Deduct or capitalize aircraft engine maintenance costs?

In FedEx Corp., WD TN, 8/27/03, a district court held that FedEx's off-wing engine maintenance program (OWEMP) expenses were ordinary and necessary business expenses, not nondeductible capital expenditures. Relying on case law, the court created a four-factor test to determine whether the component

part or the larger item of property is the appropriate "unit of property" in determining whether repair costs are deductible under Sec. 162. The court concluded that the unit of property being repaired was the aircraft, not the engine, and that engine maintenance expenses did not materially add to the aircraft's value, appreciably prolong its useful life or adapt it for a new or different use.

Facts

The taxpayer filed for a refund arising from a dispute on the tax treatment of its OWEMP for its 1993 and 1994 tax years. For those years, FedEx timely filed Form 1120, claiming and deducting OWEMP costs under Sec. 162, which the IRS denied. FedEx then paid the tax and interest due and sued in district court for a refund.

During the tax years in question, FedEx operated a fleet of over 200 aircraft. Each was propelled by three installed jet engines, plus an auxiliary power unit (APU). These engines and APUs underwent regular maintenance in accordance with the OWEMP. Under this program, when an engine or APU was due for scheduled maintenance, it was removed from the aircraft and sent for an engine shop visit (ESV). FedEx would replace that engine with an engine that had completed all ESV.

ESVs included some or all of the following integrated activities: disassembly, cleaning, inspection, repair, replacement, reassembly and testing. The ESV repairs were performed by an outside vendor or a vendor's subcontractors. If a part could be repaired, but not in time to be returned to the engine or APU with which it had arrived, the vendor would first attempt to replace the part with a similar part from customer stock. (Typically, these were used parts that had been replaced or exchanged and repaired at FedEx's cost during an earlier ESV, stored and returned to FedEx engines at no additional cost.) If a part could not be repaired, it was replaced and FedEx was charged the market price.

At issue was the invoice costs for the ESVs, which varied based on the scope of the maintenance performed and the engine or APU model. The costs ranged from 0.2% to 8.1% of the aircraft's value.

The ESVs at issue did not restore any engine or APU to "like new" condition. The value of an engine or APU after a given ESV was less than or equal to its value after the previous ESV; thus, the aircraft's value after successive ESVs either remained stable or declined. The ESVs did not adapt any engine or APU to a new or different use, nor did they materially increase the value of FedEx's aircraft, engines or APUs. The ESVs did not appreciably prolong the lives of FedEx's aircraft, engines or APUs, but merely maintained them in proper working order during their expected useful lives.

Analysis

The district court had to determine whether the costs incurred to send an engine or APU to an ESV were deductible repair expenses under Sec. 162. That provision allows taxpayers to deduct ordinary and necessary business expenses paid or incurred during the current tax year. Kegs. Sec. 1.162-4 provides that:

The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinary efficient operating condition may be deducted as an expense.

To determine whether the ESV costs were deductible as repair expenses, the court had to first identify which "unit of property" was being "re-paired" and whether the repair materially added to the unit of property's value or appreciably prolonged its life. The IRS took the position that the unit of property was the engine or APU; FedEx contended it was the aircraft powered by the engine or APU.

Ingram: The court turned to two cases: the Tax Court's decision in Ingrain Indus., Inc., TC Memo 2000-323, and the Ninth Circuit's decision in Smith, 300 F3d 1023 (9th Cir. 2002). In Ingram, before the court could determine whether towboat engine maintenance could be deducted as a repair expense, it first had to determine whether the appropriate unit of property was the towboat or the engine. It looked to whether it was industry practice to treat towboat engines separately from the towboats. The court concluded that, despite the significance of the engines, "in the towboat industry, the engines are not separately appraised and do not have an effect on the market value of the towboat as long as the engines 'are operating and are said to have been well maintained.'"

Smith: In Smith, the court held that a given aluminum-producing cell was the appropriate unit of property, rather than the line of ceils in the aluminum production operation. Looking to the realities of smelting operations, the court determined that the only reality was that the individual cell was capable of producing aluminum, even if it was not connected to a cell line. Even though the taxpayer's production was not set up for this possibility, an individual cell had the "capability of producing aluminum and was sufficiently flee-standing to constitute a separate unit of property." Also integral to the court's conclusion was the fact the production line could perform its function with a substantial number of missing cells. (For a detailed discussion, see Price and Weld, Tax Clinic, "Ninth Circuit Provides Guidance on Expense vs. Capitalize," TTA, February 2003, p. 72.)

Four-factor test: Based on Ingram and Smith, the FedEx court formulated the following four-factor test to determine the appropriate unit of property to apply the repair regulations:

1. Whether the taxpayer and the industry neat the component part as part of the larger unit of property for regulatory; market, management or accounting purposes.

2. Whether the component part's economic useful lid coexists with that of the larger unit of property's.

3. Whether the larger and smaller units of property can function without each other.

4. Whether the component part can be and is maintained while affixed to the larger unit of property.

Holding: The court applied the above factors and found that (1) the substantial weight of the evidence established that FedEx and other major air carriers considered engines to be part of an aircraft during 1993 and 1994; (2) the lives of the engines and APUs were coextensive with the airframes on which they were mounted; (3) aircraft cannot fly without engines and APUs; and (4) although the engines and APUs were removed for ESVs (unlike the towboat engines in Ingrain), this factor alone was not enough to outweigh the other factors, which supported treating the engines and APUs, and the aircraft on which they were mounted, as a single unit of property.

The court also rejected the IRS's argument that the adjective "incidental" creates all independent test to find that all item must be capitalized. According to the court, "[i]ncidental is not logically read, however, as an independent requirement, but as a description of those improvements that do not increase the value of a specified unit of property, prolong its useful life, or adapt it to a new use."

Plainfield-Union: Further, under a test articulated in Plainfield-Union Water Co., 39 TC 333 (1962), to determine whether the ESVs materially added to the value of FedEx's aircraft, appreciably prolonged their life or adapted them to a new or different use, the court compared the state of the engines and APUs before the condition necessitating an ESV to the state of the engines and APUs after an ESV.

The wear and tear on the engine and APU necessitated the ESV. Given that an engine or APU was in no better condition after an ESV than it was after the previous ESV, the ESV did improve the aircraft's condition. The evidence also established that the ESVs did not materially increase the aircraft's value or prolong its life. The IRS conceded that the ESVs did not adapt the engines or APUs to a different use. For all of these reasons, the court concluded that the ESV costs were deductible as Sec. 162 repair expenses.

Conclusion

The FedEx court set forth the factors to consider in determining whether costs to repair a component part of a larger piece of property are deductible under Sec. 162. FedEx has taken Ingram a step further. While the towboat engines were not removed from the towboats in Ingram, the jet engines and APU were removed in FedEx. Thus, while the court created a four-factor test, apparently, not all four requirements must be met.

FROM WON SHIN, WASHINGTON, DC