FedEx v. Commissioner: the continuing debate over cyclical maintenance costs

Tax Executive, The,  Nov-Dec, 2003  by James L. Atkinson

Tags: Federal Express

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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.