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 Freight Cars 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 freight car cyclical overhauls, betterments and rebuilds of freight cars 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 freight car issues be included in the examination plan? Cyclical overhauls of Freight Cars Freight Car Betterments Freight Car Rebuilds Facts: Background -the Fleet - there are nine basic types of freight cars: box, stock, refrigerator, flat, gondola, hopper, tank, special and caboose (obsolete). Variations include length, height, open or covered, lined or unlined, etc. Within car types, adaptations are made to suit customer/freight needs. For example, a simple flat car has no sides or ends and is suitable for a variety of loads without any modifications. However, to meet the demands of shippers, many designs exist. Among these are bulkhead flat cars, hooded flat cars, flat cars with racks, flat cars with tie downs, flat cars with well holes, and flat cars with depressed centers. Class I railroads own many of their cars and lease others. Regardless of whether owned or leased, each of the Class I's performs most of its own freight car maintenance. Nature of Work Performed: Cyclical Overhauls - Great variance exists in the work that is performed on freight car heavy maintenance1 visits. Unlike locomotives, freight cars do not have convenient "Class A" and "Class B" or "Class I" and "Class II "overhaul labels. As with locomotives, the work is performed on a cyclical basis, though the length of cycle generally has more variance. Cyclical maintenance on some freight cars may be performed at 7 - 8 years; but with others it may not occur until 10 - 12 years. Costs also vary greatly and are a function of car type. The level of expenditure that may be significant with respect to a flat car, may only take care of routine maintenance on a refrigerated car or a tank car. Each work project is different. Routine maintenance on trucks, brakes, draft gears and other mechanical components can be costly. Oftentimes, design flaws or repeated failures of key components dictate the cyclical shopping. For example, a particular box car series may have a latent defect in its doors that comes to light with age. As with locomotives, many projects conducted in heavy shop visits are properly expensed. Much of the difficulty in the examination of freight car projects thus lies in identifying those projects with potential capital improvement characteristics. Betterments - Over the years, many different types of betterments have been installed on freight cars. These generally result from technological breakthroughs or changes in safety standards. Examples include "end-of-train" devices which replaced the caboose; AEI tags, which enabled electronic monitoring of each car's location; and side screens on auto racks to protect new automobiles hauled by train. These types of betterments would typically be added during heavy maintenance visits. Rebuilds - the most extensive work performed in a heavy shop, short of building a new car, is the rebuild. The AAR provides financial incentives, in the form of increased car per diem rates, to encourage car rebuilds. The rebuilding of freight cars takes place much more frequently than complete rebuilds of locomotives. Rebuilds rise to the level of work described in Revenue Ruling 88-57 and beyond. They are always capitalized for regulatory accounting purposes. Regulatory Guidelines: STB - The STB's capitalization policies are covered at 49 CFR 1201 Subpart A Section 2 "Instructions for Property Accounts". Following is a summary of these concepts as relates to work performed by railroads on their cars. The "unit of property" concept dictates 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. Regulatory Guidelines: FRA - The Federal Railroad Administration addresses safety issues for the industry. Under 49 C.F.R. § 215.203, the operation of any railroad freight car that is more than 50 years old is restricted. The restrictions essentially prevent use of the car in interchange service with other railroads. No other FRA regulations provide any insight into freight car maintenance. The fifty year service life restriction would not prohibit a car from being used in dedicated service. As a practical matter, freight cars are not going to be used for fifty years unless they have been rebuilt at some point along the way. AAR Guidelines - Rebuilds - AAR Rule 88 provides that rebuilds are complete and comprehensive, and actually exceed the amount of work described in Revenue Ruling 88-57. Under AAR rules, Rule 88 rebuilds must be capitalized for book accounting purposes. Useful life - AAR Rule 107 controls inter-railroad handling of damaged or destroyed equipment for the industry. Like most AAR Rules, this rule provides a level playing field with respect to the interchange of equipment that takes place on a daily basis in the industry. Per the 2002 AAR Field Manual: "Rule 107. A. Purpose. The purpose of this rule is to provide an orderly sequence of events to compensate owners when equipment is damaged or destroyed." Stated differently, Rule 107 is used to make arms-length financial settlements between competing railroads. If railroad X damages or destroys railroad Y's freight car while it is in X's possession, the amount that X must pay Y is computed under this rule. In determining the settlement value, reproduction cost is first computed. From this figure is subtracted "Depreciated Value". The following table displays the rates used in computing depreciated value in the 2002 AAR Office Manual, Rule 107. It gives a good idea as to what the industry thinks about freight car life as of 2002. Type of Equipment Rate Years Tank, lined or non-corrosive built prior to 7/1/74 3.0% 33 Corrosive Tank Car 4.5% 22 Other cars built prior to 7/1/74 3.6% 28 All cars* built 7/1/74 or after 2.6% 38 * except unlined, corrosive Tank Cars 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, 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 freight car issue, agents should 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. The following criteria will be applied. All projects not involving "heavy maintenance" will be allowed as expense. Heavy maintenance projects conducted during the early stages of the any unit's rate study life will be allowed as expense A database of all other heavy maintenance projects containing the model, age, cost, and cost of work performed, including labor and materials, will be obtained for each year. Adjustments with respect to all other units will only be considered if a project meets the following criteria: (a) Direct cost is significant; and (b) Total cost of work is significant as compared to the car's FMV The rate study must be obtained in every case. In applying the rate study, if cars purchased used, or off lease, 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 car for representative samples of the freight car models worked, including the data supporting the FMV conclusions. Betterments: Betterments made as part of a capital project should be capitalized as well, consistent with Scenario 3 of Rev. Rul. 2001-04. Any stand alone betterment projects, that is, betterment projects that are not associated with any broader capital project, and not capitalized for book, should usually be ignored. Although stand alone betterments capitalized for book should be capitalized for tax, audit activity to identify and develop issues with respect to these should not be pursued unless the betterment itself is significant in relation to the car's FMV. Freight Car Rebuilds: A rebuild has a number of characteristics that distinguish it from cyclical maintenance or 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. The work performed in a rebuild is at least as extensive as that described in Revenue Ruling 88-57. AAR permits cars rebuilt under Rule 88 to use higher freight interchange rates, thus cars are more often rebuilt than locomotives. In some instances rebuilt cars have increased capacity over the original car. The identification of rebuilds and accompanying examination work requires 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 tax purposes, all Rule 88 or STB rebuilds will always be treated as a capital cost. For further information about development of freight car issues, contact the Railroad Technical Advisor.  “Heavy maintenance” gets its name from the railroad industry’s labels assigned to company operated shops. These run the spectrum from “running repair” shops, which perform minor maintenance on equipment while it is enroute to a destination; through heavy repair shops which perform planned, major overhauls, upgrades, and even rebuilds. For purposes of this paper the terms “heavy maintenance”, “cyclical overhauls”, and “cyclical maintenance” will be used interchangeably.  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).