A recent decision by the Federal Circuit in Hewlett-Packard Co., 12/7/95, held that rotable Spare parts used in a company's computer repair business were depreciable capital assets. This decision is consistent with that of the Tax Court in Honeywell, Inc., TC Memo 1992-453, aff'd per curiam, 8th Cir., 1994. In both cases, the IRS contended that the rotable spare parts were inventory and that it had the authority to require the use of inventory accounting in order to clearly determine income.
Both Honeywell and Apollo (Hewlett-Packard had acquired Apollo) maintained pools of rotable spare parts to facilitate their computer repair businesses. Rotable spare parts are kept by the manufacturer to be used when repairing computers that have failed. A service technician will use the parts to replace original parts suspected of malfunctioning in the customer's computer. The malfunctioning parts are then repaired and returned to the pool of spare parts. The pool of rotable spare parts is discarded at the end of the service life of the related line of computers.
In a typical arrangement, the taxpayer enters into service maintenance contracts with its customer. The maintenance contract requires the taxpayer to repair the customer's computer if it malfunctions during the maintenance period. While at the customer's location, a service technician may replace a number of parts for diagnostic purposes in order to determine which part has failed. In doing so, the service technician may replace original parts that have not failed in addition to the parts that have failed with parts from the pool of rotable spares. The service technician then brings the original parts back to the service facility, where they are tested, repaired, if needed, and returned to the pool of rotable spare parts. The customer is not charged a specific amount for the replaced parts and usually is not aware that parts have been replaced.
The Service had taken the position that rotable spare parts maintained by the manufacturer to service customer-owned equipment are properly treated as inventory, and that under Sec. 471, the IRS has the authority to require inventory accounting. Classified as inventory, the parts would not be depreciable, or (as in the cited cases) would not be eligible for the investment tax credit. In a coordinated issue paper, the Service has stated that rotable spare parts held exclusively to service equipment leased to customers may be treated as capital assets; however,...