Ninth Circuit provides guidance on expense vs. capitalize.

• Author: Ochsenschlager, Thomas P.

In a recent opinion, the Ninth Circuit upheld a Tax Court ruling requiring capitalization of business expenditures. In Richard L. Smith, 300 F3d 1023 (9th Cir. 2002), aff'g sub nom. Vanalco, Inc., TC Memo 1999-265, the taxpayer replaced the linings of approximately 200 aluminum-smelting cells and portions of the floor in smelting rooms. To justify immediate deduction of the costs, Vanalco relied on Plainfield-Union Water Co. (P-U), 39 TC 333 (1962), nonacq. on other grounds, 1964-2 CB 8, an oft-cited case in this area. However, the court did not accept the taxpayer's reliance on this case; it ruled that Vanalco had to capitalize the costs.

Facts

Vanalco is in the aluminum-smelting business. This entails refining bauxite to make aluminum oxide (alumina), which is then dumped into hoppers on the top of reduction cells. Electrolysis separates alumina into molten aluminum that is then poured into molds. Vanalco uses 650 cells in 10 rooms to continuously produce aluminum.

Cell linings are composed of several materials. An average cell-lining life is three years, but the weighted-average cell life (as opposed to a cell lining) is based on the cost of each component and is stipulated as 40 years. The cost to replace a cell lining is about $18,000, including material, labor and allocated overhead, with an additional $5,000 for removal of the old lining. Vanalco and the IRS agreed that the total cost of each cell component (as opposed to just the cell lining) was about $100,000.

Tax Court's Decision

The Tax Court ruled that replacing the cell linings could not be classified as a repair expense; the total costs for the years in question had to be capitalized. The court based its finding on four factors:

1. The cell lining is vital and integral to the smelting process;

2. The cell lining has a life independent of the cell unit, and its cost as a percentage of the cell unit's total cost is substantial;

3. The replacement cell-lining material is a very substantial portion of the cell unit; and

4. In replacing the lining, the cell essentially is rebuilt, thereby obtaining a new life expectancy of three years.

Vanalco also repaired portions of the floors in the 10 cell rooms. The original floors were constructed with a concrete subfloor containing iron rebar for structural strength. To provide insulation between the iron rebar and the electrolysis process, the concrete subfloor is overlaid with bricks. Over the years, the bricks became worn or broken and...