Press Room: Tax Release

August 04, 2011

Depreciation Issues Addressed for Computer-Based Equipment & Cellular Telephone Asset Classes

The Tax Court considers depreciable lives appropriate for a cellular telephone business that did not exist when the activity based asset class groupings were developed in 1987 and concludes on the important question of what constitute “computer-based”assets.  These conclusions may present opportunities to taxpayers.

Summary

The Tax Court in Broz v. Commissioner rejected the activity based asset classes used to determine depreciable lives for certain cellular assets.  While Rev. Proc. 2011-22 provides safe harbor depreciation methods for many of the same cellular assets based on industry representations as to the nature of the equipment, the conclusions in Broz as to what assets are “computer-based” may conflict with those industry representations and therefore impact the assets eligible for Rev. Proc. 2011-22 safe harbors.  IRS indicates informally that the Broz asset classifications should be applied by qualifying taxpayers that have not adopted the Rev. Proc. 2011-22 safe harbors.  Look for the conclusions on computer-based assets to be applied outside the cellular industry.

The Tax Court’s Conclusion

The Tax Court, in Broz v. Commissioner, 137 T.C. No. 3 (2011), considered the appropriate depreciable lives of cellular network assets, concluding that most switch, cellular, antenna support, cell site and leased digital equipment is ten and fifteen year depreciable property under Rev. Proc. 87-56.  In addition, the Court concluded that equipment does not become computer-based merely because the equipment contains computer parts.  Instead, the Court looked at the function of the equipment and whether the computer parts included a processor and extensive memory.  It is this conclusion with respect to the definition of computer-based equipment that may be most significant because it is an issue that impacts taxpayers both within and outside the cellular industry.  The case also provides guidance on determining appropriate asset classes for equipment used in industries that did not exist when the activity-based asset system was established in 1987.

Rev. Proc. 2011-22 – Safe Harbor Methods of Cellular Equipment

While the Broz case was being litigated, IRS was working with the cellular industry to develop safe harbor depreciation methods for cellular network assets.  These safe harbor methods were announced in Rev. Proc. 2011-22.  The Broz decision impacts the application of Rev. Proc. 2011-22 safe harbors by restricting the definition of assets that qualify as “computer-based” and are eligible for the 5-year recovery period afforded computer-based switching equipment.  IRS indicates informally that Broz is the correct application of the law for cellular companies that either do not qualify for or do not adopt the safe harbors in Rev. Proc. 2011-22.

The Planning Opportunity

To the extent that cellular taxpayers have used shorter depreciable lives than those permitted by Broz and have not changed to the safe harbor methods in Rev. Proc. 2011-22, there is an opportunity to file a Form 3115 under Rev. Proc. 2011-14 to change to the lives permitted by the Tax Court in Broz or to change to one or more of the safe harbor methods permitted by IRS in Rev. Proc. 2011-22.  Both method changes will provide back-year audit protection to a qualified taxpayer.  A method change under either Rev. Proc. 2011-14 or 2011-22 could result in tax savings by permitting a prospective change with a 4-year spread for unfavorable adjustments or one year for a favorable adjustment.

Details of the Broz decision

In Broz, the taxpayer had grouped its cellular network assets into categories.  The positions of the parties (and the winner on the issues) are summarized in the chart below.

The Court held for IRS on all counts, basing its conclusion on its construction of the appropriate asset classes for cellular telephone equipment under Rev. Proc. 87-56 as clarified by the FCC Uniform System of Accounts (USOA) in effect on January 1, 1986 -- in this case the 1986 revision to the USOA.  After analyzing the nature of the equipment in each of the asset groupings used by the taxpayer, the Court provided the following rationale for its conclusions:

  • It is irrelevant that asset class 48.32 provides a life closer to the actual life of the antenna support structures because both the description of the assets contained in Rev. Proc. 87-56 and the USOA category dictate use of asset class 48.14.
  • While some parts of the cell site equipment consist of computer parts, the key component of the base station and the cell site equipment is the radio which is not a computer.  Again, both the description of the assets in Rev. Proc. 87-56 and the USOA category dictate use of asset class 48.12.
  • The types of equipment in the leased digital equipment category mirror the assets in the analog equipment categories and therefore are depreciated, depending on the type of asset, over five, ten, or fifteen years.  The court rejected the taxpayer’s argument that all of the digital equipment is computer based telephone switching equipment.
  • Finally, the court did not permit the taxpayer to depreciate the digital equipment before the year 2000 when it was first put into actual use even though it had been acquired and installed in an earlier year so that it would be ready for use soon after the FCC mandated switch to digital.

In reaching a decision on what constitutes computer equipment, the court chose to focus not on the presence of computer parts but on the primary purpose of the equipment, whether the computer parts were ancillary or necessary for the intended function and whether the computer parts had computer processing capability or extensive storage.  Because radios have functioned for years without computer parts and the radio computer parts did not include processors or extensive storage, the court concluded the computer parts were only ancillary.

The court indicates other issues will be addressed in one or more future opinions of the court.