Treating Rotable Spare Parts as Depreciable Assets

In Rev. Rul. 2003-37, the IRS ruled that rotable spare parts can be treated as depreciable assets rather than inventory, in cases substantially similar to Hewlett Packard Co., 71 F3d 398 (Fed. Cir. 1995), and Honeywell, Inc., TC Memo 1992-453. It intends to issue a revenue procedure to grant taxpayers automatic consent to change accounting methods to be consistent with these cases. The Service had requested comments by May 23, 2003, on any issues to be addressed in the proposed procedure.

Background

In general, the Service has held that if a taxpayer acquires rotable spare parts for repair and maintenance of its internally used machinery, such parts can be treated as depreciable assets. For example, in Rev. Rul. 69-200, when an airline company acquired a new type of aircraft,  it would also acquire a substantial number of flight equipment rotable parts and assemblies for use on such aircraft. Even though these parts were not necessarily installed immediately, they were necessary and essential to a profitable operation when purchased. The parts included all parts and assemblies that were rotable in nature, generally reserviced or repaired, and used repeatedly. They possessed a service life approximately equal to that of the aircraft for which they were acquired.

The IRS held that these rotable parts and assemblies were property for which depreciation was allowable beginning at the time the aircraft for which they were purchased were placed in service. However, it later held in Letter Ruling 8528006 that Rev. Rul. 69-200 represented an exception to the general rule that replacement parts are inventory items, whether or not rotable. In the ruling, the taxpayer maintained a supply of repairable and reusable spare parts for both sold and rented equipment. The parts were necessary for rented and sold units covered by a maintenance agreement, as well as for units sold without an agreement.

The IRS concluded that the spare parts were not dedicated to specific items of machinery (as in Rev. Rul. 69-200), but were instead an inventory of spare parts used by the taxpayer in conducting its business of servicing units, whether purchased or leased. Consequently, it held that the taxpayer had to account for such parts by placing them in a nondepreciable account and treating them as inventory.

Cases

In contrast to Letter Ruling 8528006, two recent cases reached the opposite conclusion. In Hewlett Packard, the taxpayer manufactured and sold computers and related equipment, and operated a separate repair facility. In conducting its computer repair business, the taxpayer maintained a pool of rotable spare parts obtained from its manufacturing facility. It would repair the original part and return it to the pool for continued use in the repair business. The taxpayer followed this practice of exchanging its rotable spare parts in the customers computers to avoid the computer being inoperative while the original part was repaired. The rotable spare parts were kept separate from the regular manufacturing inventory and used only in the computer repair business.

On its Federal income tax returns for the years at issue, the taxpayer treated its pool of rotable spare parts as a capital asset, which it depreciated and on which it took investment tax credits. The Service disallowed the depreciation deductions and investment tax credits on the ground that the taxpayer was required to treat its pool of rotable spare parts as inventory. The Court of Federal Claims held in the IRSs favor, concluding that a sale had occurred to a customer for the rotable spare part; thus, the part should be treated as an inventory item.

The Federal Circuit reversed, concluding that the taxpayers exchange of rotable parts from its pool for malfunctioning parts in customers computers did not constitute a sale of those parts. The court held that the rotable spare parts used in the conduct of its repair business were capital assets subject to depreciation, not inventory, because the taxpayer maintained the pool to provide better service to its customers. Also, the court noted, the customers did not pay for replacement parts.

Similarly, in Honeywell, the Tax Court held that the taxpayers pool of rotable parts was not held for sale; thus, the taxpayer was not required to treat such parts as inventory. The court concluded that the taxpayers pool of rotable spare parts was necessary to the operation of its maintenance service business and was similar to an asset used in its trade or business within the meaning of Sec. 167 to earn revenue from its maintenance agreements.

Proposed Rev. Proc. 

In light of Hewlett Packard and Honeywell, the IRS now has concluded that a taxpayer can treat rotable spare parts as depreciable assets, rather than as inventory, if the facts and circumstances are substantially similar to those of the cases. It intends to issue a revenue procedure under which qualifying taxpayers may apply to obtain automatic consent to change to an accounting method consistent with the cases. The Service intends to issue the procedure in time for taxpayers to make the accounting-method change for tax years ending on or after Dec. 31, 2002.

From Richard C. Farley, Jr., J.D., LL.M., New York, NY