flatly rejected this proposition, reminding the IRS that any properly performed repair should increase the value of the asset. (22) The decision in FedEx recently reminded the government of this point once again.
2. TAM 9618004
The IRS's first statement regarding cyclical aircraft maintenance costs appeared in the form of a 1996 technical advice memorandum. In TAM 9618004 (May 3, 1996), the national office was asked to consider whether cyclical maintenance costs relating to commercial turboprop aircraft currently were deductible or instead were required to be capitalized. The facts involved the same basic maintenance procedures that later would be at issue in FedEx. "Hot-section" inspections are described in the TAM as changing wearable filters, plus inspecting the inlet ducts, exit ducts, combustion liners, diffusers, turbines blades, and stators of the engine. Based on the taxpayer's usage of the aircraft, the Federal Aviation Administration required the taxpayer to perform such an inspection every one to two years.
"Major inspections" occurred less frequently (approximately every four years), but were more comprehensive, being described as a repeat of the hot-section inspection, plus inspections of the gear-box, bearings, compressors, fan shaft, casings, and all other engine accessory items. The TAM states that, in performing the mandated inspections, the airline's technicians compared the actual condition of each engine part with the FAA-approved manufacturer's specifications, either reconditioning or replacing parts falling outside acceptable tolerances, and reinstalled the remainder of the parts. The cost of a major inspection was between $90,000 and $120,000, depending on the aircraft being serviced, representing between 3 and 10 percent of the cost of a new aircraft, and between 10 and 35 percent of the cost of the engine itself.
Based on these facts, the IRS national office rejected the taxpayer's argument that it was simply keeping its aircraft engines in an ordinarily efficient operating condition. Instead, the national office agreed with the field that the cost of major inspections had to be capitalized, because they:
[R]esult in substantial improvements to the overall condition of the engine that are not merely incidental and which have the effect of adding materially to the then value of the engine while at the same time prolonging the engine's useful life. Furthermore, these expenditures generate significant future benefits to Taxpayer, not the least of which is the fact that without them, the FAA would not permit Taxpayer to continue to operate its aircraft. Finally, in the case of the engines owned by Taxpayer, the major inspection costs restore exhaustion for which an allowance has been made.
TAM 9618004 ignited a firestorm of controversy. (23) Some commentators as well as industry experts claimed the national office had not been presented with an accurate view of the facts. Others expressed concern that the national office had placed too much reliance on the "significant future benefit" standard of INDOPCO in a context in which it did not belong. (24)
3. Rev. Rul. 2001-4
The controversy continued until the IRS issued Rev. Rul. 2001-4, (25) where the IRS sought to clarify for taxpayers and the field alike the absence of any bright line rules when considering whether an expenditure is a deductible repair versus a capital improvement. Rev. Rul. 2001-4 was designed to demonstrate that the analysis instead represents a spectrum of possible outcomes, with the proper tax treatment requiring an inquiry into the precise nature and effect of the purported repair expenditures. The revenue ruling does so by setting forth three fact patterns involving procedures incurred in connection with the continued operation of an airplane's airframe.
Scenario One appears to be the most like the fact pattern in TAM 9618004. In compliance with FAA regulations, an airline performed a "heavy maintenance visit" (HMV) (26) on the airframe of a 16-year-old aircraft. The HMV consisted of completely disassembling the aircraft and performing certain tasks on the disassembled airframe in order to prevent "deterioration of the inherent safety and reliability levels of the airframe." The tasks included lubrication and service; operational and visual checks; inspection and function checks; restoration of minor parts and components; and removal, discard, and replacement of certain life-limited single cell parts, such as cartridges, canisters, cylinders, and disks. The revenue ruling states that no major components of the airframe were replaced, and that no upgrades of or additions to the airframe's structural materials occurred. Significantly, the revenue ruling notes that because the value of an aircraft declines as it ages regardless of this work, the work at best maintained the relative value of the aircraft. The aircraft was out of service for 45 days, and the taxpayer incurred $2 million in labor and material costs.
On the facts of Scenario One, the revenue ruling concludes that the costs of the HMV may be deducted under section 162 as routine maintenance costs. The ruling notes that the maintenance did not involve replacements, alterations, improvements, or additions to the airframe that appreciably prolonged its useful life, materially increased its value, or adapted it to a new or different use. Instead, the HMV "merely kept the airframe in an ordinarily efficient operating condition over its anticipated useful life for the uses for which the property was acquired." (27) The FAA's mandating the HMV and providing that that the aircraft would be grounded if it were not completed were found irrelevant. (28)
Scenario Two builds upon Scenario One by having the airline conduct the same HMV. Because the inspection detected excessive wear in a number of external skin panels, however, the airline was required to replace a large section of the airframe's exterior. In addition, because the aircraft already was out of service, the airline took the opportunity to install certain upgrades to the 16-year-old plane, including fire and smoke suppression systems, a ground proximity warning system, and a passenger air-phone system.
This scenario demonstrates that determining whether a taxpayer has repaired or improved an asset is not an all-or-nothing proposition. Here, the taxpayer was required to capitalize the costs of replacing the large section of external skin panels, because doing so represents the replacement of a significant portion of a substantial structural part of the aircraft. As such, the IRS viewed this as materially increasing the value of the airframe. The IRS also required the airline to capitalize the costs of the upgrades installed at the time of the HMV, such as the smoke and fire suppression system. These, too, were seen as materially improving the airframe.
Significantly, the taxpayer was not required to capitalize the costs of the HMV itself. Thus, even though the HMV occurred concurrently with the replacement of the skin panels and with the installation of the various system upgrades, the revenue ruling correctly concludes that these procedures should not all be viewed as part of a single plan to improve the aircraft. Based on the facts under consideration, the taxpayer's intent was to make a series of discrete improvements, each of which should be analyzed separately, rather than to rehabilitate the entire aircraft. Because the aircraft was already out of service for routine maintenance, the HMV provided a convenient opportunity to install the upgrades but was not otherwise "incidental" to them. As such, the costs of the HMV remain deductible.
Scenario Three completes the spectrum. The airline decided to make substantial improvements to an airplane nearing the end of its anticipated useful life, "for the purpose of increasing its reliability and extending its useful life." The revenue ruling sets forth a long list of significant changes, modifications, and improvements made to the exterior and interior of the aircraft, and explains that in doing so, the airline also performed much of the same work that would be performed during an HMV.
Here, all costs were required to be capitalized, including those that otherwise would have been deductible as an HMV. The IRS found that unlike the work done in Scenarios One and Two, the extensive work done to the airframe in Scenario Three represented a restoration of the aircraft within the contemplation of section 263(a)(2). Based on the age of the aircraft and its nearing the end of its anticipated useful life, coupled with the extensive nature of the work done in replacing and upgrading nearly every major structural component of the aircraft, the IRS concluded that the taxpayer's intent was to increase the plane's reliability and, as in Rev. Rul. 88-57, to extend its useful life by essentially rebuilding the aircraft. Further, because the HMV-type procedures were "incidental" to this overall plan of rehabilitation, they too were required to be capitalized.
Rev. Rul. 2001-4 demonstrates the inherently factual inquiry required in any repair situation. All of the costs in Scenario One are deductible because they were routine maintenance costs that neither increased the life or value of the aircraft nor adapted it to a new or different use. Some of the costs are required to be capitalized in Scenario Two, because those particular costs did in fact increase the value or life of the aircraft; the remaining costs were unrelated to the costs of the improvements and may be deducted, even though all the costs were incurred at the same time. Finally, at the far end of the spectrum, the airline was required capitalize all the costs incurred to restore the nearly exhausted aircraft to a state-of-the-art operating condition, even though many of those costs would have been deductible had they not been "incidental" to the overall plan to rehabilitate the aircraft.
Although Rev. Rul. 2001-4 was designed as a benchmark for analyzing a wide array of repair issues, the IRS examination function has tended to interpret it narrowly as applying only to the maintenance of aircraft airframes. The field has not applied the principles of the ruling even to aircraft engines, much less to other industries with similar maintenance programs. The national office has not issued a TAM on these issues since TAM 9618004, probably because it has not been asked to do so. (29) The result is an unsatisfying and disappointing use of a document that otherwise could have provided tremendous value in resolving the many controversies pending in this area.
4. Ingrain Industries
A few months after the issuance of Rev. Rul. 2001-4, the Tax Court took the next significant step in addressing the tax treatment of cyclical maintenance costs. Ingram Industries v. Commissioner (30) dealt with cyclical maintenance costs in the context of towboats. Towboats are similar to tugboats, but are used to push barges along commercial river routes. The engine of a towboat is such an integral component of the overall vessel that towboats are valued as single assets, and separate values are not assigned to the various components.
As with aircraft, towboats require recurring inspection and maintenance to attain their expected useful lives. With proper maintenance, towboat engines have an expected useful life of 40 years, the same useful life as the remainder of the towboat. Also similar to aircraft, towboat engine maintenance is based on the number of hours of use, such that with respect to the procedures at issue in Ingram, the engines were maintained on a three-to-four year cycle. Unlike aircraft engines, however, the engines are not required to be and were not removed from the boat during maintenance. Instead, the critical components can be removed from the engine block, inspected to determine whether each part remains within acceptable tolerances, and then either returned to the engine as is, repaired, or replaced. Conducting such maintenance (31) requires the towboat to be taken out of service for approximately 10 to 12 days, whereas either replacing or rebuilding the engines requires dry-docking the boat and removing it from service for approximately three to five months. Unlike aircraft maintenance, federal regulations do not govern the towboats' maintenance intervals or procedures.
On these facts, the Tax Court held that the recurring maintenance costs are deductible. As a threshold matter, the court first addressed which "asset" is being repaired or improved--the engine separately or the entire boat. In the repair context, the IRS generally attempts to fragment larger assets in order to amplify the effect of any change in the value, life, or use of the "asset." For the same reason, taxpayers benefit when the asset is defined more broadly. In Ingram, the court agreed with the taxpayer. Judge Gerber found that, as a matter of industry practice, boats and engines are not purchased or treated separately. Instead, boats and engines are purchased as units; the engine (if properly maintained) will have a life co-extensive with that of the boat; and the engines specifically are designed to be maintained without removing them from the boats. There was no indication that towboat owners regularly and periodically replaced the engines over the life of the boats. Accordingly, the Tax Court rejected the IRS argument that as a matter of law or fact the engines should be treated as the relevant asset.
Turning to whether the expenditures appreciably prolonged the life of the asset, the IRS argued that, without maintenance, the engines would completely wear out after four or five years. As a consequence, the IRS argued, the engines have a useful life of only four or five years, and the taxpayer essentially restores and acquires a new asset every time maintenance is conducted and a new four-year operating cycle begins. In contrast, the taxpayer argued that the engines had expected useful lives of 40 years (the same as the boat), and that the periodic maintenance simply was a means of allowing it to achieve that expected useful life. The IRS also pointed to the fact that the taxpayer had to take the boat out of service for 10 to 12 days and to have approximately 10 individuals work on the boat to perform the required maintenance as evidence of the scope of the operation. The taxpayer countered by showing that the total costs incurred represented only 1.6 percent of the costs of a new boat, or 5 percent of the costs of a used boat, and that as a percentage of purchase price, this is equal to a $480 repair bill on a $30,000 automobile.
Again the Tax Court agreed with the taxpayer. First, it agreed that in comparison with either the cost of a replacement boat or the cost and disruption of either overhauling or replacing the engine, the $100,000 cost appears to be an incidental repair. Judge Gerber explained that it would be unreasonable to expect someone to pay $6.5 million for an asset, and then to choose to replace or rebuild the asset every five years at several times the cost of simply maintaining the original asset.
Second, the Tax Court found it significant that the taxpayer performed the maintenance procedures at a time when the engines are completely serviceable, with the purpose of performing the procedures being to keep the towboat engines in a sound operating condition. The court distinguished the cases in which the taxpayer expended funds to restore the asset to an ordinarily efficient operating condition as opposed to keeping it in that condition. By conducting periodic preventive maintenance, the court noted, the taxpayer was able to achieve the 40-year operating life expected at the time that it purchases the engines. Importantly, however, the court also observed that this cyclical maintenance program primarily involved inspecting the vast majority of the engine's parts on a regular basis and replacing only the relatively few that are worn beyond a certain tolerance.
Finally, the Tax Court also held that the maintenance procedures did not materially add to the value of the boat. The court rejected as factually unsupported the IRS's allegation that a buyer would pay a higher purchase price for a boat whose engines had recently been maintained, (32) Accordingly, because the towboat owner was doing what any reasonable owner would have done in order to maintain the value and operating efficiency of a critical asset, and because those actions neither increased the value or life of that asset nor adapted it to a new or different use, the towboat owner was entitled to currently deduct those costs as incidental repairs.
As with the issuance of Rev. Rul. 2001-4, the IRS examination function read and applied Ingram narrowly, essentially limiting the case to its facts rather than applying the underlying legal principles. As such, the IRS pressed forward with litigation against taxpayers incurring cyclical maintenance costs outside the context of aircraft airframes and towboats. This narrow view has now resulted in the taxpayer's victory in FedEx.
In all material respects, FedEx is consistent with the national office's holding in Rev. Rul. 2001-4 and the Tax Court's decision in Ingram. FedEx involves the cyclical maintenance of aircraft engines. As part of its package delivery business, FedEx owns and operates a large fleet of sophisticated jet aircraft. Pursuant to the Federal Aviation Regulations (FARs), FedEx must conduct ongoing maintenance operations on both the airframes and the engines of its aircraft. Only the engines were at issue in the case. In purchasing the aircraft, FedEx bought airframes and engines as single units, although it also bought additional engines as part of the original purchase for use as rotable spares. FedEx typically did not purchase engines separately from airframes, and the company expected the engines to remain in service for the entire useful life of the aircraft that they powered (approximately 30 years).
The FARs required FedEx to perform certain maintenance procedures after specified intervals, measured in either hours of flight operations, elapsed time since the last visit, or in cycles (one take-off and one landing). The specific tasks required at particular intervals were developed in conjunction with the aircraft's manufacturer and were incorporated into a maintenance manual, which the FARs mandated be followed. At certain intervals, specified maintenance was required in order to permit FedEx to continue operating the plane. Failure to comply with the maintenance schedule would result in the FAA grounding the aircraft (i.e., rendering it "unserviceable"), regardless of its actual physical condition.
In almost all cases, FedEx contracted with third-party vendors to conduct the required maintenance. FedEx removed the engine from the aircraft and shipped it to the vendor for maintenance. The engine was immediately replaced with another, rotable engine, so that the plane could remain in service. The district court provides a thorough discussion of the maintenance procedures performed on the engine, but in general, the maintenance procedures at issue closely resembled those in TAM 9618004.
The district court agreed with FedEx that the costs at issue represent deductible expenses for incidental repairs. As did the Tax Court in Ingram, the district court began by examining whether the relevant asset was the engine (as argued by the IRS) or the entire airplane (as argued by FedEx). The court in FedEx turned to Ingram for guidance, and based on that case, found four factors relevant in identifying the relevant "unit of property." (33)
First, the court should consider whether the taxpayer and the industry treat the component part as part of the larger unit of property for regulatory, market, management, or accounting purposes. Second, the court should determine whether the economic useful life of the component part is coextensive with the economic useful life of the larger unit of property. Third, the court should determine whether the larger unit of property and the smaller unit of property can function without each other. Finally, the court should weigh whether the component part can be and is maintained while affixed to the larger unit of property. (34)
In applying these four factors to FedEx's aircraft engines, the court concluded that the entire airplane, not the engine, was the relevant unit of property. First, the court found as a factual matter that a limited market exists for the sale of stand-alone aircraft engines, and that most taxpayers, including FedEx, typically buy engines only in conjunction with an airframe (either as part of a single unit or as a spare engine to be used on that aircraft).
Second, the court found that the lives of the engines at issue were co-extensive with the airframes on which they were mounted. FedEx's engine maintenance program was specifically designed to allow an engine to remain in service for the life of the aircraft with respect to which it was associated, as demonstrated by FedEx's rarely entering the secondary engine market for a replacement engine.
Third, the district court understandably found with limited discussion that an aircraft cannot fly without an engine attached, and as such "the larger unit of property and the smaller unit of property cannot function without one another." Finally, the court considered whether the smaller unit of property must be removed from the larger unit of property for maintenance to occur. Although recognizing that this factor "slightly favors" treating the engines and airframes as separate assets, the district court concluded that the first three factors were sufficiently strong to overcome FedEx's failure to satisfy the fourth. The court viewed these factors as merely instructive, with the failure to satisfy any one factor not being dispositive.
Having concluded that the engine and the airframe constitute a single, indivisible asset--an airplane--for purposes of the Repair Regulations, the court next turned to the traditional tests permitting a deduction for the cost of "incidental repairs" that neither increase the value or life of the asset nor adapt it to a new or different use. The court considered the government's argument that the "incidental" nature of the expenditure is an independent test of magnitude requiring capitalization regardless of whether the life, value, or use of the asset has been affected. In short, the government argued that a large expenditure must be capitalized simply by reason of its absolute size.
Correctly, the district court rejected this expansion of the law and had no trouble distinguishing the cases on which the government relied, finding that the costs in those cases were required to be capitalized not simply because they were large, but because they either adapted the property to a new use, (35) increased the value of the property in comparison to its value at the time acquired by the taxpayer, (36) or increased the asset's useful life. (37) The district court correctly held that while the absolute size of an expenditure may be probative in gauging the character of an expense as a capital improvement or a repair, it is not an independent basis for capitalization. Instead, capitalization is required only upon a finding of a material change in the asset's life, value, or use.
The court next had to determine the proper standard for determining whether the expenditures in fact had increased the life, value, or uses of the airplane. Needless to say, the critical question becomes--compared to what? The government argued that the court had to make this determination by comparing the state of the engine immediately preceding the maintenance with the state of that engine immediately following the maintenance. In contrast, FedEx contended that the district court should apply the Tax Court's Plainfield-Union standard, (38) under which "an expenditure which returns property to the state it was in before the situation prompting the expenditure arose, and which does not make the relevant property more valuable, more useful, or longer-lived, is usually deemed a deductible repair." (39) The district court stated, "The court considers a capital expenditure 'to be a more permanent increment in the longevity, utility, or worth of the property' rather than an expenditure intended to correct a situation." (40)
The district court rejected the test espoused by the government as one that would require the capitalization of any properly performed repair. Presumably, any successful repair will improve the value of the property compared to its condition while still inoperable or damaged. (41) Hence, the government's standard would have eviscerated the concept of deductible repairs. The district court, however, did not immediately adopt the Plainfield-Union standard either, but noted that the Ninth Circuit's decision in Smith "highlights a situation in which the Plainfield-Union approach is ill-suited: the replacement of an essential functional component of the property." (42) The court found that the Plainfield-Union standard is inapplicable if the component being replaced is so critical that its replacement is tantamount to reconstituting the asset itself.
On the facts at issue, however, the district court concluded that this "essential component" rule was inapplicable. First, the district court did not view the engine as constituting an "essential component" of the airplane, because unlike the aluminum smelter cell linings at issue in Smith, the engines' replacement would not be "tantamount to reconstituting the [airplane] itself." (43) Second, the court also did not view the procedures as a replacement. Most of the engine parts were simply cleaned and inspected, and in some cases, repaired. Many of the parts that were removed from the engine and replaced with parts from "customer stock" were repaired and returned to a compatible engine in a later repair visit. The parts could have been returned to the same engine but for the commercial need to return the engine to service as quickly as possible, thereby necessitating the need to maintain a pool of rotable parts. Because the maintenance did not involve the replacement of an essential component (tantamount to reconstitution of the asset itself), the court found application of Plainfield-Union to be appropriate.
The district court found Plainfield-Union to be highly analogous to cyclical engine maintenance. The underground pipelines owned by the water company in Plainfield-Union had become partially clogged over time through their use in the ordinary course of the taxpayer's business. The Tax Court upheld the taxpayer's right to deduct costs that did no more than repair the damage that had occurred through such routine business operations. Similarly, the district court in FedEx found that the engines required cyclical maintenance as a foreseeable consequence of their having been used in routine flight operations. The FAA required that the engines undergo certain procedures after a prescribed period or amount of usage, because that usage necessarily inflicted wear and tear on the engine's components. Just as the taxpayer in Plainfield-Union was entitled to restore the pipeline to its condition immediately prior to the event necessitating that repair--i.e., routine business usage--so too was FedEx. The district court stated:
The 'condition' necessitating the [maintenance] was the wear and tear an engine ... had sustained in powering FedEx's aircraft since a previous [maintenance visit]. Under this analysis, if an engine ... is in no better condition after a given [maintenance visit] than it was after the preceding [maintenance visit], the [maintenance visit] could not have improved the condition of the aircraft, and the court must conclude that the [maintenance visit] only corrected the damage sustained by the aircraft during the ordinary course of its operation. (44)
The court found as a factual matter that the maintenance visit did not increase the value of the aircraft, because the government had been able to show that at best the maintenance kept the value relatively flat over time.
The court also found that the maintenance did not extend the useful life of the aircraft. FedEx acquired the aircraft with the expectation that it would remain in service for 30 years and designed its maintenance program to keep the component parts--airframes and engines--in working order during that time. As in Ingram, the government was unsuccessful in arguing that the maintenance resulted in extending the useful life of the asset.
The district court thus concluded in FedEx that the company acquired its aircraft as a single unit with an expected economic life of 30 years, and that its maintenance program was designed to preserve, but not to extend that expected useful life. In the absence of evidence that the value of the aircraft was enhanced, (45) the taxpayer was permitted to currently deduct the maintenance costs as incidental repairs.
Into the Future
Although taxpayers should be careful not to assign too much importance to one district court opinion, especially pending a probable appeal by the IRS, the district court's opinion in FedEx reaffirms in a new context a number of established legal principles relating to repair costs. By focusing on these principles and not on the factual distinctions with prior authority, the district court took a step that may go a long way toward resolving the tax treatment of cyclical maintenance costs for air carriers and for other industries as well.
First, the court reaffirmed that the absolute size of an expenditure is irrelevant in determining whether a cost is currently deductible. Just as taxpayers frequently claim to be entitled to deduct any amount falling below a de minimis amount, anecdotal evidence suggests some IRS field personnel believe that expenditures exceeding an unspecified amount should be capitalized. On occasion, even courts appear to fall into this trap. (46) The district court in FedEx correctly noted that unless there is a specific provision in the law stating otherwise, (47) the size of an expenditure may be probative in gauging deductibility, but it certainly is not determinative.
Second, the district court reaffirmed that not only is Plainfield-Union appropriately applied to situations in which the repairs simply reverse the routine effects of wear and tear, but that the "event" giving rise to the need for the expenditure is the prior routine business operation resulting in the wear and tear. The court recognized that in attempting to "match" maintenance expenses with the associated income, the relevant income is that occurring in prior years, such that a current deduction arguably provides the clearest reflection of income. (48) The alternative view is that the maintenance expenses permit the continued operation of the aircraft engine for another three or four years, so that the costs associated with keeping the engine in service should be capitalized and amortized over that future income-producing period. The district court's rejection of the government's argument that the repair costs give rise to a new four-year operating life essentially rejects this view of the matching concept as well. (49)
Third, it is interesting to note that neither the government nor the court appears to have considered whether capitalization was required by virtue of section 263(a)(2). This would appear to be the classic case for the government's frequent argument that many repairs restore exhaustion with respect to which a deduction has been claimed.
Finally, FedEx's most far-reaching benefit to taxpayers would arise if it reinforces that determining whether an expenditure is an incidental repair is a conceptual issue that must be administered using sound judgment, common sense, and a realistic understanding of the practicalities of an industry. The legal concepts set forth and explained in tremendous detail by the national office in Rev. Rul. 2001-4 should have been recognized and acknowledged as broad-based principles adaptable to a variety of repair contexts. Even recognizing that revenue rulings bind the IRS only with respect to their specific fact patterns, drawing arbitrary distinctions in order to avoid the application of a revenue ruling does a profound disservice to sound tax administration.
A number of other industries also incur cyclical maintenance costs with respect to large, complex assets. Within the transportation industry alone, the same issue arises in connection with railroad locomotives, ships, tractor-trailers, and other assets. Again, however, one should be cautious in trying to derive any bright-line rules in this area. "Cyclical maintenance" is not per se deductible. In the world of capitalization, labels or motives are irrelevant. All that matters is the result. Regardless of why the taxpayer incurs a particular maintenance cost or the label attached to the cost, the tax treatment will depend entirely upon whether the result of that expenditure is an increase in value, an extension of useful life, or the adaptation to a new or different use. These principles, not bright lines or labels, must be applied in assessing the deductibility of cyclical maintenance costs in these other industries. It is critical that both taxpayers and the IRS apply these standards thoughtfully rather than reactively.
One important mechanism for taxpayers and the IRS to ensure that each of these areas is resolved in accordance with established legal principles as well as a sound understanding of industry practice is to take advantage of the Large & Mid-Size Business Division's Industry Issue Resolution Program. (50) This program brings together representatives from the IRS national office, the field function, and the relevant industries to work together cooperatively to produce a revenue ruling or revenue procedure that will assist in resolving industry-wide issues, such as cyclical maintenance. This approach allows an open dialog between the IRS and the entire industry (rather than a few isolated taxpayers) and aims at resolving difficult legal and factual issues through the published guidance program rather than through private rulings or litigation. To date, this innovative program has been successful in resolving a number of previously troublesome tax accounting issues and has proven to be a real success story in demonstrating the benefits of having the IRS and taxpayers work amicably and cooperatively to resolve industry-wide issues.
In addition, if unable to resolve a particular repair issue on audit, taxpayers should consider inviting the participation of the national office through the new Technical Expedited Advice Memorandum (TEAM) program. (51) The new TEAM procedures allow taxpayers to benefit from a review of the issue by the national office's capitalization experts on a much more expedited (and presumably less costly) basis than typically is the case with a technical advice memorandum. (52) The national office frequently views situations from a different perspective than does the field. For example, while the field may be reluctant to apply a particular revenue ruling to a different but analogous set of facts, the revenue ruling's principal author may be more comfortable applying the ruling more broadly.
A second benefit of the TEAM process is that, unlike the traditional TAM procedures, if the field and the taxpayer are unable to agree on the facts to be submitted for the national office's consideration, the taxpayer and the field will each submit its own versions of the facts. If the national office decides that these factual differences would lead to different legal conclusions, it will issue a TEAM containing both legal conclusions. The field must process the case consistently with the legal analysis in the TEAM as applied to the facts as the field ultimately determines them. (53)
While this dual-answer mechanism is unlikely to help the taxpayer in successfully resolving its disagreement with Exam, highlighting these different legal results may well prove beneficial if Appeals ultimately considers the case. In addition, this new TEAM procedure infuses considerably more fairness into the process from the taxpayer's perspective by ensuring that the taxpayer will have a full and fair opportunity to present its version of the facts and to receive the national office's position based on those facts. The traditional TAM procedures require the national office to consider only the field's facts where they differ from the taxpayer's. The accuracy of the national office's legal position can be no better than the accuracy of the facts presented for its consideration.
The Income Tax & Accounting (IT&A) division of the IRS Office of Chief Counsel not only is responsible for administering the Code's capitalization rules, it also has the greatest experience with the TEAM procedures. That division was chosen to conduct the pilot program for the new procedures, (54) and based on its success in issuing TEAMs expeditiously, the program was made permanent in 2003 and was expanded to other areas of Chief Counsel as well. Taxpayers gave generally good reviews to the manner in which IT&A conducted the TEAM pilot, (55) which should give additional encouragement to taxpayers to seek to enlist the national office's participation where appropriate.
FedEx does not establish any fundamentally new capitalization principles or engage in any truly groundbreaking analysis. For the most part, the district court in FedEx follows squarely in the footsteps of earlier judges who have wrestled with whether an expenditure is a capital improvement or is instead a deductible repair. The decision rests upon established legal principles and applies them correctly to a situation which the courts had not previously considered and which, for whatever reason, the IRS examination function has been loath to concede as being governed by these well-established legal concepts.
The importance of the FedEx decision lies not in breaking new ground, but instead in demonstrating that by applying existing legal principles, an objective understanding of an industry and its behavior, and a healthy dose of judgment and common sense, taxpayers and the IRS should be able to reach the correct result under the Repair Regulations even in areas lacking specific guidance. The issue of repair costs is, and in all likelihood will remain, a fact-intensive area. (56) The FedEx decision demonstrates, however, that had it more carefully considered the operational effect of FedEx's cyclical maintenance program, the IRS should have been able to see beyond the high cost of the maintenance, beyond the number and complexity of the pieces that were disassembled, inspected, and then reinstalled, and beyond FedEx's having been required by law to perform the maintenance. In doing so, it would have been able to see instead that at the end of the day, the company had for the most part simply checked under the hood of an extraordinarily complex and expensive asset that, as a matter of public safety, must be kept in an ordinarily efficient operating condition. Had the IRS been willing to discern and apply the principles of Ingram, of Rev. Rul. 2001-4, and of the many cases providing a roadmap in this area, the tax system would have reached the correct decision more efficiently, more expeditiously, and at significantly less cost and burden to FedEx and other air carriers.
If the true lesson of FedEx is learned, the IRS will be more willing to apply the principles espoused in FedEx, in Ingram, and in Rev. Rul. 2001-4 to a larger variety of cyclical maintenance costs rather than focusing on the factual distinctions. If these principles are applied with an open mind to other industries, railroads, the trucking and shipping industries, and others with similar cyclical maintenance programs may be able to escape much of the cost, uncertainty, and administrative burdens to which air carriers have been subjected in having to resort to the courts. If so, FedEx will have been a truly groundbreaking opinion.
(1) So much time and effort have gone into this debate that the Treasury Department lamented more than 30 years ago:
[R]esolution of [the repair cost] issue has been treated as a question of fact, involving subjective or negotiated judgments and arbitrary rules of thumb which vary from industry to industry, revenue agent to revenue agent and audit to audit. This process traditionally led to numerous and extended controversies with taxpayers, which is necessarily the case when a factual judgment is made with respect to each of hundreds, or even thousands, of such expenditures in any particular audit. This is not productive of fair and uniform treatment of taxpayers and has been a major administrative problem for the Internal Revenue Service for many years.
Announcement 71-76, 1971-2 C.B. 503, 520 n.79.
(2) No. 01-2200 Ma/A (W.D. Tenn. Aug. 27, 2003). Because the district court's memorandum opinion addresses only one part of a multipart trial, the court has not issued a formal decision. References in this article are to numbered paragraphs of the opinion as published by Tax Notes Today (Tax Analysts) at 2003 TNT 172-9 ("FedEx's Engines, APUs Part of Aircraft for Repair Reg; Maintenance Program Expenses Deductible"). See also 2003 U.S. Dist. LEXIS 7371, 91 AFTR2d (RIA) 1940, 2003-1 USTC (CCH) [paragraph] 50,405 (W.D. Tenn. Apr. 7, 2003) (district court refused to grant summary judgment on whether aircraft and engines are separate and distinct assets).
(3) See, e.g., American Bemberg Corp. v. Commissioner, 177 F.2d 200 (6th Cir. 1949), aff'g 10 T.C. 361 (1948), nonacq. 1948-2 C.B. 5 (costs to fill cavities beneath textile plant with grout to prevent cave-ins held deductible); Kansas City Southern Ry. v. United States, 112 F. Supp. 164 (Ct. Cl. 1953) (deduction permitted for driving wooden poles into railroad track bed to shore up the tracks along a river bank when it was softened by water pockets); LaSalle Trucking Co. v. Commissioner, T.C. Memo 1963-274 (costs to overhaul engines and to replace truck cabs and tanks held capital); Hotel Sulgrave v. Commissioner, 21 T.C. 619 (1954) (costs to install sprinkler in apartment building under order from city building inspector held capital); Midland Empire Packing Co. v. Commissioner, 14 T.C. 635 (1950), acq. 1950-2 C.B. 3 (costs to install a concrete lining in basement of meat packing plant at order of federal inspector held deductible); Illinois Merchants Trust Co. v. Commissioner, 4 B.T.A. 103 (1926), acq. V-2 C.B. 2 (costs to replace rotted wooden building supports with concrete supports held deductible); Rev. Rul. 2001-4, 2001-1 C.B. 295 (three scenarios demonstrate application of repair analysis and plan of rehabilitation analysis); Rev. Rul. 94-38, 1994-1 CB 35 (costs of remediating environmental contamination held deductible where contamination occurred during taxpayer's ownership of property).
(4) Estate of Walling v. Commissioner, 373 F.2d 190 (3d Cir. 1967) (characterization as repair depends on whether the improvement was made to put the capital asset in efficient operating condition rather than to keep the asset in that condition); Bloomfield Steamship Co. v. Commissioner, 33 T.C. 75 (1959), and, 285 F.2d 431 (5th Cir. 1961) (costs incurred to put merchant marine vessels "in-class" were incurred to put rather than keep the ships in ordinarily efficient operating condition). See also Stoeltzing v. Commissioner, 266 F.2d 374 (3d Cir. 1959), aff'g T.C. Memo 1958-111 (capitalization required where extensive refurbishment put rather than kept building in an ordinarily efficient condition).
(5) 4 B.T.A. 103 (1926).
(6) Illinois Merchants, 4 B.T.A at 106.
(7) See, e.g., Jacks v. Commissioner, T.C. Memo 1988-237 (costs of installing a rebuilt engine into construction equipment did more than keep the asset in an efficient operating condition; life of asset was significantly extended); Rev. Rul. 88-57, 1988-2 C.B. 36 (cost of rebuilding freight cars nearing the end of their useful lives was incurred to put the assets into a sound operating condition rather than to keep them in that condition).
(8) Libby & Blouin Ltd. v. Commissioner, 4 B.T.A. 910 (1926), acq. VI-I C.B. 4 (costs to replace all tubing in a larger machine was a deductible repair).
(9) Electric Energy, Inc. v. United States, 13 Cl. Ct. 644 (1987) (costs of upgrading tubing in "economizers" attached to six power plant boilers were capital expenditures where the economizers rather than the boilers were the relevant unit of property); Denver & Rio Grande Western R.R. v. Commissioner, 279 F.2d 368 (10th Cir. 1960), aff'g 32 T.C. 43 (1959), acq. 1959-2 C.B. 4 (costs to replace many of the floor planks and stringers of a viaduct were capital expenditures where doing so was more than a mere "patch" or repair).
(10) 98 F.3d 1359 (Fed. Cir. 1996).
(11) See also Teitelbaum v. Commissioner, 294 F.2d 541 (7th Cir. 1961), aff'g T.C. Memo 1960-11 (cost of converting electricity in building from D.C. to A.C. was a capital expenditure despite the fact that it was compelled by a Chicago city ordinance); Woolrich Woolen Mills v. United States, 289 F.2d 444 (3d Cir. 1961), rev'g 178 F. Supp. 875 (M.D. Pa. 1960) (cost of building a filtration plant must be capitalized even though it was only built because of state anti-pollution law); RKO Theatres, Inc. v. United States, 163 F. Supp. 598, 602 (Ct. Cl. 1958) (extensive structural changes made to theater to comply with new fire code had to be capitalized, notwithstanding that complying with a governmental order is an ordinary and necessary reaction of a business owner); L&L Marine Service, Inc. v. Commissioner, T.C. Memo 1987-428 (work performed on barge that was necessary to allow it to continue to qualify for sea duty was a deductible repair).
(12) United States v. Wehrli, 400 F.2d 686 (10th Cir. 1968) (capitalization required where significant structural changes and improvements made to building).
(13) See Moss v. Commissioner, 831 F.2d 833 (9th Cir. 1987), rev'g T.C. Memo 1986-128 (mere existence of a written plan is not sufficient to trigger capitalization; is just sound business practice); Rev. Rul. 2001-4, 2001-1 C.B. 295 (existence of written plan alone does not require capitalization)
(14) Compare Moss v. Commissioner, 831 F.2d 833 (9th Cir. 1987) (repainting and wallpapering hotel in need of refurbishment was not part of an overall plan of rehabilitation notwithstanding taxpayer also replaced furniture, carpet, and window treatments at same time) with Norwest Corp. v. Commissioner, 108 T.C. 265 (1997) (asbestos removal costs capitalized where were required by and done in connection with the rehabilitation of the building).
(15) See Rev. Rul. 2001-4, 2001-1 C.B. 295, and the cases discussed therein.
(17) See Wolfsen Land & Cattle Co. v. Commissioner, 72 T.C. 1 (1979) (taxpayer required to capitalize cost of drag-lining irrigation ditches where in lieu of periodic maintenance it chose to allow ditches to deteriorate until they were nearly inoperable and then drag-line them; the drag-lining cost equaled the original construction costs).
(18) See, e.g., Ingram Industries v. Commissioner, T.C. Memo 2000-323 at n.9 (not reasonable to expect taxpayer to purchase a multimillion dollar asset with the expectation of rebuilding or replacing it after a few years rather than incurring significantly lower costs to properly maintain it; such maintenance costs allow the expected useful life to be obtained, not extended).
(19) 1988-2 C.B. 3, modified by Rev. Rul. 94-38, 1994-1 C.B. 35. Rev. Rul. 88-57 revoked Rev. Rul. 69-116, 1969-1 C.B. 86, which had held that a railroad was required to capitalize costs related to the maintenance of freight cars where the result was to extend the useful life of the freight cars beyond the seventeen-year depreciable life provided in Rev. Proc. 62-21, 1962-2 C.B. 418. Compare Rev. Rul. 69-119, 1969-1 C.B. 141 (permitting a current deduction for repairs made to freight cars).
(20) An alternative perspective would have been that without regular maintenance the expected 30-year life of the freight car is shortened by half. On the facts posited in the revenue ruling, however, the IRS's formulation may be more accurate.
(21) Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962), nonacq. 1964-2 C.B. 8.
(22) Plainfield-Union, 39 T.C. at 338. See also Smith v. United States, 300 F.3d 1023 (9th Cir. 2002), aff'g Vanalco, Inc. v. Commissioner, T.C. Memo 1999-265 (any increase in property value attributable to repairs must be assessed relative to the condition of the property in its original functioning state; otherwise, every repair would be deemed a capital expenditure). The IRS itself recognized this principle in Rev. Rul. 2001-4.
(23) See generally Stratton, "IRS Draws Flak for Aircraft Overhaul Capitalization TAM," 73 Tax Notes 119 (Oct. 14, 1996); Raby & Raby, "Capitalizing the Costs of Aircraft Engine Overhauls, 71 Tax Notes 1221 (May 27, 1996).
(24) INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992) (holding that capitalization is required by presence of a significant future benefit, regardless of whether a separate asset is created). The national office attempted to allay such concerns, however, in Rev. Rul. 94-12, 1994-1 C.B. 36, holding that INDOPCO had no effect on a taxpayer's ability to deduct repair expenses.
(25) 2001-1 C.B. 296.
(26) Also known in the industry as a "D check" or a "heavy C check".
(27) Rev. Rul. 2001-4, citing Illinois Merchants Trust, 4 B.T.A. at 106.
(28) This signaled a reversal from the national office's position in TAM 9618004, in which it had cited as a significant future benefit the fact that unless the taxpayer incurred the maintenance costs, the FAA would not permit it to continue operating the aircraft. The national office also stated in the TAM that an engine that has been inspected and meets FAA airworthiness requirements is more valuable to the taxpayer than an aircraft with an engine that has net been inspected and as a result cannot be operated in its business; it also concluded that the useful life of the engine is no longer than the period the airplane will be allowed to fly until the next required inspection, such that the useful life is extended by each such inspection. Rev. Rul. 2001-4 effectively reversed these conclusions.
(29) Despite not having formally withdrawn TAM 9618004, because the analysis relied upon in that document is irreconcilable with the later analysis in Rev. Rul. 2001-4, it is unlikely that the national office would reach the same conclusion today on the facts at issue in the TAM. Otherwise, the courts' opinions in Ingram and FedEx make clear that the position would not be sustained.
(30) T.C. Memo 2000-323.
(31) The Tax Court notes that the procedures in controversy involved cleaning and inspecting engines to determine which of the parts were within acceptable operating tolerances and could be reused and which if any of these parts needed to be reconditioned back to acceptable operating tolerances or replaced with appropriate replacements.
(32) The court also notes that the parties agreed that the maintenance did not equip the engines or the boat for a new or different use.
(33) The district court also closely considered the Ninth Circuit's decision in Smith v. Commissioner, 300 F.3d 1023 (9th Cir. 2002) (any increase in property value attributable to repairs must be assessed relative to the condition of the property in its original functioning state; otherwise, every repair would be deemed a capital expenditure). Although Smith also involves cyclical repair of operating assets, it relates to the maintenance of an aluminum smelter rather than to transportation assets and will not be discussed in detail here.
(34) FedEx, 2003 TNT 172-9, at [paragraph] 51.
(35) Dominion Resources, Inc. v. United States, 219 F.3d 359 (4th Cir. 2000), aff'g 48 F. Supp. 2d 527 (E.D. Va. 1999) (capitalization of environmental cleanup costs required where property could be used for new or different use).
(36) United Dairy Farmers, Inc. v. United States, 267 F.3d 510 (6th Cir. 2001), aff'g 107 F. Supp. 2d 937 (S.D. Oh. 2000) (capitalization of environmental cleanup costs required where contamination was present at time taxpayer acquired the property, thereby improving its value in comparison to its value when acquired).
(37) Smith v. Commissioner, 300 F.3d 1023 (9th Cir. 2002) (costs essentially "reconstituted" asset).
(38) Plainfield-Union Water Co. v. Commissioner, 39 T.C. 333 (1962).
(39) FedEx, 2003 TNT 172-9, at [paragraph] 72, citing Plainfield-Union, 39 T.C. at 337.
(41) Plainfield-Union, 30 T.C. at 338.
(42) FedEx, 2003 TNT 172-9, at [paragraph] 74.
(43) FedEx, 2003 TNT 172-9, at [paragraph] 77.
(44) FedEx, 2003 TNT 172-9, at [paragraph] 80.
(45) The government did not contend that the costs equipped the aircraft for a new or different use.
(46) Cf. Ford Motor Company v. Commissioner, 71 F.3d 209 (6th Cir. 1995), aff'g 102 T.C. 87 (current deduction for full liability would distort income); Exxon Mobil Corp. v. Commissioner, 114 T.C. 293 (2000) (concern that current deduction for large amount would distort income).
(47) See, e.g., Prop. Reg. [section] 1.263(a)-4(d)(6)(ii) (permitting a deduction for de minimis amounts incurred in obtaining certain contract rights); Rev. Proc. 2002-12, 2002-1 C.B. 374 (permitting a deduction for the purchase price of small appliances costing no more than $500).
(48) In other words, a current deduction arguably matches the costs most closely in time to the income earned from flight operations in prior years; any capitalization will increase the time period between the income recognized in year 1 and the related expenses not recognized until a subsequent year. Given the annual accounting concept, however, arguably if the expenses and income are not properly matched in the same taxable period, the number of years separating the two items is not relevant. Either the items are matched in the same taxable period or they are not. Regardless of the theoretical purity of this matching argument, simply as a matter of equity taxpayers should be entitled to deduct expenses related to prior-year income immediately upon being incurred; to do otherwise simply provides the government with an unearned, tax-free loan.
(49) TAM 9618004 also relied in part on the notion that the engine's useful life was no longer than the period of future operations permitted by compliance with the FAA requirement, and that the maintenance costs should be matched against the "new" four-year life created by those expenses.
(50) Rev. Proc. 2003-36, 2003-1 C.B. 859; "IRS Selects New Issues for Industry Issue Resolution Program" (IR-2003-92), 2003 TNT 143-8 (July 24, 2003).
(51) See generally Rev. Proc. 2003-2, 2003-1 C.B. 76. Taxpayers may request that the field submit the issue through the TEAM procedures and have limited appeal rights if the revenue agent rejects that request. Ultimately, however, taxpayers are unable under the IRS's current procedures to require the field to seek a TEAM or a TAM, reflecting the IRS's traditional reluctance to enable taxpayers to affect the scope or timing of an examination.
(52) A TEAM is a form of technical advice memorandum, pursuant to which the national office aims to issue its answer within 60 days of receiving the formal request for technical advice. The primary differences between a TEAM and a TAM are procedural. The procedures applicable to each are set forth in an annual revenue procedural. Rev. Proc. 2003-2, supra note 51.
(53) Section 21.14 of Rev. Proc. 2003-2.
(54) Rev. Proc. 2002-30, 2002-1 C.B. 1184.
(55) Voght & Monahan, "New IRS "TEAM" Initiative Could Prove Helpful To Some Taxpayers," 99 Tax Notes 545 (Apr. 28, 2003).
(56) As part of the 2003-2004 Priority Guidance Plan, the IRS and Treasury announced plans to develop regulations under section 162 and 263 regarding the deduction and capitalization of expenditures for tangible assets. Optimally, the Repair Regulations will be included within the scope of the new regulations, with the new rules following the lead of Prop. Reg. [section] 1.263(a)-4 (the proposed capitalization regulations applicable to intangible assets) and provide as many examples as possible. Even if this area retains its traditional fact-intensive character, a wide array of examples of deductible repairs would have independent value.
JAMES L. ATKINSON is Counsel with Miller & Chevalier Chartered in Washington D.C. Prior to joining the firm, Mr. Atkinson was the IRS Associate Chief Counsel (Income Tax & Accounting).
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|Date:||Nov 1, 2003|
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