DEPARTMENT OF THE TREASURY INTERNAL REVENUE SERVICE WASHINGTON, D.C. 20224 LARGE AND MID-SIZED BUSINESS DIVISION MEMORANDUM FOR DIRECTORS, FIELD OPERATIONS, HMT DIRECTOR, FIELD SPECIALISTS DIRECTOR, PRE-FILING AND TECHNICAL GUIDANCE FROM: John Petrella, Jr. /s/ John Petrella, Jr. Industry Director, Heavy Manufacturing and Transportation SUBJECT: Field Guidance on the Planning and Examination of the Cyclical Overhauls, Betterments, and Rebuilds of Locomotives For Class I Railroads DATE: 03-04-05 The purpose of this memo is to provide guidance to examiners in the planning and examination of locomotive cyclical overhauls, betterments and rebuilds of locomotives for Class I railroads. This LMSB Directive is not an official pronouncement of the law or the position of the Service and cannot be used, cited or relied upon as such. Issue: In what circumstances must the following locomotive issues be included in the examination plan? Cyclical overhauls of locomotives Locomotive Betterments Locomotive Rebuilds Facts: Background - Nature of Work Performed: Practices vary greatly among Class I railroads for maintaining and overhauling their locomotive fleets. Unlike an aircraft air frame or engine, a locomotive and its internal components are not rated or evaluated by a regulatory standard or empirical measurement. A locomotive comprises a number of parts, principally the chassis, prime mover, main generator, trucks, traction motors and electrical system. Each Class I derives its own best method of determining when overhauls must be performed. Some use mileage, some use hours, and some use more subjective factors. Regardless of these differences, a new high horsepower locomotive in heavy-haul service on a Class I railroad will substantially consume its major components over a five to seven year period, during which the unit will have logged approximately one million miles. To prevent recurrent breakdowns and/or destruction of the locomotive, Class I's must routinely perform an overhaul of a locomotive's engine, generator/alternator, compressors, traction motors and a multitude of other smaller components after this five to seven year period. During this "heavy maintenance visit", or overhaul, these components are restored to new condition consistent with the technology of their original manufacture, but with predominantly used and rebuilt parts. While the need for this work on a cyclical basis is a given, the manner in which it is conducted varies from railroad to railroad. Some Class I's conduct the overhaul on a preventative basis, component by component, at the same time as routine repairs and maintenance are performed. Others conduct the locomotive overhaul on a planned cycle using the wear of the engine component as the determinant, and still others follow a "run to failure" approach. As these locomotives move through their service life, the maintenance cycles are repeated; but with each additional cycle, an increased amount of work is conducted. For example, the locomotive's chassis needs little work at its first cycle, but by the third, some modernization may take place along with body work and repainting. As another example, much more extensive work on the trucks is required in the third cycle than the first. Oftentimes labels are assigned by companies to their heavy maintenance work. Such designations as Class A / Class B overhauls, or Class I / Class II overhauls are used. These classes distinguish as to degree of work performed. For example, the engine block may not be reworked in a Class B overhaul but is completely rebuilt in a Class A overhaul. To avoid down time, all Class I railroads maintain an inventory of previously rebuilt components, referred to by the Service as rotable parts. If the referenced Class A overhaul is performed, the engine can be immediately replaced with a rebuilt one from inventory. In this document, the phrase Class A1 overhaul will be used to refer to an overhaul where the engine is removed and completely rebuilt, or replaced with rebuilt. While horsepower can seldom be increased, as technology changes, to the extent possible, upgrades (betterments) are conducted at these cyclical maintenance visits (or in between these overhauls depending again on the preferred practice). Some examples of betterments are included later in this directive At times, a Class I will determine an older series of locomotives is sufficiently valuable to warrant a much more extensive degree of work, referred to as a rebuild. A rebuild is a still more substantial amount of rehabilitation work that can easily exceed $500,000 per locomotive. Often rebuilds are performed by contract shops or manufacturers, and are costly enough that they are financed. The degree of work performed includes more new parts than the overhauls and always includes substantial betterments. For regulatory purposes, STB requires rebuilds to be capitalized. Useful Life: As with any cyclical maintenance issue, the question of useful life is critical, and difficult to ascertain. As described below, STB mandated information can be used to determine useful life. Regulatory Guidelines - STB - The STB's capitalization policies are covered at 49 CFR 1201 Subpart A Section 2 "Instructions for Property Accounts". The following is a summary of these policies as it relates to work performed by railroads on their locomotives. The "unit of property" concept dictates the STB's capitalization guidelines for overhauls, betterments, and rebuilds. STB specifies that each freight car and locomotive is a unit of property. Under instruction 2-8, when a unit of equipment property is added to the plant, capitalization is required. Similarly, under instruction 2-12, units of property rebuilt or converted are capital improvements. Betterments are addressed at Instruction 2-9: "...When an item of road or equipment property, other than a complete unit, is added to the plant, and the addition is not a replacement, the cost thereof shall be treated in the same manner as an addition of a complete unit." All other equipment maintenance such as replacements of components and overhauls are also covered by this instruction: "...When an item of property other than a complete unit is replaced, independent of the unit of which it is a part, the cost of replacement shall be treated as maintenance and charged to operating expenses. If the replacement constitutes an improvement then the cost of replacement should be accounted for as a rebuilding expenditure under Instruction 2-12." STB - Useful Life - For regulatory purposes, the Class I railroads are required to conduct depreciation studies on their equipment on a periodic basis. These studies are performed by an independent consultant. The depreciation studies are an accurate estimate of useful life not only for regulatory but also for tax purposes because they are based on the Iowa Curve methodology. The life that this study yields is known as the "average service life". This average service life is determined through a relatively complicated, but quite reliable and accurate actuarial method called the Retirement Rate Method, also known as the Annual Rate Method in Iowa Curve publications. This method is commonly used for lifing assets and its results are widely accepted by statisticians and lifing experts. STB uses the results of the studies to insure that the railroads maintain an adequate depreciation reserve. The STB R-1 report, filed annually with the STB, Schedules 332 and 340, contains a composite rate for locomotives that is derived from the rate studies. Book Treatment of Costs - Rebuilds, betterments, and overhauls: General Rule - The Class I's usually follow regulatory for book purposes. Whether an overhaul is an improvement for STB purposes depends on the policy and practices of individual railroads. Betterments - Since these are required to be capitalized for regulatory purposes, they are usually capitalized for financial purposes as well. Betterments are generally handled on an AFE. Rebuilds - Since these are required to be capitalized for regulatory purposes, they are usually capitalized for financial purposes as well. These too are handled on an AFE. Heavy Maintenance (Overhauls) - Book accounting follows regulatory; but as shown above, STB capitalization of locomotive overhaul costs is controlled by the particular railroad's interpretation of two subjective concepts. First, the railroad must believe that the work performed rises to the level of a "replacement". Second, even if the work does equate to a replacement, the railroad will only capitalize it "if the replacement constitutes an improvement". For these two reasons, there is great variability among the Class I's as to which overhauls are capitalized for regulatory and book purposes. In general, Class B overhauls are typically not capitalized while Class A overhauls at times are. Law: There is a great deal of guidance on capitalization, unit of property and repair versus improvement. Cases such as Lehigh Valley Railroad Co. v. Commissioner, B.T.A.M. (P-H) Para. 39381 (1939), West Virginia Steel Corp., 34 T.C. 851 (1960), W.C. Hudlow, Jr., T.C. Memo. 1971-218, La Salle Trucking Co.v. Commissioner, T.C. Memo. 1963-274, FedEx Corp. v. United States, 291 F.Supp. 2d 699 (W.D. Tenn. 2003), aff'd, No. 03-6514, 2005 WL 372309 (6th Cir. Feb. 16, 2005), to name a few. In addition Rev. Rul. 2001-04 is instructive on heavy maintenance of aircraft. These can all be looked to for legal interpretations of the Regulations. Regarding useful life, a number of court cases have commented on and accepted the "Iowa Curve method", which the railroads use for regulatory and book purposes. In fact, Burlington Northern Inc. v. United States, 230 Ct. Cl. 102, 676 F.2d 566 (Cl. Ct. 1982), discusses most of the cases that preceded it that involved Iowa Curves. The life developed from the Iowa Curves was accepted in all of the cases preceding the Burlington case, and the Burlington case did not criticize those earlier decisions. A more recent case that supports the use of Iowa Curves is Citizens and Southern Corp. v. Commissioner, 91 T.C. 463 (1988). Although it doesn't mention the Retirement Rate Method by name, the description of the method in that case appears identical to the Retirement Rate Method, and the court accepted it "carte blanche". Audit Requirements: Cyclical Overhauls: In auditing the locomotive issue, agents are required to compare the factual situations to those described in Revenue Ruling 2001-04 and apply similar analysis in characterizing the costs as deductible or capital. The technical advisor team can provide IDRs for use in development of this issue as described below. The criteria for projects to be examined are: "Class B" overhauls, where only the engine power assemblies are rebuilt, will be allowed as expense. "Class A" overhauls conducted in the early stages of a unit's rate study life, will be allowed as expense. All other Class A overhauls will be analyzed. A database containing the model, age, cost basis, and cost of work performed before overheads will be obtained for each year. From this information, adjustments will only be considered if the locomotive model worked meets the following criteria: Class A engine overhaul performed, and Total cost of work is significant as compared to the FMV of the locomotive. The rate study must be obtained in every case. Note: if used locomotives are being shopped, the built date, or rebuilt date if applicable, should be used, not the acquisition date. Issue development - Where all of the above criteria are met, in addition to any other information requested for the issue, every case must obtain the following: A description of the work performed during the overhaul; A list of and description of any betterments2 made during the overhaul; The estimated FMV of the locomotive for representative samples of the models worked, including the data supporting the FMV conclusions. Betterments: Though betterments are often handled within the cyclical work, to the extent they are not, a separate analysis of the area is warranted. Two factors facilitate the ease of this audit area: the STB requirement that betterments be capitalized for regulatory purposes; and the use of AFEs for significant stand alone betterments. Consistent with Rev. Rul. 2001-04, significant betterments will be capitalized, whether stand-alone or in conjunction with the cyclical overhaul section above. Audit of this area should be limited to the installation of significant betterments, such as radial trucks, also known as high adhesion trucks and on-cab communications control equipment, also known as LOCOTROL or distributed power. Separate activity to identify small dollar betterments should not be pursued. Locomotive Rebuilds: A rebuild has a number of characteristics that distinguish it from cyclical maintenance/overhauls. Under a rebuild program, the unit is rebuilt using major components that are new as opposed to the inspection, repair and re-qualification of existing components. In many cases rebuilt units enter the program as one model (for example an EMD SD40), are rebuilt to meet a higher specification standard with upgraded components, and are returned to service with a new model designation (such as an EMD SD40-2 in this example). Generally, the work performed in a rebuild is equal to, and often exceeds the work described in Situation 3 of Rev. Rul. 2001-04. The work described in Rev. Rul. 88-57 regarding freight car rebuilds is similar to that performed in locomotive rebuilds. AAR statistics indicate, however, that only 555 locomotives were rebuilt by Class Is between January 1, 1997 and December 31, 2002. The identification of rebuilds and accompanying examination work require minimal resources as they are identified in STB R-1 Schedule 710S, are always conducted under the AFE process, and are also identified in the UMLER file. For more information on rebuilds, contact the railroad technical advisor. For tax purposes, a rebuild will always be treated as a capital cost. For further information about development of locomotive issues, contact the Railroad Technical Advisor.  This terminology is not used by each railroad, but as stated earlier, is intended herein to refer to a complete engine overhaul, one that requires removal of the engine, and includes reworking the block. The railroads have an inventory of rebuilt engines available for immediate placement into the locomotive for Class A type overhauls. Class B type overhauls are generally conducted with the engine in place, with most of the work being replacement of the power assemblies.  For this purpose, the term betterments is used in the context of Situation 2 of Revenue Ruling 2001-04, wherein additions and upgrades in the form of fire protection, air phone and ground proximity warning systems were capitalized because they materially improved the airframe. (See also the IDR on betterments).