Rev. Rul. 81-185

ISSUE

Under the circumstances described below, is it permissible to depreciate major standby emergency spare parts over the useful lives of the machinery or equipment they serve?

FACTS

An electric generating public utility maintains its books and records in accordance with the Uniform System of Accounts prescribed for public utilities by the Federal Energy Regulatory Commission (FERC). Like numerous other state and federal regulatory agencies, FERC permits utilities under its jurisdiction to change their accounting for major standby emergency spare parts by removing them from their materials and supplies accounts and transferring them to the pertinent plant in service accounts, where these parts will be subject to depreciation at a straight line composite rate for FERC purposes.

The utility has asked FERC's permission to change its accounting for major standby emergency spare parts from expensing such parts when actually used to depreciating them when placed in service. Contingent on receiving FERC's approval, the utility has requested the Internal Revenue Service to grant it permission to change its method of accounting for such parts for federal income tax purposes by timely filing an Application for Change in Accounting Method, Form 3115. The utility seeks permission to use an accelerated depreciation method under section 167 of the Internal Revenue Code and proposes to normalize the tax difference between the accelerated depreciation method and the straight line method in accordance with section 167(1).

The utility has elected the Class Life Asset Depreciation Range (CLADR) system under section 1.167(a)-11 of the Income Tax Regulations and for federal income tax purposes accounts for all of its spare parts of a type that are not repaired and reused by removing the costs of such parts from the materials and supplies accounts and charging them to expense when installed. Presently included in such accounts are major standby emergency spare parts that are (1) acquired when particular machinery or equipment is acquired (or later acquired and set aside for use in particular machinery or equipment), (2) set aside for use as replacements in order to avoid substantial operational time loss caused by emergencies due to particular machinery or equipment failure, (3) located at or near the site of the installed related machinery or equipment so as to be readily available when needed, (4) directly related to the particular machinery or piece of equipment they serve, (5) generally units of property or major parts of units, (6) normally expensive, (7) only available on special order, (8) not subject to normal periodic replacement, (9) not interchangeable in other machines or equipment, (10) not readily available from a vendor or manufacturer, (11) not acquired in quantity (generally only one is on hand for each piece of machinery or equipment), and (12) not repaired and reused.

Examples of such major standby emergency spare parts include a bearing seal for a plant generator, a rotor support bearing for use in an air preheater, a specially designed large electric motor for use on a specific large oil pump, and a turbine blade assembly. Under present accounting, if the part has not been used when the related machinery or equipment is retired, the part is also retired. At that point, the salvage value of the part is negligible compared to its cost when it was acquired.

LAW AND ANALYSIS

Section 162(a) of the Code provides that there shall be allowed a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

Section 167(a) of the Code provides that a deduction for depreciation is allowable for the exhaustion, wear and tear, and obsolescence of property used in a trade or business.

Section 446(a) of the Code provides that taxable income shall be computed under the method of accounting regularly employed by a taxpayer to compute income in keeping its books.

Section 446(e) of the Code provides that a taxpayer who changes the method of accounting regularly employed to compute taxable income must first secure the consent of the Secretary.

Section 1.446-1(a) of the regulations provides that the term "method of accounting" includes not only the overall method of accounting of a taxpayer, but also the treatment of any specific item, including the accounting treatment used to depreciate equipment. In essence, methods of accounting determine the proper time for the inclusion of an item in income or the taking of a deduction.

Rev. Rul. 69-200, 1969-1 C.B. 60, considered whether an airline's flight equipment rotatable parts and assemblies that were purchased for use as replacements for specific aircraft, and that were repeatedly repaired and reused, were depreciable property. Also considered were spare parts described as a type that was purchased for certain aircraft to avoid operational time loss, but ordinarily would be recurrently expended and replaced rather than repaired and reused.

Basically, Rev. Rul. 69-200 considered two types of spare parts, expendable and rotatable. It held that the cost of expendable spare parts is deductible as an expense in the year used under section 162 of the Code. It further held that rotatable spare parts are tangible property for which depreciation is allowable under section 167.

The major standby emergency spare parts being considered here are distinguishable from the expendable spare parts of Rev. Rul. 69-200, which are of a type that are recurrently expended and replaced. There the stocks of expendable spare parts were maintained based on the airplane manufacturer's recommendations and the airline's predicted needs based on experience. Maintenance of the stock of these spare parts assured that there would be no operational delays because of the lack of such parts. However, replenishment of the stocks of expendable spare parts would not require substantial special order lead times. They are generally not units of property nor major parts of such units. They are subject to normal periodic replacement. They are interchangeable with like parts in other airplanes of the airline's fleet.

The major standby emergency spare parts being considered here are of a type that are not recurrently expended and replaced. They are not maintenance items, stocks of which are kept on hand because of manufacturer's recommendations or predicted maintenance requirements based on experience. Because they are not manufacturer or supplier shelf items, their acquisition required significant special order lead times. Consequently, operational delays would be significant if spares were not kept on hand. The failure of one, without a ready replacement, would cause a substantial shutdown of a vital unit or service. These parts benefit the taxpayer's business during the taxable periods in which the related equipment is used as much as the equipment itself, since the parts insure that if an equipment failure occurs the business will not suffer detriment because of prolonged delays while the equipment is being repaired. Such parts, which fit the 12 criteria listed above, are an integral and essential part of the machinery they serve; and the useful life of these parts is coterminous with that of the related equipment. As such, the parts are in substance a component of the depreciable asset and hence subject to an allowance for depreciation in the same manner as that asset.

The major standby emergency spare parts are not subject to the holding of Rev. Rul. 69-200, which provides that an airline's expendable flight equipment spare parts of an aircraft are materials and supplies within the meaning of section 1.162-3, the cost of which is deductible as an expense when used. Further, the major standby emergency spare parts are of a different category than are the flight equipment rotatable parts of Rev. Rul. 69-200, but qualify on their own merits as depreciable property under section 167 of the Code. The major standby emergency spare parts are considered placed in service under section 1.167(a)-11(e)(1)(i) of the regulations.

HOLDING

The utility's major standby emergency spare parts are depreciable property and may be depreciated using an accelerated method when the parts are acquired and set aside as standby emergency replacements provided the taxpayer normalizes the tax benefits in accordance with section 167(1) of the Code. However, if a taxpayer wishes to change to this method of accounting for major standby emergency spare parts, the taxpayer must obtain permission by timely filing an Application for Change of Accounting Method, Form 3115.