Stop Taxing Airline Safety Procedures

By Roy Whitehead, Jr.

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AUGUST 2006 - When you board a commercial aircraft, do you trust that the airline and the government have adopted policies that encourage the greatest possible attention to aircraft maintenance for your safety? As we shall see, the government has arguably given the collection of revenue a higher priority than safety. In FedEx Corporation v. United States of America [No. 03-6514 (2005)], the Sixth Circuit Court of Appeals was compelled to deal with a long-simmering dispute between the IRS and the airline industry concerning the deductibility of the costs of periodic aircraft engine repairs. The case is of enormous importance to the financial health of the struggling commercial aviation industry and to the safety of the traveling public. The IRS’s holding in a controversial Technical Advice Memorandum (TAM 96-18004), that “the cost incurred for major inspections of aircraft engines may not be deducted as ordinary business expenses under Internal Revenue Code section 162, but instead must be treated as capital expenditures under Internal Revenue Code section 263,” has generated considerable controversy because it can be viewed as a disincentive for strict airline maintenance and safety procedures as well as a substantial increase in the tax liability of the struggling airline industry.

In reaction to the TAM, on September 19, 1996, 31 members of Congress and House Ways and Means Committee chairman Bill Archer asked for the reversal of the TAM and expressed concerns that the resulting additional costs were an unwise tax burden on airline safety programs and contrary to the effective administration of airline safety goals. Chairman Archer, citing Treasury Regulations section 1.162-4, backed the airline industry’s contention that the engine repairs neither materially add to the value of the engines nor appreciatively prolong their useful life, but merely keep the engines in an ordinary operating condition.

The House Ways and Means Committee eventually dropped the matter without acting, because of concern about the considerable loss of tax revenue that legislative reversal of the TAM would cause. The controversial TAM and the exchange between Congress and the IRS about the TAM is discussed in my article “Taxing Airline Safety Procedures” (The CPA Journal, February 1997). Congress then had the heart to support airline safety but lacked the will to wean itself from the considerable additional airline tax dollars flowing into government coffers. Congress has been scared to get involved and somewhat intimidated by the IRS. The costs of the TAM to the airline industry are starkly illustrated by the fact that Fed-Ex received a $66.5 million refund plus interest for a mere two taxable years, representing the difference between deducting the repair costs and the IRS’s position that the repair costs had to be capitalized. If the FedEx case holding is adopted nationwide, as this author contends it ought to be, there will be billions of dollars in refunds due the major airlines.


As a matter of course, in the airline industry periodic inspection and repair of engines is required either because of the total hours operated or because of Federal Aviation Administration regulations. These inspections and repairs are commonly referred to in the industry as an engine shop visit (ESV). In the case at hand, when FedEx removed an engine from the airplane’s wing to send it for an ESV, it merely replaced the engine with another FedEx engine that had been removed and stored from a previous ESV. This was to keep the aircraft in continuous operation, delivering packages and earning revenue.

The economic useful life of an aircraft or aircraft engine is the period of time over which operating it in its intended role is physically and economically feasible. Periodic maintenance and repair is required to preserve safety and efficiency throughout the economic life of the engine. The court characterized the issue as whether ESVs materially increased the value of FedEx’s aircraft or engines or appreciatively prolonged the lives of the aircraft and engines. If so, the repair expenses must be capitalized. (Engine repairs often cost in excess of $300,000.) If the repairs merely maintained engines in normal working order during their expected useful lives, the repair expense might properly be deducted. To decide the issue, the court first turned to the provisions of the IRC.


IRC section 162 allows taxpayers to deduct ordinary and necessary business expenses paid or incurred during the current taxable year. Treasury Regulations section 1.162-4 (the “expense regulation”) provides that “the costs of incidental repairs which neither materially add to the property nor appreciatively prolong its life, but keep it in an ordinary efficient operating condition, may be deducted as an expense.” On the other hand, the regulations concerning capitalization of costs provides that items that are capital expenditures if they: 1) add to the value, or substantially prolong the useful life, of property owned by the taxpayer, or 2) adapt that property to a new or different use. The capitalization regulations further provide that “amounts paid or incurred for incidental repairs or maintenance of property are not capital expenditures.”

There has been considerable controversy over what constitutes the distinction between capital expenditures and ordinary and necessary business expenditures. They are not easy to describe. Whether an expense is a capital or a deductible expense is ultimately a fact question for the court.

The court in FedEx said that to solve the regulatory riddle, it must first identify which “unit of property” is being repaired and whether the repair materially adds to the value or appreciatively prolongs the life of that unit of the property. The court chose to use a four-part test to identify the relevant unit of property.

The court set out the factors that it would consider in identifying an appropriate unit of the property to which to apply the regulations:

  • First, the court should consider whether the taxpayer and the industry treat the component part as part of a larger unit of property for regulatory, market, management, or accounting purposes.
  • The court should determine whether the economic useful life of the component part is co-extensive with the economic useful life of the larger unit of property.
  • The court should determine whether the larger unit of property and the smaller unit of property can function without each other.
  • Finally, the court should weigh whether the component part can be and is maintained while affixed to the larger unit of property.

Applying the first factor, the court found that the taxpayer (FedEx), the airline industry, and the FAA all treat the engines and airframes as combined to form a single unit of property. The court indicated that FedEx flew airplanes, not airframes and engines separately. Therefore, the definition of an airplane is a relevant definition to consider in deciding whether repairs should be deducted or capitalized. The court said that based on the evidence presented at trial, FedEx and all other major air carriers considered engines to be a component part of their aircraft during the relevant taxable years of 1993 and 1994. The court also said that when an air carrier sold an aircraft, the sale included the engines physically on the aircraft and spare engines that had been removed and inspected, because the seller no longer had an aircraft with which those component parts would be compatible. The court found that the substantial weight of the evidence established that the engines were treated as part of a fully assembled and operating aircraft for purposes of acquisition, operation, maintenance, and disposal. These relevant factors favor classification of the aircraft as one unit of property for the purpose of applying the regulations.

The second factor was whether the expected useful life of an engine, if properly maintained, is co-extensive with the useful life of the aircraft. The court determined that the lives of the engines at issue here were co-extensive with the airframes on which they were mounted. This was because FedEx expected all of their main components to last at least 30 years. FedEx did not regularly or periodically replace all of its aircraft engines. It continued to use the same engines purchased with the aircraft to power those same aircraft throughout their 30-year useful lives.

The third factor was whether the larger unit of property and the smaller unit of property can function without each other. Clearly, engines cannot perform their function of powering jet aircraft unless they are mounted on those aircraft in proper working order, thus operating as a single unit.

The last factor the court considered was whether the smaller unit of property must be removed from the larger unit of property for maintenance to occur, which it must. The court quite reasonably concluded that FedEx’s airplanes require working engines to remain in service at all times. To keep the planes in the air, one of the engines can be removed from the aircraft, quickly replaced by another, and sent in for an ESV. This procedure provides economic utility to the airline and service to its customers by allowing the aircraft to remain in service while the engine is being repaired.

FedEx argued that the case of Plainfield-Union Water Company v. Commissioner (39 T.C. 33) mandated that engine repairs be treated as deductible expense. The Plainfield-Union test stated that “an expenditure which returns property to the state it was before the situation prompting the expenditure arose and which does not make the relevant property more valuable, more useful, or more longer lived, is usually deemed a deductible repair.”

The United States responded to FedEx’s argument by citing several cases where the courts treated certain repair costs as requiring capitalization. In two of the cases the court’s findings were based on a finding that the taxpayer had adapted (“put”) the property to a new use. In Dominion Resources v. United States [219 F. 3d 359 (4th Circuit 2000)], the court found that after the taxpayer had acquired the property, it incurred substantial environmental cleanup costs to “put” the property into a new condition rather than “keep” the property in its ordinary condition. Likewise, in United Dairy Farmers v. United States [267 F.3d 510 (6th Circuit 2001)], the court decided that the Plainfield-Union test allowing a deduction did not apply when “a taxpayer has improved defects that were present when the taxpayer acquired the property.” In other words, the repair expenditures were not to “keep” the property in its original condition, as intended in the FedEx engine repair case. The United Dairy Farmers repairs were intended to “put” the property in a new condition rather than to “keep” it in its original condition. In perhaps the strongest case favoring capitalization, Smith v. Comm’r [300 F. 3d 1023 (9th Circuit 2002)], the court held that repairs to some electrical cell linings by replacing them substantially prolonged the life of the property. Smith was not persuasive, because in FedEx the engine repairs merely restored the engines so they could meet their intended life expectancy of 30 years. Finally, the United States was forced to agree that the fourth case it cited, Louisville and Nashville Railroad [641 F.2d 435 (6th Circuit 1981)], had nothing to do with the repair regulations.

The FedEx court decided that Plainfield-Union was the appropriate measure of the impact of the ESVs on the state of FedEx’s aircraft, and applied the test to the facts of the case.

To determine whether the ESVs materially added to the value of FedEx’s aircraft, appreciatively prolonged their life, or adapted them to a new or different use, the court compared the state of the engines before the condition necessitating an ESV to the state of the engines fresh from undergoing an ESV. The condition necessitating an ESV was the wear and tear that an engine had sustained in powering FedEx’s aircraft since the previous repair. Under this analysis, if an engine is in no better condition after being given an ESV than it was after the preceding ESV, the ESV could not have improved the condition of the engine or the airframe. The court concluded that the ESV only corrected the wear-and-tear damage sustained by the aircraft during the ordinary course of its operation since the last repair.

The court also said that the periodic ESVs did not materially increase the value of FedEx’s aircraft. This is because an engine fresh from an ESV is not worth more than it had been worth immediately following the previous ESV. Because the ESV did not increase the value of the engine, it did not increase the value of the entire aircraft. Likewise, the ESVs here did not appreciatively prolong the useful life of FedEx’s aircraft. FedEx acquired its airframes and engines with the expectation that they would last 30 years. The maintenance program was carefully designed to meet that expectation by keeping both airframes and engines in working order throughout their useful lifespan.

Finally, the court said that it was concerned primarily with the economic useful life of FedEx’s aircraft, a term that the aviation community defines as “the period of time over which it is (or expected to be) physically and economically feasible to operate (both aircraft and engines) in their intended role.” Obviously, periodic maintenance and repairs will usually be required to preserve safety and efficiency during the engine and airframe’s economically useful life. Here, FedEx treated each aircraft as a unit, and the ESVs operated to maintain FedEx’s engines so that they, as a part of the aircraft they powered, would continue to operate for the 30 years that FedEx intended. Consequently, the engine repairs clearly preserve, but do not prolong, the useful economic life of FedEx’s engines and aircraft. The court concluded that the ESVs do not put the engines or aircraft to a new or different use.

Hopes for Future Decisions

The court logically concluded that during taxable years 1993 and 1994, the engines were so closely linked to the aircraft they propelled that they were part of a single unit of property. Second, the court said that the engine repairs merely restored the engine and airframes to the same condition they were in immediately after the last repair. In other words, the engines were “kept” to the same use that they had prior to the repairs. The repairs did not materially add to the value of the engines or “put” them to some new use. The court held that the engine repair costs were incurred as ordinary and necessary business expenses incidental to the maintenance of FedEx’s aircraft, and were properly deductible under IRC section 162.

The raising of revenue is surely one of the functions of the IRS, and that need for revenue is made very clear by the federal government’s current fiscal position. Although the decision is this case is binding only in the Sixth Circuit, it is puzzling that the IRS has not relaxed its seemingly inflexible position with regard to the deductibility of aircraft engine repairs. Given this decision, the author can reasonably foresee similar litigation, and lots of it, in the other federal circuits. The facts, the compelling interest in airline safety, and the relief from this unwarranted tax burden on the struggling airline industry certainly mitigate toward a finding of deductibility as in the FedEx case. Such decisions will surely be in the best interest of the traveling public.

Roy Whitehead, Jr., JD, LLM, is a professor of business law at the University of Central Arkansas, Conway, Ark.




















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