Aluminum Smelting Company Argues Cost of Repairs Were Business Expenses

Vanalco is an aluminum smelting company and claimed a business expense deduction for the cost of replacing the cathode linings in its aluminum reduction cells which are necessary in the production of aluminum, as well as the costs incurred in repairing a portion of the brick floor of the aluminum plant's cell rooms. It asserted that the expenses constituted incidental repairs. The IRS determined that the costs were capital expenditures that must be amortized. The Tax Court agreed with the IRS and held that the cell relining costs were not deductible because they increased the value and useful life of the property. The Tax Court also agreed that Vanalco must capitalize its expenditures for floor repairs because the company repaired the floor with a different material and because the repairs were substantial and not incidental.

Vanalco maintains that the Tax Court failed to recognize that a cell is not a separate unit of property but is a mere part of the aluminum producing cell line. The company argues that the cell relining expense did not increase the value of the cell. Vanalco further insists that the repair to one component of the cell does not give the entire cell a new life expectancy. Vanalco emphasizes that the court also erred in rejecting its argument that the cell relining repairs did not appreciably prolong the life of the cell as a whole. Finally, the company argues that the cell room floor repairs did not materially add to the value of Vanalco's property and did not prolong the life of the floor.

The IRS argues that the cost of relining the smelting pots must be capitalized under section 263(a) because the work constituted the replacement of a major part of the pots and arrested their deterioration. The Service asserts that replacing portions of the plant's floor and its roof increased the plant's value; thus, those expenses must be capitalized.

[1] Pursuant to Federal Rule of Appellate Procedure 26.1, Appellant Vanalco, Inc. ("Vanalco") discloses that it has no parent corporation or subsidiaries, and no publicly held company owns 10% or more of the stock of Vanalco.

TABLE OF CONTENTS

I. INTRODUCTORY STATEMENT

[2] The Tax Court in this case misapplied 75 years of case law in holding that the costs incurred in the replacement of one part of a large, complex piece of industrial machinery cannot be deducted as an ordinary and necessary business expense under section 162 of the Internal Revenue Code.¹ In ruling that "the productive phase of [the machine's] cycle ends upon the exhaustion of [the part]," the Tax Court opened the door for the Commissioner of the Internal Revenue Service (the "Commissioner") to require capitalization of virtually every expense incurred in replacing a worn-out component of a larger machine. Memorandum Opinion ("Mem. Op.") at 18, Excerpts of Record ("E.R.") 216.

[3] The machine at issue is an aluminum producing machine known as a "cell line," which operates only when a group of over 100 individual "cells" is functioning together, linked by a shared electrical current. The part at issue is the lining of each cell (the "cell lining") that Vanalco replaced every three years on average with a new lining virtually identical to the original (pre- deteriorated) version. The new cell lining, like a new set of tires or an oil change in a car, creates no additional or improved functionality over the original version. It merely keeps the cell line and cell in efficient operating condition, just as the new tires or oil change do for a car.

[4] The Tax Court reached the erroneous conclusion that cell relining costs were not deductible by failing to apply the plain language of section 162 and the corresponding regulations, which authorize a deduction for the ordinary and necessary business expenses related to incidental repairs. Moreover, the Tax Court improperly applied the very test it described for determining whether an expenditure is deductible or is capital in nature:

[C]omparing the value, use, life expectancy, strength, or

[5] Instead of correctly applying the Plainfield-Union test, the Tax Court compared the life expectancy and value of the cell AFTER THE RELINING EXPENDITURE with the status of the cell AFTER the condition necessitating the expenditure occurred, i.e., after the lining had deteriorated. Because "any repair increases the useful life of property over what it would have had without the repair," Illinois Merchants Trust Co., Executor, 4 B.T.A. 103, 107 (1926), acq. 1926-2 C.B. 2, the courts have long rejected the approach taken by the Tax Court as it necessarily leads to the conclusion that the repair expenditure increased the life and value of the property. Had the Tax Court applied Plainfield-Union correctly, it would have concluded that the replacement of the cell lining did not materially increase the value of the cell (let alone the cell line), nor did it appreciably prolong the useful life of the cell (let alone the cell line).

[6] This case also involves the Tax Court's erroneous conclusion that Vanalco must capitalize its expenditures for repairing a portion of the floors in its aluminum plant, which required repair to prevent injury to Vanalco's employees. The Tax Court held that the floor repair expenses must be capitalized because Vanalco repaired the floor with a different material and because the floor repairs were "substantial," not "incidental." In so holding, the Tax Court misapplied the case law relating to floor repair expenditures because the portion of the floor repaired by Vanalco was not substantial enough to add materially to the value of the property, nor did the repair prolong the life of the plant floor.

II. STATEMENT OF JURISDICTION

[7] This appeal is taken from the United States Tax Court's final decision, which was entered on November 19, 2000 and incorporated the Tax Court's memorandum opinion of August 6, 1999. The Tax Court had subject matter jurisdiction based on 26 U.S.C. §§ 6213 and 7442, as a result of appellants' timely filing of a petition with the Tax Court on March 31, 1998. This Court has jurisdiction to review a decision of the Tax Court under 26 U. S.C. § 7482(a). Venue is proper in the Ninth Circuit because the principal place of business of Vanalco is within the State of Washington. 26 U.S.C. § 7482(b).

[8] Appellants Vanalco and its Tax Matters Person, Richard L. Smith, (collectively referred to herein as "Vanalco") filed a notice of appeal on January 19, 2000, within 90 days after the entry of the Tax Court's decision disposing of all claims of all the parties. E.R. 225. This appeal therefore is timely under Federal Rule of Appellate Procedure 13(a)(1).

III. STATEMENT OF ISSUES

[9] 1. Whether the Tax Court erred in ruling that the costs incurred in repairing cell linings used in the production of aluminum are not ordinary and necessary business expenses under section 162, even though the relining expenditures did not change the functionality or in any way 'increase the value of the property or prolong its life compared to the condition of the property before the cell lining required maintenance?

[10] 2. Whether the Tax Court erred in ruling that the costs incurred in repairing a portion of the brick floor of the aluminum plant's cell rooms are not ordinary and necessary business expenses under section 162, even though only a portion of the floor was repaired, and the repair did not materially add to the value of the property or prolong the life of the plant floor?

IV. STATEMENT OF THE CASE

A. NATURE OF THE CASE

[11] The case involves Vanalco's challenge to the federal income tax deficiency asserted by the Commissioner for the tax years ending December 31, 1992 and December 31, 1993. E.R. 1.

B. Proceedings and Disposition Below

[12] The deficiency at issue was asserted in a Notice of Final S Corporation Administrative Adjustment dated January 5, 1998. E.R. 8. The notice asserted that Vanalco had incorrectly deducted the following expenses: cell relining expenses ($4,411,245 for 1992 and $4,224,991 for 1993), floor repair expenses ($386,327 for 1992 and $408,154 for 1993), and roof repair expenses ($115,346 for 1992). Vanalco timely filed a petition for redetermination with the Tax Court on March 31, 1998. E.R. 226. The Commissioner answered the petition, and the parties subsequently entered a stipulation of facts. E.R. 27. The Tax Court set a briefing schedule calling for each party to submit an opening brief and a reply brief. The case, was decided by the Tax Court without a trial, pursuant to Tax Court Rule 122, based on the parties' briefs.

[13] Judge Carolyn Miller Parr of the United States Tax Court issued an opinion dated August 6, 1999, upholding the Commissioner's position that the cell relining costs must be capitalized under section 263 and that the floor repair costs also must be capitalized. E.R. 199. By contrast, Judge Parr ruled that the costs of repairing Vanalco's roof were deductible under section 162. Following the parties' submission of computations of the deficiency under Tax Court Rule 155, Judge Parr entered a final decision on November 19, 1999. E.R. 223. Vanalco timely filed a notice of appeal on January 19, 2000 relating to the cell relining and floor repair expenses. E.R. 225. The Commissioner did not file a notice of appeal of the decision relating to the roof repair expenses.

V. STATEMENT OF FACTS

A. VANALCO'S BUSINESS

[14] Throughout 1992 and 1993 (the tax years in dispute), Vanalco was in the business of smelting aluminum.² E.R. 30, Stipulation of Facts ("Stip.) ¶ 25. Vanalco's business is located in Vancouver, Washington. E.R. 27, Stip. ¶ 1. The plant was owned and operated by ALCOA (The Aluminum Company of America) from 1940 until 1987, when Vanalco purchased the facility. E.R. 33, Stip. ¶ ¶ 46-47. Vanalco is a Subchapter S corporation, which means that the corporation's income tax liability flows through to the corporation's shareholders. E.R. 28, Stip. ¶ 3; see 26 U.S.C. § § 1363, 1366.

B. THE PROCESS OF SMELTING ALUMINUM

[15] Although aluminum exists naturally in combination with other elements, it must be separated from those other elements to be commercially viable. E.R. 29, Stip. ¶ 14. Smelting is the process by which the aluminum is separated from other elements. Id. Smelting literally means to "melt or fuse (ores) in order to separate the metallic constituents." The American Heritage College Dictionary 1285 (3rd ed. 1997). The smelting process involves running an electrical current through aluminum oxide and carbon to separate the aluminum from the other elements. E.R. 30, 32, Stip. ¶ ¶ 28, 41.

[16] The central component of Vanalco's aluminum production equipment is the cell (also known as a "pot")³; as this is where the electrical current meets the aluminum oxide and carbon, and the separation or smelting occurs. E.R. 32, Stip. ¶ ¶ 39, 41. A cell is a large structure. One part of the cell is an oblong steel shell resembling an oversized dumpster approximately twenty-one feet, eight inches long; six feet, four inches wide; and three feet high. E.R. 33, Stip. ¶ 49; E.R. 188, Ex. 6-J, Tab 6 (photo of shell). In 1992 and 1993, Vanalco produced aluminum in 650 cells,, which are arranged in five "cell lines" of 130 cells each. E.R. 34, Stip. ¶ ¶ 54, 58. Cells do not operate independently, as Vanalco could not operate on a sustained basis without a minimum of 112 cells working together, absent substantial modifications to the electrical system. E.R. 34, Stip. ¶ 60. There is no evidence in the record that Vanalco substantially modified its electrical system during the years in question so that Vanalco could have operated on a sustained basis with any less than 112 cells linked together. The 130 cells in a cell line share the same electrical current. E.R. 34, Stip. ¶ 55, 58.

[17] The cell is not simply the steel shell, but has numerous other parts including: (1) the cell lining, (2) the flexible strap, (3) the ring bus, (4) the riser, (5) the carbon anodes, (6) the anode assembly, (7) the pot shield, (8) the anode clamp, (9) the ore bin, (10) the cradle, and (11) the superstructure. E.R. 36, Stip. ¶ 68; E.R. 182, Ex. 54 (drawing of end view cross section of one of Vanalco's cells). The anode assembly has multiple parts, including copper rods, steel stubs, bolts, nuts, and cast iron. E.R. 36, Stip. ¶ 68. The cell lining is primarily comprised of carbon cathode blocks, but also includes collector bars, silicate refractory brick, castable refractory, steel plate, insulation board, carbon sidewall blocks, carbon lining paste, and various nuts and bolts. E.R. 38, Stip. ¶ 72. The carbon cathode blocks in each cell lining consist of the following size blocks: 8 blocks that are 60" x 18" x 14"; 2 blocks that are 60" x 15" x 14"; 1 block that is 60" x 17" x 14"; 2 blocks that are 30" x 18" x 14"; and 2 blocks that are 30" x 17" x 14." E.R. 38, Stip. ¶ 74. Therefore, the total volume of the cathode blocks is roughly one-quarter the volume of the shell.⁴ The cell lining covers the bottom and much of the inside surfaces of the shell. E.R. 38, Stip. ¶ 71; E.R. 182, Ex. 5-j⁵ On the cell bottom, therefore, the cell lining is as long and as wide as the shell's interior. E.R. 182, Ex. 5-J. Although the exact height of the cell lining is not specified in the stipulation, the engineering drawing of the cell indicates that the depth of the lining on the shell's bottom is roughly two-thirds of the height of the shell.⁶ Id. Photographs of the cell lining at the final stage of relining-before the other parts of the cell are re-attached to the shell-show that the cell lining does not fill the whole interior of the shell. E.R. 196-97, Stip. Ex. 6-J (Tabs 14-15).

[18] Because the cell lining covers the bottom of the shell, which is about 22-feet long and six-feet wide, it is not literally "small." But in relation to the cell line as a whole,, a cell's lining is physically a very small component; even a single cell is several times greater in volume than its lining. E.R. 182, Ex. 5-J. Moreover, the cell lining is limited in function and not mechanically complex. E.R. 32, Stip. ¶ 39. Finally, as discussed more fully below, the cell lining is a minor economic contributor to the economic value of the cell, let alone of the whole cell line.

[19] It is important to keep in mind that the cell is not the same as the shell. The carbon anodes, anode assembly, riser, pot shield, ore bin, and the superstructure are additional parts of the cell that are substantial in size and that rise above the shell to a total height of 10 feet. E.R. 182, Ex. 5-J. The best illustration of the cell lining's physical contribution to the cell as a whole is the exhibit referred to above, Exhibit 5-J to the stipulation, a drawing of an end view cross section of one of Vanalco's cells, which Vanalco has copied on the following page for the Court's reference:

[20] The parts of a cell work together as follows. An overhead crane deposits the aluminum oxide into the hopper (also known as the ore bin), and then periodically, some of the aluminum oxide flows through the alumina feeder into the cell. E.R. 31, 35, Stip. ¶ ¶ 30, 34-35, 65; E.R. 182, Ex. 5-J. In the cell, the aluminum oxide is dissolved in a molten cryolite solution. E.R. 31, Stip. ¶ 30. An electrical current flows into the cell through the carbon anodes, passes through the cryolite solution, and separates the aluminum oxide into aluminum and oxygen. E.R. 32, Stip. ¶ 39. The current then flows into the carbon cathode blocks in the cell lining, flows out of the cathode blocks through collector bars into a riser, and then into the carbon anodes in the next cell in the line. Id. The electrical charge of the cathode is negative while the anode is positive, which results in the molten aluminum being attracted to the bottom of the cell, whereas the oxygen is attracted to the anode at the top of the cell. E.R. 32, Stip. ¶ ¶ 40-41. In addition to providing-the negative electrical charge, the cell lining protects the cell from having molten metal spill onto the plant floor. E.R. 38-39, Stip. ¶ 76.

[21] As in any manufacturing operation, parts of the equipment used by Vanalco require regular maintenance in order to keep the cell line operational. As is also typical, the individual parts have varying average lives, i.e., how long the part lasts before it is replaced. At one extreme, the shell, superstructure, ring bus, riser, and ore bin all have a life of over 50 years. E.R. 36, Stip. ¶ 68. At the other extreme, the carbon anodes have a 14-day life. Id. Somewhere in the middle are the cradle (26.4-year life), flexible strap (13-year life), and pot shield (10.4-year life). Id. The cell lining lasts for three years on average before it is replaced. Id. Based on a simple, unweighted average of all the parts' lives, the life of the cell as a whole is approximately 22 years.⁷

[22] As in any manufacturing operation, the cost of replacing each part in a cell varies dramatically. The cost of each part is important because it illustrates the relative economic or financial contribution of the respective parts to the whole cell. In 1992 and 1993, the cost of replacing the superstructure would have been $35,100; the cost of replacing the ring bus would have been $11,000; the cost of replacing the riser would have been $6,400; and the cost of replacing the ore bin would have been $3,000.⁸ E.R. 3 5, Stip. ¶ 65. Had every part in one cell been replaced it would have cost Vanalco $99,666, but the cost of replacing the cell lining alone was $17,993. Id.

[23] Taking into account the cost of each part relative to the other parts of the cell, and their average lives, the "weighted average life" of the cell as a whole is approximately 40 years. E.R. 37, Stip. ¶ 70. This alternate method of calculating the average asset life "weights" each part by using the following calculation (cost per part/total cost) x (average life per part). Id. ⁹ Because the cell lining represents just under 18% of the cell's total cost, its average life of three years is given a "weight" of just under 18%, thereby contributing 0.539 years (3.0 years x 18%) to the weighted average life of the cell. Id. By comparison, the superstructure, with an average life of 54 years and accounting for over 35% of the cell's total cost, contributes 19 years to the cell's weighted average life. Id. Indeed, taken together, the shell, ring bus, riser, and superstructure account for 34.762 years, or 87% of the cell's weighted average life, whereas the cell lining contributes a little over 1%. Id. This is what one would expect -- when a machine is viewed in economic terms, the long-lived parts with significant value contribute more to its economic life expectancy than do quite short-lived parts, even those with reasonably substantial value.

C. THE CELL RELINING PROCESS

[24] Vanalco monitored the status of its cell linings by regularly measuring the iron content of the aluminum in the cell and monitoring the voltage of the electrical current flowing through the cell. E.R. 38-39, Stip. ¶ 76. When the iron content increased above a certain level or the voltage varies from a designated level, it was time to replace the cell lining in order to ensure the efficient and safe operation of the cell line. Id. Vanalco did not wait until the entire lining was destroyed to replace it, but instead, typically replaced the cell lining when approximately 30% of the cathode blocks in the cell lining had eroded beyond recognition. E.R. 40, Stip. ¶ 78. If the cell lining is not replaced, the "pot will eventually rupture, spilling molten metal onto the floor." E.R. 39, Stip. ¶ 76.

[25] After determining that a cell lining needed to be replaced, Vanalco removed the individual cell from the line and removed certain parts of the cell, such as the carbon anodes, superstructure, and shields. E.R. 39, Stip. ¶ 78. After a period for cooling, Vanalco removed the aluminum metal from the cell. E.R. 40, Stip. ¶ 78. Next, the used cell lining was removed and the replacement cell lining installed. E.R. 40-41, Stip. ¶ 78. During the cell relining process, Vanalco repaired the shell, cradles, and superstructure if necessary. E.R. 40, Stip. ¶ 78. After installing the new lining in the old shell, Vanalco re-attached many of the original parts of the cell, including the ring bus, the superstructure, and the shields. E.R. 41-42, Stip. ¶ 78. New anodes were attached, as these parts were replaced every two weeks. E.R. 36, 42, Stip. ¶¶ 68, 78. Once it re-attached all the parts of the cell, Vanalco "baked" the new lining and cathode blocks for about 48 hours before it put the cell back into operation in the cell line. E.R. 42, Stip. ¶ 78.

[26] The cell relining process averaged 15 days before the cell was returned to the line. E.R. 42, Stip. ¶ 81. Out of its 650 cells, Vanalco replaced the cell lining in 206 cells in 1992 and 192 cells in 1993. E.R. 42, Stip. ¶¶ 82-83. Vanalco employed a cell lining crew of 22 to 26 workers to accomplish its cell relining. E.R. 42, Stip. ¶ 79. For 1992, Vanalco incurred $4,411,245 in cell relining expenses and for 1993, $4,224,991 in cell relining expenses, which Vanalco deducted for federal income tax purposes as ordinary and necessary business expenses under section 162, and which the Commissioner contends are capital expenditures. E.R. 28-29, Stip. ¶¶ 10-11. The total amount of cell relining expenses at issue includes (1) the cell lining installation costs; (2) the cell lining removal costs; and (3) miscellaneous other expenses. E.R. 35-36, Stip. ¶¶ 65-67.

D. THE FLOOR REPAIR

[27] Prior to 1991, the floors in Vanalco's cell rooms were entirely covered with brick, which lay over a concrete subfloor with rebar. E.R. 46, Stip. ¶¶ 107-08. Over time, the brick floors wore unevenly, causing an unsafe situation for Vanalco's workers. E.R. 47- 48, Stip. ¶¶ 111, 113. The uneven floor caused turned ankles and falls, wobbling ladders, and even a life- threatening electrical hazard from the brick being so worn down in places that it no longer served as an insulator from the concrete rebar. Id.

[28] In 1992 and 1993, Vanalco replaced a portion of its brick floors with Fondag cement. E.R. 46-47, Stip. ¶ 110. Vanalco chose Fondag cement for its floor surface primarily because it becomes electrically nonconductive in a shorter time period than brick. E.R. 48, Stip. ¶ 116. That is, it sets far more quickly than brick or regular cement and, therefore, causes less interruption in the manufacturing process. E.R. 48, Stip. ¶¶115-16. Fondag is also easier to clean and repair than brick. Id. In 1992, Vanalco repaired the floor in the center passage of 6 of its 10 cell rooms and in the side (or "tap end") of 3 of its cell rooms at a total cost of $386,327. E.R. 46-47, Stip. ¶ 10. In 1993, Vanalco repaired the floor in the center passage of 2 of its 10 cell rooms and at the tap end of 4 of its cell rooms at a total cost of $408,154. Id. It is undisputed that "[t]he bulk of the expenditures were for tap end repairs." E.R. 47, Stip. ¶ 110. The third and final area of the cell rooms-the duct end-was not repaired in any of Vanalco's 10 cell rooms during the years in question. E.R. 45-47, Stip. ¶¶ 104, 110. For federal income tax purposes, Vanalco deducted the floor repair costs as ordinary and necessary business expenses under section 162, which the Commissioner contends are capital expenditures.

VI. SUMMARY OF ARGUMENT

[29] With respect to the cell relining expenditures, the Tax Court made the following errors of law: (1) failing to conclude that the property at issue is the aluminum producing cell line, not the cell, which cannot function independently; (2) failing to conclude that the cell relining expenses did not materially increase the value of the property, when compared to the condition of the property prior to the deterioration of the cell lining, where the new cell lining did not enhance the functionality of the property and the cost of replacing the cell lining is low compared to the cost of replacing all the parts in a cell; (3) deciding that the repair to a component with a 3-year life gives the entire cell a new life expectancy, where the cell's average life is at least 20 years; (4) failing to conclude that the cell relining expenses did not appreciably prolong the life of the cell as a whole, even though the cell's average life is at least 20 years; and (5) to the extent it did so implicitly, basing its decision on the "factor" that the expenses must be capitalized if they provided Vanalco with a benefit beyond one year.

[30] In addition, the Tax Court made an error on a mixed question of law and fact in deciding that the cell lining is a "very substantial" portion of the cell as a whole, where the cell lining is not a very large contributor to the whole cell, whether measured in physical size, economic importance or functionality. To uphold the decision would be to uphold the Commissioner's increasingly aggressive posture on capitalization after INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992), for which the Commissioner has been severely criticized. See, e.g., PNC Bancorp, Inc. v. Commissioner, 212 F.3d 822, 824-25 (3rd Cir. 2000).

[31] With respect to the floor repair expenses, the Tax Court made the following error of law: concluding that the floor repairs were so substantial that capitalization was required, where Vanalco repaired only a portion of its floors and, thus, the costs neither materially added to the value of Vanalco's property nor appreciably prolonged the life of the original plant floor.

VII. ARGUMENT

A. STANDARD OF REVIEW

[32] In general, this Court reviews decisions of the Tax Court on the same basis as a decision rendered by the United States District Court in a bench trial. Estate of Rapp v. Commissioner, 140 F.3d 1211, 1214 (9th Cir. 1998); Condor Int'l, Inc. v. Commissioner, 78 F.3d 1355, 1358 (9th Cir. 1996). The Tax Court's factual findings are reviewed for clear error. Estate of Rapp, 140 F.3d at 1215. The Tax Court's conclusions of law and construction of the Code are reviewed de novo. Id. In this case, where the parties stipulated to the facts in the Tax Court proceedings, this Court reviews de novo the Tax Court's application of the law to the stipulated facts. Sennett v. Commissioner, 752 F.2d 428, 430 (9th Cir. 1985); see also Pahl v. Commissioner, 150 F.3d 1124, 1127 (9th Cir. 1998); Melvin v. Commissioner, 894 F.2d 1072, 1074 (9th Cir. 1990); Stem v. Commissioner, 747 F.2d 555, 557 (9th Cir. 1984). Mixed questions of law and fact are also subject to de novo review. Moss v. Commissioner, 831 F.2d 833, 838 (9th Cir. 1987).

[33] In Moss, this Court reviewed de novo the issue presented in this case -- whether certain expenses incurred by a taxpayer were deductible under section 162 or must be capitalized under section 263. Id. at 837-38. A recent decision by the Third Circuit also confirms that the issue of whether expenses are deductible under section 162 is a question of law subject to de novo review. PNC Bancorp, 212 F.3d at 827 ("[W]e have plenary review over the Tax Court's findings of law, including its construction and application of the Internal Revenue Code.").

[34] The Tax Court in this case erroneously stated that "[w]hether an expenditure may be deducted or must be capitalized is a question of fact." Mem. Op. at 16, E.R. 214 (citing INDOPCO, 503 U.S. at 86 (1992); Norwest Corp. v. Commissioner, 108 T.C. 265, 280 (1997); Plainfield-Union, 39 T.C. at 337-38). A review of these three cases reveals that the citations do not support the proposition for which the Tax Court offered them. The Supreme Court in INDOPCO merely noted that, in interpreting section 162, "each case 'turns on its special facts.'" 503 U.S. at 86 (quoting Deputy du Pont, 308 U.S. 488, 496(1940)). The Norwest decision indeed states that whether an expenditure is deductible is a question of fact, citing Plainfield- Union, but the decision in Plainfield-Union provides no support for the statement by the Tax Court in Norwest or in this case. Like most legal issues, the issue of deductibility versus capitalization depends on the facts of the case, see INDOPCO, 503 U.S. at 86, but when the facts are stipulated, the issue before this Court is a legal one -- the application of the undisputed facts to the Code, regulations, and case law regarding what type and level of expenses are deductible.

B. THE STATUTORY AND REGULATORY SCHEME RELATING TO THE

[36] Here, Vanalco's business is smelting aluminum. If Vanalco did not replace its cell lining when the iron content in the molten aluminum rose above a certain level, the smelting process was no longer efficient and, unless corrected, the cell would eventually rupture, molten metal spill onto the floor, and the cell would become inoperable. The Commissioner did not -- and cannot -- contend that the relining expenses or the floor repair expenses were not "ordinary and necessary" in Vanalco's aluminum smelting business. There is no question that it was necessary for Vanalco to incur the cost of relining the cells in order to maintain the operation of the smelting process. Similarly, there is no question that it was necessary for Vanalco to repair certain areas of worn-out brick floor in order to mitigate the possibility of an accident that could hinder the smelting process. The relining expenses were ordinary in Vanalco's business in the sense that they occurred regularly; Vanalco was typically in the process of lining eight to ten cells. And the floor repair expenses were ordinary as it is normal or usual for a business to attempt to prevent its employees from being injured. Unsurprisingly, the Tax Court did not hold that Vanalco's cell lining costs or its floor repair costs were not "ordinary and necessary" in Vanalco's business.

[37] The Tax Court based its decision, instead, on Treasury Department regulations that flesh out the meaning of section 162 as applied to repair expenses. The regulations specifically provide that deductible business expenses include expenses for "incidental repairs." 26 C.F.R. § 1.162-2 (2001). The regulations lay out the type of repairs that are deductible:

The cost of incidental repairs which neither materially add

Repairs in the nature of replacements, to the extent that they

[38] Under the plain language of the Code and the corresponding regulations, therefore, whether an expense may be deducted as an incidental repair generally turns on five issues: (1) what is "the property" being repaired or replaced, (2) whether the expense materially adds to the value of that property, (3) whether the expense appreciably prolongs the life of the property, (4) whether the expense adapts the property to a new or different use, and (5) whether the expense is part of a general plan of rehabilitation.

C. VANALCO'S ARGUMENTS TO THE TAX COURT AS TO WHY THE CELL REFINING COSTS ARE DEDUCTIBLE AND THE TAX COURT'S DECISION

[39] Vanalco argued below that its cell relining expenses were not of the nature or magnitude necessary to trigger capitalization. Specifically, Vanalco argued as follows on the five issues: (1) the property repaired was the entire line of 130 cells that operates as an integrated unit of production and certainly not just the lining of an individual cell, but even if the property is considered an individual cell, a current deduction is permitted; (2) cell relining expenses did not materially add to the value of the cell as it was before the lining deteriorated; (3) cell relining expenses did not appreciably prolong the life of the cells; (4) cell relining expenses did not adapt the cell to a new use; and (5) cell relining expenses were not part of a general plan of rehabilitation. The Commissioner conceded the fourth and fifth issues in its reply brief below, acknowledging that the relining expenses did not convert the property to a different use and that, if the property at issue is the cell, the cell relining expenses were not part of a general plan of rehabilitation.

[40] As to the three disputed issues raised by Vanalco, the Tax Court failed to address any of them directly, but rather concluded that the "cell lining is an essential and substantial component without which the cell cannot function," and, therefore, the replacement of the cell lining gave each cell "a new life expectancy of 3 years." Mem. Op. at 18, E.R. 216. Although the cell cannot function without a cell lining, this fact alone should not require capitalization because the cell cannot function if it is without any of its component parts, nor can the cell line function without a minimum of 112 cells operating together. In reaching this decision, the Tax Court misapplied the long-standing Plainfield-Union test by comparing the condition of the cells after the linings needed to be repaired with the cells' condition after the linings had been repaired. The Tax Court's decision cannot be supported by the Code, the regulations, or the legion of case law upholding current deductions of expenses for repairs that did not increase the value of the property or appreciably prolong its life relative to its pre- need-of-repair condition. See, e.g., Libby & Blouin, Ltd. v. Commissioner, 4 B.T.A. 910 (1926), acq. 1927-1 C.B. 4.

[41] Moreover, the Tax Court failed to analyze the cases cited by Vanalco, expressly stating that the court "shall not attempt to harmonize the decided cases." Mem. Op. at 16, E.R. 214. Although cases concerning the distinction between deductible repairs and capital expenditures inevitably involve "an exercise of line drawing," see Badger Pipe Line Co. v. Commissioner, 74 T.C.M. (CCH) 856, 859 (1997), it is the court's job to draw that line by analyzing the facts of the case presented in light of prior cases on the same issue. The Tax Court further erred in failing to apply the overriding principle that emerges from the cases involving repairs to components of large manufacturing equipment: "[e]xpenditures for small parts of a large machine, in order to keep that machine in an efficient working condition . . . are . . . ordinary and necessary expenses and are not capital expenditures." Libby & Blouin, 4 B.T.A. at 914. The Tax Court's decision is an incorrect application of the law to the stipulated facts of this case. And to the extent that the Tax Court inferred from the undisputed facts that the cell lining is not a relatively minor contributor both physically and economically to the cell, let alone the cell line as a whole, the decision is clearly erroneous.

1. THE TAX COURT ERRED IN FAILING TO RECOGNIZE THAT A CELL

[43] Without directly responding to Vanalco's argument on the issue of what is the property under repair, the Tax Court commented that "the difference between the cell lining as a separate asset and as a substantial and essential component is one of semantics, not substance." Mem. Op. at 17, E.R. 215. The issue is substantive, however, because of the "small parts of a large machine" standard articulated in Libby & Blouin. If the cell line -- 130 cells operating together -- is the property, then the two cell linings generally being repaired at any given time in 1992 and 1993 were a very small physical and economic component of that property.¹¹ But even if the individual cell is considered the property, the cell lining is still a relatively small physical and economic component of that cell.¹²

[44] The recent case of Ingram Indus. Inc. v. Commissioner, 80 T.C.M. (CCH) 532 (2000), is instructive on the issue of what is considered the "property" under repair. The case involved costs incurred in a barge transportation business, specifically the costs for regularly cleaning and inspecting engines of towboats. The Tax Court rejected the Commissioner's contention that the engines should be treated separately from the towboats, i.e., the Commissioner's contention that the engine -- not the towboat -- was the property under repair. Id. at 538. The Tax Court noted that the towboats were purchased with engines and that the engines were not treated separately from the towboats by the taxpayer or those in the barge transportation business. Id. at *26; see also Badger Pipe Line Co., 74 T.C.M. (CCH) at 859 (considering the disruption to petitioner's "entire pipeline system" in determining whether costs for relocation of 1,000 feet of pipeline out of 25 miles of 16-inch pipeline in a 335-mile pipeline system were deductible). So too, the cell lining is not treated separately from the cell by Vanalco. The cell lining cannot function by itself. Nor can an individual cell. Therefore, the cell lining is simply a part of the whole cell line, which should be treated as the property for the purpose of the deductibility analysis.

[45] If this Court determines that the cell line is not the property, then this Court should conclude that the property at issue is the cell itself. The cell lining cannot function independently of the many other working parts in a cell and, therefore, at a minimum, the property being repaired is the cell. The cases support the conclusion that the property at issue is the cell line or the cell. In Libby & Blouin, the Board of Tax Appeals held that the copper tubes used in a sugar manufacturing machine known as an evaporator were "not in any sense separate units but were mere parts of one machine." 4 B.T.A. at 914. Similarly, in Berkley Mach. Works & Foundry Co. v. Commissioner, 36 T.C.M. (CCH) 733 (1977), rev'd on other grounds, 623 F.2d 898 (4th Cir. 1980), the Tax Court viewed the wheelabrator machine used for blast cleanings of castings in a foundry as the property under repair, not the various component parts that needed to be replaced for the machine to stay in efficient operating condition.

[46] Although it is logically and legally compelling that the property at issue is the whole cell line, the result is the same if the property is an individual cell. Thus, for the remainder of this brief, Vanalco assumes for the sake of argument that a cell is considered the "property" for the purpose of determining whether the relining expenses materially increased the value of the property or appreciably prolong the useful life of the property.

2. THE TAX COURT ERRED IN FAILING TO CONCLUDE THAT THE CELL

[48] The principle is well established that replacing worn-out parts of an industrial machine does not materially increase the value of the machine. See Berkley, 36 T.C.M. (CCH) at 746. The description of the wheelabrator machine involved in Berkly could be used to describe a Vanalco cell: "[b]y the nature of the work it performs, a wheelabrator is a SOMEWHAT SELF-DESTRUCTIVE MACHINE and it requires the replacement of liners and various component parts to stay in efficient operating condition." Id. at 740 (emphasis added). In Berkley, the Tax Court held that the replacement parts "did not materially increase the value of the machine." Id.

[49] As acknowledged by the court in Plainfield-Union, "any properly performed repair adds value as compared with the situation existing immediately prior to that repair," 39 T.C. at 338, so every repair would require capitalization if the sole measure of deductibility were an increased property value post-repair as compared to the value when it needed repair. The "proper test" for deductibility is therefore, "whether the expenditure materially enhances the value . . . as compared with the status of the asset prior to the condition necessitating the expenditure." Id. The phrase, "the condition necessitating the expenditure," is clarified in the subsequent sentence in the Plainfield-Union decision: "Comparing THE PERIOD BEFORE TUBERCULATION and after expenditure, we see that the useful life of the Maple Avenue main was not increased by the cleaning and lining and that neither the strength nor the capacity of said main was enhanced." Id. (emphasis added).

[50] Tuberculation is the production of iron oxide, which damaged the lining of the water pipes operated by the water company in Plainfield-Union after the company switched from well water to more acidic river water. In other words, tuberculation was the condition or the damage that necessitated the repair of cleaning and lining the utility's pipes with cement. The water company was allowed to deduct its repair even though it arguably resulted in an improved functionality, namely the improved ability to handle more acidic river water.

[51] Here, the condition that necessitated the cell relining repairs in 1992 and 1993 was the wearing-out of the material in the cell lining over time. The proper application of Plainfield-Union to the facts of this case requires comparing the value of a cell before THE LINING WORE OUT and the cell's value AFTER IT HAS BEEN RELINED. The only reasonable answer to this question is that the relining expenses did not increase the value of the cells. There is no dispute that, after relining, the cell looks no different, is no stronger, no better, no more functional, or in any way materially different than it was before the cell lining deteriorated. In other words, after a cell was relined in 1992, the cell was just as functional -- but no more so -- than it was after the last relining was done. Thus, the relining process merely puts the cell back to the condition it enjoyed before its lining deteriorated.

[52] Unlike the Tax Court in this case, the court in Jacks v. Commissioner, 55 T.C.M. (CCH) 968 (1988), properly applied Plainfield-Union. Jacks owned a construction company, which purchased a five-year-old 70-ton CAT loader for $40,000. Six years later, its transmission malfunctioned so that "the loader would not move when the reverse gear was engaged. To fix the transmission, petitioner purchased for $17,500 a used transmission for a CAT loader." Id. at 970. The Tax Court held that the cost incurred in purchasing the used transmission was deductible because it did not increase the value of the CAT loader, even though the "new" used transmission functioned properly whereas the original used transmission did not function properly. Had the Tax Court in Jacks used the same reasoning as the Tax Court below, the result certainly would have been that a functioning transmission was more valuable than a non-functioning transmission. However, the Tax Court in Jacks concluded that comparing the property as a whole pre-damage and post-repair, the loader had essentially the same value because at each of those times, it "still had a used transmission." Id. at 970. Here, before the lining has deteriorated and after the lining was replaced, the cell had the same value because at each instance, the cell still had the same type of lining that performed exactly the same function in exactly the same way in the smelting process.

[53] In determining whether a particular expenditure increases the value of the property to the point that it must be capitalized, the courts consider two factors: (1) whether the expenditure enhances the functionality of the property and (2) the cost of the expenditure relative to the cost of replacing the entire piece of property. In Plainfield-Union, the court held that the expenditures at issue did not need to be capitalized because they did not increase the functionality of the pipe main by enhancing the strength or capacity of the main. 39 T.C. at 338. This aspect of the Plainfield-Union decision was followed in the Tax Court's recent Ingram Indus. case, in which the court held that the expenses for maintaining the engines in the towboats did not need to be capitalized because the repairs did not improve the functionality of the towboats. 89 TCM (CCH) at 536 ("A towboat's horsepower is not increased, nor is its use or ability changed, as a result of the procedures.").

[54] In this case, the cell's functionality was not improved, nor was its use or ability changed, as a result of the new lining. A relined cell does not produce any additional quantity or improved quality of aluminum compared to the cell that was originally placed in operation. A relined cell has exactly the same appearance, function, properties, and value as a cell before the lining deteriorated. Vanalco's cell relining process "only restores value to the property that existed prior to deterioration." See Dominion Resources, Inc. v. United States, 219 F.3d 359, 371 (4th Cir. 2000) (holding expenses for environmental cleanup of asbestos in power plant not deductible in part because the property had not deteriorated; the asbestos dated to the original construction of the property).

[55] It is noteworthy that the Tax Court made no finding that the process of cell relining created a substantial functional improvement over the original linings, or that the new linings made the property more valuable to Vanalco. The Tax Court made no such ruling with respect to the cell relining costs because nothing in the record would support it. The cells that were relined in 1992 and 1993 provided no more functionality than the original cells. The Tax Court did not conclude otherwise and therefore erred in failing to rule that the expenses for relining were ordinary and necessary.

[56] That the new cell linings did not increase the value of the cells is also supported by Libby & Blouin. In that case, the Board of Tax Appeals determined that the replacement of 2400 copper tubes in the sugar evaporator every two to four years did not add value to the evaporator, "except such value as was added by the fact that the machine was kept in an efficient condition." 4 B.T.A. at 914. The value of keeping the machine in an efficient condition was not sufficient to require that the expenses be capitalized. Id.

[57] Other than increased functionality, cases holding that a particular expenditure must be capitalized because of an increased property value often turn on the cost of the expenditure relative to the cost of the property as a whole. For example, the Fourth Circuit recently made the following analysis on the factor of relative costs:

[T]he cost of the environmental cleanup, $2.2 million, may have

[58] In contrast to the facts of Dominion Resources, LaSalle Trucking, and Jacobson, Vanalco's cost of replacing the cell lining was less than one-fifth of the cost of replacing all the parts in a cell. E.R. 35, Stip. ¶ 65. Even if this Court considers the additional cost of $5,401 per cell to remove the used lining before installing the new lining, the cost of replacing all the parts of the cell would still dramatically outweigh the cost of removing and replacing the lining. E.R. 36, Stip. ¶ 67.

[59] Instead of examining the cost of replacing the cell lining in relation to the cost of replacing all the parts of a cell, the Tax Court examined the cost of replacing the cell linings in the abstract. Mem. Op. at 18, E.R. 216 (noting that the cell lining process is an "expensive, time-consuming procedure"). Whether the repair is "expensive" or "time-consuming" to such an extent that capitalization is required depends on the nature of the business. Viewed in context, the cell relining costs are not that extraordinary relative to the cost of replacing all the parts in a cell. In the context of an aluminum smelting operation on the scale operated by Vanalco, a two-week repair period is not that extraordinary. See Rev. Rul. 2001-4 ($2 million cost for 45-day heavy aircraft maintenance visit, disassembling much of the aircraft, repairing and replacing certain parts, and performing preventive maintenance is deductible).

[60] Because the new linings offer no new functionality to the cell and because of the relatively low cost of replacing the lining compared to the cost of replacing all of a cell's parts, the Tax Court erred in failing to conclude that the relining expenses do not materially increase the value of the cell.

3. THE TAX COURT ERRED IN DECIDING THAT THE REPAIR TO ONE

[62] The facts of Ruane are distinguishable from Vanalco's, the critical difference being that one of Ruane's ovens had an original useful life of approximately three to four years, which was how often the taxpayer in that case renovated the property. See Ruane, 17 T.C.M. at 871 ("According to normal experience, an oven would last from three to four years.") Id. The rebuilding in Ruane was essentially a replacement of the entire oven, as the decision does not indicate that any significant long-lived parts continued in use. In contrast, here the cell lasts far longer than the cell linings. The arithmetic average life of the components of the cell as a whole is approximately 22 years. The weighted average life of the cell is approximately 40 years.¹⁴ The cell lining contributes only 1% of this weighted average life.¹⁵ In light of the stipulated fact that five parts of a cell last for OVER 50 YEARS, the Tax Court erred in concluding that the replacement of only one short- lived part of a cell gave the entire cell a new life.

[63] The relative average lives of Vanalco's cell and cell lining make this case closer to the facts of Libby & Blouin, which involved the replacement of certain tubes with a two-to four-year life in a machine with a 20-year life. The Libby & Blouin court concluded that because the evaporator machine lasts for 20 years, the replacement of the tubes after two to four years "does not prolong the life of the evaporator." 4 B.T.A. at 912. The Ingram Indus. case also has similar facts to this case: the towboat engine had an expected life of 40 years, but the "towboat engine would not likely realize its anticipated useful life if the procedures in question were not performed periodically." 80 TCM (CCH) at 536.

[64] Likewise, in Vanalco's case, if the cell lining was not periodically replaced, the cell as a whole would not realize its anticipated useful life. If the Tax Court were correct that the cell as a whole received a new life expectancy of three years every time the lining was replaced, it would lead to absurd results-a car would have a new life expectancy every time it gets an oil change or a new set of tires. The reality is that no matter how many times the cell lining is replaced, the cell as a whole will have no greater useful life than its original useful life. When the longer-lasting parts of the cell, such as the superstructure, ore bin, ring bus, riser, and shell, eventually wear out, relining the cell without replacing those parts will not make the cell usable. In the same manner that the regular replacement of the tubes in the sugar evaporator or the periodic maintenance on the towboats kept those machines in ordinary, efficient, working condition for their expected life or the changing of oil in a car allows the car to reach its expected useful life, the periodic replacement of the cell lining kept each cell in its ordinary, efficient working condition during the cell's expected life. Accordingly, the cell relinings costs should be deducted rather than capitalized.

4. THE TAX COURT ERRED IN REJECTING VANALCO'S ARGUMENT THAT

[66] First, and as stated above, the Plainfield-Union test requires that this Court examine whether the expenditure at issue appreciably prolonged the life of the property when compared to its original useful life -- here before the cell lining has deteriorated. In determining that the cell relining gave the cell a "new life expectancy," the Tax Court incorrectly applied the Plainfield-Union test by comparing the life of the cell lining after it has been replaced with the life of the cell lining after the lining has deteriorated. The relevant "life" of the property is the property's "probable, normal, useful life." Illinois Merchants Trust, 4 B.T.A. at 107. The normal life of the cell as a whole is far greater than three years and, therefore, the Tax Court erred in determining that the relining process gave the cell as a whole a new life expectancy.

[67] Second, the Tax Court's decision that the cost of replacing "essential" parts must be capitalized proves too much because it would authorize the Commissioner to require capitalization of the expenses for replacing any working part of a larger machine, no matter how short the part's life relative to the machine as a whole. In this case, it would authorize the Commissioner to require capitalization of the expenses for replacing the carbon anodes in a cell, which Vanalco does every two weeks. A cell cannot function without these anodes, yet the Commissioner has never required Vanalco to capitalize the cost of replacing these parts.

[68] To uphold the decision would be to sanction and encourage the Commissioner's increasingly aggressive posture on capitalization after INDOPCO, in which the Supreme Court held that certain expenses incurred by a target corporation in the course of a friendly takeover were not deductible under section 162. The Commissioner's post- INDOPCO positions have been criticized by at least one federal court of appeals and numerous commentators. See PNC Bancorp, 212 F.3d at 824-25 ("[s]ee, e.g., W. Curtis Elliott Jr., Capitalization of Operating Expenses After INDOPCO: IRS Strikes Again, S.C. Law., Sept./Oct. 1993, at 29, 30 (commenting on the IRS's 'recently aggressive posture on capitalization' after INDOPCO, and noting that while the INDOPCO decision itself was not 'necessarily troubling,' the IRS's interpretation of it has stretched far beyond the scenario presented in INDOPCO); IRS Loses Battle in INDOPCO War: Advertising Remains Deductible, Taxes on Parade, July 16, 1998, at 1 (describing the IRS's INDOPCO-fueled juggernaut.')."

[69] Third, the decision that the cell relining expenses must be capitalized because the cell lining is a "very substantial" component of the cell is factually and legally wrong to the extent that the Tax Court determined that the lining is not a relatively small physical and economic component of the cell. The Tax Court failed to cite to the record or provide any numerical evidence to support its statement that the cell lining is a "very substantial portion of the cell unit." Mem. Op. at 17, E.R. 215. The Tax Court's finding that the cell lining is a "very substantial" component is a clearly erroneous inference from the stipulated facts.

[70] The record shows that the cell lining is minor, both in economic and physical terms, in relation to the cell as a whole. The cell lining contributes only approximately 1% to the weighted average life of the cell as a whole. Physically, the cell lining constitutes only a relatively minor part of the overall cell structure. E.R. 182, Ex. 54 (drawing of cell). The drawing indicates that the volume of the cell lining is roughly a quarter of the cell as a whole. The cathode blocks in the cell lining are only 14 inches thick, with additional components adding to the overall thickness of the cell lining, but THE CELL AS A WHOLE rises 10 feet high. E.R. 38, Stip. ¶ 72, 74; E.R. 182, Ex. 5-J. The cell as a whole includes the numerous substantial parts that he on top of the shell, such as the anodes, pot shield, riser, superstructure, alumina feeder, and ore bin. E.R. 182, Ex. 5-J. The Tax Court may have determined the relative size of the cell lining by comparison only to the shell, which is an inaccurate comparison because several other parts of the cell rise two times above the height of the shell.

[71] The cases establish that the size of a part should be viewed in relation to the size of the machine as a whole: "Expenditures for small parts of a large machine, in order to keep that machine in an efficient working condition" do not appreciably prolong the life of the property. Libby & Blouin, 4 B.T.A. at 914. What is a "small" part is relative. Id. A small part of a machine used in manufacturing might be considerably larger than a small part in a laptop computer. In Libby & Blouin, the part considered "small" was actually four feet long. In Vanalco's case, the cell lining is not that substantial in size in relation to the cell as a whole, E.R. 182, Stip., Ex. 5-J, and, just as importantly, it is a minor economic contributor to the whole cell, constituting only about 1% of the weighted average life of the cell.

[72] Although there are apparently no decisions from this Court interpreting Libby & Blouin, the Tax Court relied on a Second Circuit decision that in turn relied on Libby & Blouin. See Buffalo Union Furnace Co. v. Helvering, 72 F.2d 399 (2nd Cir. 1934). Buffalo Union Furnace Co. involved whether the taxpayer, an iron-founder, properly deducted a "relining reserve" to cover the expense of lining its furnaces when it occurred. Id. at 401. The furnace linings lasted on average from between two to two and a half years before they needed to be replaced. In Buffalo Union Furnace Co., the court read Libby & Blouin as permitting a deduction where the repair is "too small an incident, too regularly repeated in the life of any large factory," to require capitalization. Id. at 402. By contrast, the Second Circuit determined that the furnace lining expenditure in question was of such a magnitude that it required capitalization. Id.

[73] Unfortunately for future litigants and courts interested in analogizing to or distinguishing from this case, the Buffalo Union Furnace Co. opinion by Judge Learned Hand contains no specific details about the period of time for which the furnace was under repair, the cost of replacing the entire furnace in relation to the cost of the repair, or the expected average life of the furnace parts other than the repaired portion. This lack of factual development to support the court's conclusion that the furnace linings needed to be capitalized may explain why the Tax Court here also cited Buffalo Union Furnace Co. by a "cf." citation. Without the facts to support the conclusion, Buffalo Union Furnace Co. cannot be relied on, and, in any event, the case is not binding on this Court. Further, the limited facts provided show that the entire interior of the property under repair (the furnace) was replaced, whereas here although much of the interior of the SHELL is replaced, the entire interior of the cell is not replaced in the cell relining process. See E.R. 196-97, Stip. Ex. 6-J (photographs at Tabs 14-15).

5. TO THE EXTENT THAT THE TAX COURT BASED ITS DECISION ON

D. VANALCO'S ARGUMENTS TO THE TAX COURT AS TO WHY THE FLOOR

[76] The Tax Court concluded that the floor expenses had to be capitalized under section 263. The Tax Court reasoned that the floor repairs provided a "substantial functional improvement" over the brick and "made the property more valuable to Vanalco in its business, because the Fondag cement enabled Vanalco to effect faster repairs and to use mechanical cleaning devices, in addition to increasing the safety of its employees. Mem. Op. at 20-21, E.R. 218-19. The Tax Court futher concluded that the "substantial nature of the replacements during the years at issue tends to prove that they were more than incidental repairs." Mem. Op. at 19, E.R. 217.

1. THE TAX COURT ERRED IN CONCLUDING THAT THE FLOOR REPAIRS

a. THE CELL ROOM FLOOR REPAIRS DID NOT MATERIALLY ADD

[79] The lesson of these cases is that replacing an entire floor or roof usually adds material value to the property such that the cost of the new floor must be capitalized. But repairing only a portion of a floor by the addition of some new flooring material does not materially add to the value of the property and therefore is deductible. Here it is undisputed that only certain relatively small areas of the plant floor were repaired in 1992 and 1993. In 1992, the center passage of six of the ten cell rooms and the tap end of three of the cell rooms were repaired, and, in 1993, the center passage of two of the cell rooms and the tap end of four cell rooms were repaired. E.R. 46-47, Stip. ¶ 110. The center passage is the center area (lengthwise) of the cell room through which the cells run down in the cell line. E.R. 45-46, Stip. ¶ 104. (The exact size of the center passage is not contained in the stipulation.) The tap end of the cell room is only 21-25% of the size of the cell room as a whole. E.R. 46, Stip. ¶¶ 104, 105. It is undisputed that "[t]he bulk of the expenditures were for tap end repairs." E.R. 47, Stip. ¶ 110. The third and final area of the cell rooms -- the duct end -- was not repaired in any of Vanalco's 10 cell rooms during the years in question. E.R. 45-47, Stip. ¶¶ 104, 110.

[80] The Tax Court cited only one case involving floor repairs to support its decision requiring capitalization. Mem. Op. at 20, E.R. 218 (citing Phillips & Easton Supply Co. v. Commissioner, 20 T.C. 455, 460 (1953)). But that case is easily distinguishable. In Phillips & Easton Supply Co., the taxpayer had deducted the costs of "replacement of the entire floor, excepting 225 square feet in the rear of the building" and the 225 square foot area not replaced "represented only a small and minor part of the entire floor area." 20 T.C. at 460 (emphasis added). By contrast, here the repairs were only to certain relatively minor areas of the massive cell room floors: in 1992, to the center passages in six cell rooms, three of the rooms' tap ends, and zero of the rooms' duct ends. The 1993 repairs were to only two of the rooms' center passages, four of the rooms' tap ends, and zero of the rooms' duct ends. Vanalco's floor repairs are far from a replacement of the entire floor in the cell rooms and not even close to half of the entire floor -- the standard for capitalization suggested in the Farmers Creamery case.

[81] If this case were about the repair to a linoleum floor in a large manufacturing facility and some linoleum became damaged and had to be replaced, there would be no doubt that the expenses of that project would be deductible. That is essentially this case. The brick floor in discrete areas of the cell rooms became damaged, and it was repaired with Fondag cement. It is hardly an entirely new floor, but more like the replacement of the damaged pieces of linoleum with a different type of linoleum.

[82] Vanalco could have removed and replaced the entire brick floor in its cell rooms, but it did not, choosing instead to repair the damaged portions of floor. Like Vanalco, the taxpayer in Hudlow chose not to completely remove and replace its deteriorated concrete floor, insulation, and subfloor, choosing instead to "remove the bad spots of the floor and pour concrete over what remained." 30 T.C.M. (CCH) 894 at 921. The court in Hudlow distinguished the floor repair expenditures at issue from Phillips & Easton Supply Co. because the taxpayer in Hudlow did not do "a complete restoration of the floor." Id. at 923. Applying Plainfield-Union, the Tax Court in Hudlow concluded that because "the increment in value . . . was only that which always follows from the performance of a properly done repair," the expenditures were deductible. Id. at 922. So too, in this case, the floor repair expenditures merely restored Vanalco's floor to its pre-deteriorated condition, in which the floor was safe for Vanalco's employees and operated as an insulator.

[83] The material Vanalco used to replace the broken bricks in the floor is a fast drying cement called Fondag. Vanalco acknowledges that this product has certain advantages over brick, the most important being that Fondag is electrically nonconductive in a shorter period than brick. E.R. 48, Stip. ¶ 116 ("Fondag is electrically non-conductive in 24 hours v. 7 days or longer for brick (this being THE MOST IMPORTANT REASON to use Fondag for the repairs . . . . ")) (emphasis added). In other words, it took less time for Vanalco to resume normal smelting operations after repairing the floor areas with Fondag as opposed to brick. This difference between Fondag and brick did not affect the basic functioning of the floor in terms of the cell room floor's purpose in the aluminum plant. E.R. 46, Stip. ¶ 109. Moreover, the use of a different material in a repair does not itself mean that the expense must be capitalized. See, e.g., Badger Pipeline Co., 74 T.C.M. (CCH) at 859 ("Regardless of whether the 1991 pipe is of better quality or has a longer life than the materials used in constructing the 1968 pipeline, we are satisfied that the Route 83 relocation, given its limited scope, did not materially add to the value of the pipeline or appreciably prolong the life of the 1968 pipe."). The appropriate inquiry is whether the extent of the floor repairs was so great that the repair expenditures materially added to the value of the property as a whole. Under the undisputed facts of this case, the limited extent of the floor repairs in 1992 and 1993 was such that the floor repair costs did not materially add to the value of Vanalco's plant.

b. THE CELL ROOM FLOOR REPAIRS DID NOT PROLONG THE

VIII. CONCLUSION

[85] For the foregoing reasons, this Court should reverse the decision of the Tax Court and remand with instructions to enter a decision in favor of Vanalco that the cell relining and floor repair costs are deductible business expenses.

DATED: September 28, 2001.

[86] Pursuant to Ninth Circuit Rule 28-2.6, Vanalco states that it is not aware of any related case pending in this Court.

CERTIFICATE OF COMPLIANCE

[87] Pursuant to Ninth Circuit Rule 32(e)(4), I certify that the Brief of Appellants Vanalco, Inc. and Richard L. Smith is proportionately spaced, has a typeface of 14 points and, according to the word-processing system used to prepare the brief, contains 13,319 words.

Date 09/28/01 Signature of Filing Party [signed]

[88] I, June Starr, certify that on September 28, 2001, I caused to be delivered by overnight courier (Federal Express), two copies of Brief of Appellants Vanalco, Inc. and Richard L. Smith and one copy of Appellants Vanalco, Inc. and Richard L. Smith's Excerpts of Record to Annette M. Wietecha, Esq., U.S. Department of Justice, Tax Division, Appellate Section, 601 D Street, Room 7037, Washington, D.C. 2004.

[89] I also caused to be delivered by overnight mail (Federal Express) the original and fifteen copies of Brief of Appellants Vanalco, Inc. and Richard L. Smith and five copies of Appellants Vanalco, Inc. and Richard L. Smith's Excerpts of Record on the Clerk of the Ninth Circuit Court of Appeals at 95 Seventh Street, San Francisco, California 94103-1526.

JUNE STARR

² Subsequent to the Tax Court's decision and in approximately December 2000, Vanalco suspended its aluminum smelting operations pending renewed stability in energy prices. Vanalco is currently a debtor in possession in bankruptcy proceedings pending in United States Bankruptcy Court for the Western District of Washington, Cause Number 00-40285.

³ For consistency, Vanalco uses the terms "cell line," "cell," "cell room," and "cell lining" throughout the brief, which Vanalco considers identical in meaning to "pot line," "pot," "pot room," and "pot lining," respectively.

⁴ The volume of the cathode blocks is 189,840 cubic inches, whereas the volume of the empty shell (260" x 76" x 36") is 711,360 cubic inches. E.R. 33, 38, Stip. ¶ ¶ 49, 74.

⁵ The drawing, Exhibit 5-J, identifies the "pot lining" and cathode blocks as separate items in the cell, but the cathode blocks are considered a part of the "cell lining" in the parties' stipulation. E.R. 38, Stip. ¶ 72. The drawing was reduced from its original size.

⁶ The two-thirds estimate is supported by an estimate of the cell lining height at 25 inches, which may be calculated by adding the thickness of the tallest cathode blocks (14"), the height of the two layers of refractory fire brick (2.5" thick each), and the height of the two layers of TR-19 insulation (3 " each). ER. 38, 41, Stip. ¶ ¶ 74, 78(1).

⁷ The average life of the cell was calculated by adding the average lives of the parts of a cell (26.4 + 53.8 + 3.0 + 13 + 59.0 + 59.0 + 0.0 + 5.0 + 1.0 + 4.1 + 0.5 + 0.3 + 10.4 + 5.3 + 54.0 + 54.0 + 32.0 = 380.8) and dividing by the number of parts (17). E.R. 36-37, Stip. ¶ 68.

⁸ None of these items was replaced in 1992 or 1993. E.R. 35, Stip. ¶ 65, n.*.

⁹ The "weighted average life" of the cell was determined by adding the "weighted" average lives of all the parts of the cell and dividing by the number of parts. E.R. 37, Stip. ¶ 70.

¹⁰ The Stipulation of Facts to the Tax Court provided that "[r]eference to the words 'repair' or 'replace' should not be construed as an admission relating to the legal characterization of the work performed." E.R. 27. Similarly, Vanalco suggests that its use of the terms "repair" or "replace" in this brief should not be construed as an admission.

¹¹ Because 8-10 cell linings are being repaired at any given time and Vanalco uses 5 cell lines, roughly 2 cell linings per cell line will be under repair at any given time. E.R. 34, 42, Stip. ¶¶ 61, 84.

¹² If the cell lining itself is considered a separate unit of property and not a part of a larger machine, the question is almost answered in favor of the Commissioner before the analysis is begun. Therefore, such an assertion is nonsensical on its face.

¹³ We conclude that the Tax Court "apparently" based its decision on Ruane because the Tax Court cited Ruane by a "cf." citation and did not directly quote from Ruane for its use of the phrase "a new life expectancy." Mem. Op. at 18-19, E.R. 216-17.

¹⁴ See infra up. 13-14 and note 9 for a description of the term "weighted average life."

¹⁵ See infra pp. 13-14.