The IRS has issued new tax guidance that affects parts, materials and supplies. Some of these regulations will affect PMA parts manufacturers, while other will affect their customers (and may affect their future buying patterns).
The new guidance has been issued in the form of Temporary Guidance Regarding Deduction and Capitalization of Expenditures Related to Tangible Property. This temporary guidance become effective on January 1. At the same time, the IRS issued a proposal to make that temporary guidance permanent. The proposal provides the public with the opportunity to comment on the rules before they become permanent.
These new rules are meant to help companies distinguish between expenses and capital expenditures related to property. It also provides guidance on depreciating materials and supplies (guidance that may change the tax treatment of some inventory held by your customers). PMA manufacturers may find themselves affected by several elements of this rule, including guidance distinguishing “materials and supplies” from inventory, as well as new guidance for the tax treatment of rotable parts.
Clarifying Repairs vs. Capital Expenditures
One purpose of the new (proposed) regulations is to clarify that if an expenditure merely restores the property to the state it was in before the work (like a repair), then situation prompting the expenditure arose and does not make the property more valuable, more useful, or longer lived, then such an expenditure is usually considered a deductible repair. In contrast, a capital expenditure is generally considered to be a more permanent increment in the longevity, utility, or worth of the property.
Materials and Supplies
The new rules also address the tax treatment of materials and supplies. They clarify that the costs of acquiring or producing units of tangible property are required to be capitalized. This means that if a company purchases and /or produces goods for resale, the amount paid to acquire or produce those goods must be capitalized. So if you are supplying a manufacturer, the manufacturer may not deduct the cost of the inventory that goes into the final product until the product is actually sold. This provides a firm tax basis for just-in-time manufacturing and discourages manufacturers from carrying a substantial raw materials or parts inventory.
The new rule also clarifies that an exception exists for materials and supplies that are not considered inventory. Amounts paid for such materials and supplies are deductible in the year in which the goods are used in your company’s operations. However, incidental materials and supplies for which no records of consumption, or for which beginning and end of year inventories are not taken, may be deducted in the year in which they are purchased (yes, this will provide a tax inventive to avoid keeping metrics on items, but the value of tracking such materials usually exceeds the tax inventive to not track them). In all cases, the materials and supplies do not need to be capitalized into the value of the larger items on which the materials and supplies are used.
The formal definition of materials and supplies is:
Definitions—(1) Materials and supplies. For purposes of this section, materials and supplies means tangible property that is used or consumed in the taxpayer’s operations that is not inventory and that—
(i) Is a component acquired to maintain, repair, or improve a unit of tangible property (as determined under § 1.263(a)–3T(e)) owned, leased, or serviced by the taxpayer and that is not acquired as part of any single unit of tangible property;
(ii) Consists of fuel, lubricants, water, and similar items, that are reasonably expected to be consumed in 12 months or less, beginning when used in taxpayer’s operations;
(iii) Is a unit of property as determined under § 1.263(a)–3T(e) that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations;
(iv) Is a unit of property as determined under § 1.263(a)-3T(e) that has an acquisition cost or production cost (as determined under section 263A) of $100 or less (or other amount as identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter)); or
(v) Is identified in published guidance in the Federal Register or in the Internal Revenue Bulletin (see § 601.601(d)(2)(ii)(b) of this chapter) as materials and supplies for which treatment is permitted under this section.
Finally, the guidance specifies that rotable and temporary spare parts are used or consumed in the taxpayer’s operations in the taxable year in which the taxpayer disposes of the parts. This new guidance may drive some interesting recordkeeping among air carriers that carry rotable inventory. Under this new rule, there is a distinct tax advantage to being able to show that you are using rotables in the year purchased (so they can be treated as ordinary and necessary business expenses in the year that they are purchased). This may encourage air carriers to keep fewer rotables in their inventories, relying more heavily on distributors to provide rotables on a just-in-time basis.
The new rule defines rotables as:
“rotable spare parts are materials and supplies under paragraph (c)(1)(i) of this section that are acquired for installation on a unit of property, removable from that unit of property, generally repaired or improved, and either reinstalled on the same or other property or stored for later installation”
The new rule provides three different examples of the tax treatment of rotables under the new rule. Examining these examples provides an interesting view of the future tax treatment of rotables. [note that we have skipped example one from the IRS publication].
Example 2. Rotable spare parts. X operates a fleet of specialized vehicles that it uses in its service business. Assume that each vehicle is a unit of property under § 1.263(a)–3T(e). At the time that it acquires a new type of vehicle, X also acquires a substantial number of rotable spare parts that it will keep on hand to quickly replace similar parts in X’s vehicles as those parts break down or wear out. These rotable parts are removable from the vehicles and are repaired so that they can be reinstalled on the same or similar
vehicles. X does not use the optional method of accounting for rotable and temporary spare
parts provided in paragraph (e) of this section. In Year 1, X acquires several vehicles
and a number of rotable spare parts to be used as replacement parts in these vehicles.
In Year 2, X repairs several vehicles by using these rotable spare parts to replace worn or
damaged parts. In Year 3, X removes these rotable spare parts from its vehicles, repairs
the parts, and reinstalls them on other similar vehicles. In Year 5, X can no longer use the
rotable parts it acquired in Year 1 and disposes of them as scrap. Under paragraph
(c)(1)(i) of this section, the rotable spare parts acquired in Year 1 are materials and
supplies. Under paragraph (a)(3) of this section, rotable spare parts are generally used
or consumed in the taxable year in which the taxpayer disposes of the parts. Therefore,
under paragraph (a)(1) of this section, the amounts that X paid for the rotable spare parts in Year 1 are deductible in Year 5, the taxable year in which X disposes of the parts.
Example 3. Rotable spare parts; application of optional method of accounting. Assume the same facts as in
Example 2, except X uses the optional method of accounting for all its rotable and temporary spare parts under paragraph (e) of this section. In Year 1, X acquires several vehicles and a number of rotable spare parts (the ‘‘Year 1 rotables’’) to be used as replacement parts in these vehicles. In Year 2, X repairs several vehicles and uses the Year 1 rotables to replace worn or damaged parts. In Year 3, X pays amounts to remove these Year 1 rotables from its vehicles. In Year 4, X pays amounts to maintain, repair, or improve the Year 1 rotables. In Year 5, X pays amounts to reinstall the Year 1 rotables on other similar vehicles. In Year 8, X removes the Year 1 rotables from these vehicles and stores these parts for possible later use. In Year 9, X disposes of the Year 1 rotables. Under paragraph (e) of this section, X must deduct the amounts paid to
acquire and install the Year 1 rotables in Year 2, the taxable year in which the rotable spare parts are first installed by X in X’s vehicles. In Year 3, when X removes the Year 1 rotables from its vehicles, X must include in its gross income the fair market value of each part. Also, in Year 3, X must include in the basis of each Year 1 rotable the fair market value of the rotable and the amount paid to remove the rotable from the vehicle. In Year 4, X must include in the basis of each Year 1 rotable the amounts paid to maintain, repair, or improve each rotable. In Year 5, the year that X reinstalls the Year 1 rotables (as repaired or improved) in other vehicles, X must deduct the reinstallation costs and the amounts previously included in the basis of each part. In Year 8, the year that X removes the Year 1 rotables from the vehicles, X must include in income the fair market value of each rotable part removed. In addition, in Year 8, X must include in the basis of each
part the fair market value of that part and the amount paid to remove the each rotable from the vehicle. In Year 9, the year that X disposes of the Year 1 rotables, X may deduct the amounts remaining in the basis of each rotable.
Example 4.′ Rotable part acquired as part of a single unit of property; not material or supply. X operates a fleet of aircraft. In Year 1, X acquires a new aircraft, which includes two new aircraft engines. The aircraft costs $500,000 and has an economic useful life of more than 12 months, beginning when it is placed in service. In Year 5, after the aircraft is operated for several years in X’s business, X removes the engines from the aircraft, repairs or improves the engines, and either reinstalls the engines on a similar aircraft or stores the engines for later reinstallation. Assume the aircraft purchased in Year 1, including its two engines, is a unit of property under § 1.263(a)–3T(e). Because the engines were acquired as part of the aircraft, a single unit of property, the engines are not materials or supplies under paragraph (c)(1)(i) of this section nor rotable or temporary spare parts under paragraph (c)(2) of this section. Accordingly, X may not apply the rules of this section to the aircraft engines upon the original acquisition of the aircraft nor after the removal of the engines from the aircraft for use in the same or similar aircraft. Rather, X must apply the rules under §§ 1.263(a)–2T and 1.263(a)–3T to the aircraft, including its engines, to determine the treatment of amounts paid to acquire, produce, or improve the unit of property.
Finding the Regulations
The temporary regulations can be found online here:
The purpose of the temporary regulations is to implement the rule immediately before going through notice and comment.
The permanent version of the regulation is subject to notice and comment. The proposed permanent rule can be found online here:
Comments on whether these temporary rules should be made permanent, and how they should be changed, are due by March 26, 2012.