Ninth Circuit Provides Guidance on Expense vs. Capitalize

In a recent opinion, the Ninth Circuit upheld a Tax Court ruling requiring capitalization of business expenditures. In Richard L. Smith, 300 F3d 1023 (9th Cir. 2002), affg sub nom. Vanalco, Inc., TC Memo 1999-265, the taxpayer replaced the linings of approximately 200 aluminum-smelting cells and portions of the floor in smelting rooms. To justify immediate deduction of the costs, Vanalco relied on Plainfield-Union Water Co. (P-U), 39 TC 333 (1962), nonacq. on other grounds, 1964-2 CB 8, an oft-cited case in this area. However, the court did not accept the taxpayers reliance on this case; it ruled that Vanalco had to capitalize the costs.

Facts

Vanalco is in the aluminum-smelting business. This entails refining bauxite to make aluminum oxide (alumina), which is then dumped into hoppers on the top of reduction cells. Electrolysis separates alumina into molten aluminum that is then poured into molds. Vanalco uses 650 cells in 10 rooms to continuously produce aluminum.

Cell linings are composed of several materials. An average cell-lining life is three years, but the weighted-average cell life (as opposed to a cell lining) is based on the cost of each component and is stipulated as 40 years. The cost to replace a cell lining is about $18,000, including material, labor and allocated overhead, with an additional $5,000 for removal of the old lining. Vanalco and the IRS agreed that the total cost of each cell component (as opposed to just the cell lining) was about $100,000.

Tax Courts Decision

The Tax Court ruled that replacing the cell linings could not be classified as a repair expense; the total costs for the years in question had to be capitalized. The court based its finding on four factors:

1. The cell lining is vital and integral to the smelting process;

2. The cell lining has a life independent  of the cell unit, and its cost as a percentage of the cell units total cost is substantial;

3. The replacement cell-lining material is a very substantial portion of the cell unit; and

4. In replacing the lining, the cell essentially is rebuilt, thereby obtaining a new life expectancy of three years.

Vanalco also repaired portions of the floors in the 10 cell rooms. The original floors were constructed with a concrete subfloor containing iron rebar for structural strength. To provide insulation between the iron rebar and the electrolysis process, the concrete subfloor is overlaid with bricks. Over the years, the bricks became worn or broken and were replaced. This resulted in an irregular floor, which contributed to 21 documented accidents during the first half of 1992.

During the tax years in question, Vanalco removed sections of the floors and replaced the bricks with a special cement that is more pliable than regular cement, easier to patch, wears smoother than brick and be-comes electronically nonconductive in 24 hours.

The Tax Court ruled that replacing the floor sections was a capital expenditure, because of the (1) substantial nature of the work, (2) functional improvement from using the special cement and (3) increase in the propertys value. Vanalco appealed to the Ninth Circuit.

The Taxpayers Position

Cell relining. Vanalco proposed several arguments in support of immediate expensing. It first contended that the relevant basis of comparison was the entire cell line of 650 units. Vanalco cannot operate less than 112 cells at any one time, because of the electrical wiring system. Thus, the 200 cell linings replaced during the tax years in question are a relatively small component of the total unit.

Second, Vanalco disagreed that the cell-relining expenditures increased the cells value. It cited P-U and the increased-value test. Sec. 263(a) prohibits deducting any expenditure made for new buildings or for permanent improvements or betterments made to increase a propertys value. In P-U, the Tax Court stated the proper test is whether the expenditure materially enhances the value, use, life expectancy, strength, or capacity as compared with the status of the asset prior to the condition necessitating the expenditure. Vanalco argued that replacing the cell linings simply restored the cells to their original condition before the linings deteriorated.

Along the same line, Vanalco argued that the relative cost of the lining, as compared to the cell as a unit, was not substantial. Because the relining cost was only about 22% of the cells value, Vanalco maintained that it was de minimis.

Third, Vanalco disputed the finding that the new cell lining gave the cell a new life of three years. As stipulated, the cells weighted-average life was about 40 years. Vanalco contested the determination that the new cell lining prolonged the cells useful life.

Floor repair. Because only portions of the floor were replaced in any one room, Vanalco mainly argued that there was no material increase in the propertys value. Again referencing P-U, it contended that if an expenditure does not materially enhance value, the expenditure should be immediately deductible. The taxpayer cited several cases in which replacing an entire floor (or very close to an entire floor) required capitalization.

In addition, Vanalco argued that there was no evidence that the repairs prolonged the original life of the cell-room floors. Thus, absent an increase in value or prolonged life, the expenditures should be immediately deductible as repairs.

Ninth Circuits Analysis

Cell relining. First, the court rejected the argument that the cell line (i.e., all 650 cells) was the proper unit of measure, finding (1) that each cell can operate independently of the others and (2) irrelevant that the company must operate a minimum of 112 cells.

Second, it rejected the conclusiveness of the P-U test: all repairs return property to its prior operating condition. Accepting this test would mean, for example, that replacement of a vehicles engine would be a deductible repair, contrary to existing precedents.

Courts must evaluate other factors in addition to an increase in value to determine proper treatment of repair costs. Regs. Sec. 1.162-4 states the cost of incidental repairs is deductible. To determine if a repair was incidental, the court examined a cell linings functional nature, deciding that the taxpayer was essentially putting the cell into a usable state, rather than keeping it in an operating condition. The court, in distinguishing between put and keep, relied on Est. of Walling, 373 F2d 190 (3rd Cir. 1967), revg and remg 45 TC 111 (1965).

Third, the court evaluated a cells expected life. Replacing a cell lining cost approximately $20,000 and took around 15 days. This was more than simply replacing a worn part and was essential to proper cell functioning. Because of to cost and significant work involved, the court decided that the relining process effectively rebuilt the cell. Thus, the process yielded a new life expectancy of three years.

For a proper treatment of the relining process, the court relied on Buffalo Union Furnace Co., 72 F2d 399 (2d Cir. 1934), which involved the cost of relining a blast furnace. That process required deactivating the furnace for a long time and cost between $50,000$100,000. As such, it was more natural to treat these costs as capital expenditures.

Lastly, the court referenced INDOPCO, Inc., 503 US 79 (1992), which requires capitalization of expenditures that provide more than an incidental future benefit.  A long-standing guideline is the one-year rule. The Tax Court did not err in deciding that the relining process provided a future benefit that extended beyond the current year.

Floor repair. The repairs were substantial, and the special cement provided a functional improvement that increased the propertys value. Even though the cases that the taxpayer cited required capitalization of costs for replacing an entire floor, there was no bright-line rule to determine the percentage of replacement that requires capitalization. The expenditures increased functionality; the floors were easier to clean, became nonconductive faster and wore in a smoother pattern than the original floors. The Tax Court did not err in deciding that the repairs materially increased the floors value, requiring capitalization of the repair costs.

Conclusion

It is dangerous to rely solely on one argument to support immediate expensing. The core of Vanalcos argument was based on P-U and on the lack of an increase in the propertys value. Both courts, however, considered several other factors, such as the relative importance of the repairs to determine if they were incidental.

The Ninth Circuit also referenced the put and keep distinction found in Walling. Finally, both courts considered the material future benefit of the repair. This INDOPCO-provided guideline is hard to dispute given the lack of any definitive measure of material. The IRS will often argue that an amount is material; rebutting the assertion is difficult. This is especially true if the expenditure gives rise to benefits beyond the current tax year.

From Charles E. Price, Ph.D., CPA, Charles M. Taylor Professor of Taxation, Auburn University, Auburn, AL, and Leonard G. Weld, Ph.D., Professor of Accounting, Valdosta University, Valdosta, GA (Neither affiliated with Grant Thornton LLP)