Opinion
Docket Nos. 106473 111869 15992 15994 15995 15996 15997.
1950-03-13
UNION PACIFIC RAILROAD COMPANY, PETITIONER, ET AL.,* v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
Joseph F. Mann, Esq., Frank E. Barnett, Esq., and Arthur Z. Gray, Esq., for the petitioners. Walt Mandry, Esq., for the respondent.
1. Railroad company keeping its books on an accrual basis, held, required to accrue as income in taxable years interest on bonds owned by it even though payment of part of interest due in those years was deferred and was received by it in later years.
2. Pursuant to a court-approved plan (For the Modification of Interest Charges and Maturities‘ of funded debt of B. & O.R.R. Co., bonds of that company owned by Union Pacific were modified in 1940. Held, a recapitalization and a reorganization under section 112(g) resulted, and no gain or loss was recognized under section 112(b)(3); held, further, the basis for gain or loss upon B.&O. bonds sold by Union Pacific in 1941 is cost. Mutual Fire, Marine & Inland Insurance Co., 12 T.C. 1057, followed.
3. Petitioners, on the retirement method of accounting for depreciation, during taxable years retired and wrote off specific assets which had been acquired prior to 1913. Held, under section 113, calling for ‘proper‘ adjustment to basis for depreciation, petitioners are not required to make adjustment for pre-1913 depreciation. Los Angeles & Salt Lake Railroad Co., 4 T.C. 634, followed. Joseph F. Mann, Esq., Frank E. Barnett, Esq., and Arthur Z. Gray, Esq., for the petitioners. Walt Mandry, Esq., for the respondent.
The respondent determined deficiencies in income and declared value excess profits taxes as follows:
+---+ ¦¦¦¦¦ ++++¦ ¦¦¦¦¦ +---+
Declared value Docket No. Year Income tax excess profits tax 106473 1934 $101,920.71 ------------- 1935 173,259.58 ------------- 1936 115,384.41 ------------- 1937 65,962.23 ------------- 111869 1938 49,019.74 ------------- 1939 76,505.58 ------------- 15992 1941 424,381.76 ------------- 15994 1941 ---------------- $208.08 15995 1941 ---------------- 4,004.95 15996 1941 ---------------- 14,153.48 15997 1941 ---------------- 3,423.29 Total 1,006,434.01 21,789.80
The petitioner in Docket No. 15992 claims an overpayment for the year 1941.
The cases were consolidated for hearing and were submitted on the pleadings, a stipulation of facts to which were attached certain exhibits, exhibits introduced at the hearing, and a supplemental stipulation of facts filed subsequent thereto.
Many issues raised by the pleadings have been settled by stipulation. The parties have also stipulated that, in the event the B.&O.R.R. bond issue is decided in favor of the petitioners, certain adjustments are to be made with respect to the basis of the bonds and with respect to the reallocation of accrued interest on the bonds. Effect will be given to these stipulations in the computation under Rule 50.
The four issues remaining are as follows:
(1) Whether the petitioner, Union Pacific Railroad Co., should accrue as income in the years 1938 and 1939, or in later years, certain interests on bonds of the Lehigh Valley Railroad Co.
(2) Whether the modification of the terms of Baltimore & Ohio Railroad Co. bonds, pursuant to a bond adjustment plan dated August 15, 1938, resulted in a taxable exchange in the year 1940.
(3) Whether the aggregate of the adjusted bases of the individual units of ways and structures charged to taxable income in a particular year upon retirement thereof in that year must be reduced by depreciation sustained prior to March 1, 1913, on such of those individual units as were acquired prior to that date. This issue is common to all dockets involved herein and will be sometimes referred to hereinafter as the ‘pre-1913 depreciation issue.‘
(4) Whether the decision of this Court in Los Angeles & Salt Lake Railroad Co., Docket No. 106462, promulgated January 30, 1945, and reported at 4 T.C. 634, is res judicata as to the pre-1913 depreciation issue in all the dockets herein involved.
FINDINGS OF FACT.
We find the facts to be as stipulated and as alleged and admitted in the pleadings.
GENERAL FACTS.
Union Pacific Railroad Co. (hereinafter called ‘Union Pacific‘) was at all times hereinafter mentioned and still is a corporation of the State of Utah, with an office at 120 Broadway, New York, New York. Union Pacific is the petitioner in Docket Nos. 106473, 111869, and 15992, which involve the consolidated income tax liability of Union Pacific and its affiliated railroad companies for the years 1934-1937, 1938-1939, and 1941, respectively.
Oregon Short Line Railroad Co. (hereinafter called ‘Short Line‘), the petitioner in Docket No. 15995, was at all times pertinent hereto a corporation of the State of Utah and one of the Union Pacific's affiliated railroad companies, all of its stock being owned by Union Pacific.
Los Angeles & Salt Lake Railroad Co. (hereinafter called ‘Salt Lake‘), the petitioner in Docket No. 15997, was at all times pertinent hereto a corporation of the State of Utah and one of Union Pacific's affiliated railroad companies, one-half of its stock being owned by Union Pacific, and one-half by Short Line.
Oregon-Washington Railroad & Navigation Co. (hereinafter called ‘Navigation Co.‘), the petitioner in Docket No. 15996, was at all times pertinent hereto a corporation of the State of Oregon and one of Union Pacific's affiliated railroad companies, all of its stock (except directors' qualifying shares) being owned by Short Line.
The St. Joseph & Grand Island Railway Co. (hereinafter called ‘Grand Island ‘), the petitioner in Docket No. 15994, was at all times pertinent hereto a corporation of the State of Kansas and Nebraska and one Union Pacific's affiliated railroad companies, approximately 99 per cent of its stock being owned by Union Pacific.
Short Line, Salt Lake, Navigation Co. and Grand Island share the office of Union Pacific at 120 Broadway, New York, New York.
At all times pertinent hereto the accounts of Union Pacific, Short Line Salt Lake, Navigation Co. and Grand Island were kept on the accrual basis.
The consolidated income tax returns of Union Pacific and its affiliated railroad companies for the years 1934, 1935, 1936, 1937, 1938, 1939, and 1941 were filed with the collector of internal revenue for the second district of New York.
The declared value excess profits tax returns of Grand Island, Short Line, Navigation Co., and Salt Lake for the year 1941 were filed with the collector of internal revenue for the second New York district.
Lehigh Valley Railroad Co. Bond Interest.
At all times pertinent hereto Union Pacific owned $605,000 face amount of general consolidated mortgage 4 1/2 per cent bonds of Lehigh Valley Railroad Co., due May 1, 2003.
On August 25, 1938, Lehigh Valley Railroad Co. notified Union Pacific and other holders of its bonds that because of decreases in business and increases in taxes and wages, the Lehigh Valley Railroad Co. did not have the cash to meet its obligations during the remainder of that year and proposed a plan and agreement, dated August 25, 1938, for, among other things, the extension of certain interest maturities on its bonds, including the general consolidated mortgage 4 1/2 per cent bonds owned by Union Pacific.
As to such general consolidated mortgage bonds, the plan provided that the interest due November 1, 1938, May 1, 1939, November 1, 1939, May 1, 1940, and November 1, 1940, would be paid to the extent of 25 per cent and the remaining 75 per cent would be paid without interest within five years of the respective due dates. The plan also provided for a redemption of the bonds, at the option of the company upon 30 days' notice, at their principal amount plus accrued interest, and for a supplemental indenture which was to contain covenants for the release from the mortgage of properties not needed in the operation of the business upon deposit with the trustees of the proceeds of the disposition of said properties, or the substitution of an equivalent amount of capital expenditures made during or after the calendar year in which the release occurs upon property subject to the lien of the mortgage and for the setting aside in a separate fund or funds certain portions of the net income. The plan was to become operative when so declared by the company.
Said plan dated August 25, 1938, was duly approved by decree dated August 7, 1940, of the District Court of the United States for the Eastern District of Pennsylvania, pursuant to the provisions of chapter XV of the National Bankruptcy Act.
The supplemental indenture provided for by the plan was executed as of August 7, 1940. The evidence does not disclose when the company declared the plan operative.
The interest on said $605,000 face amount of bonds of Lehigh Valley Railroad Co. owned by Union Pacific, at the full 4 1/2 per cent rate, was $27,225 in 1938 and $27,225 in 1939, but Lehigh Valley Railroad Co. paid to Union Pacific during 1938 only $13,615.53 and during 1939 only $6,813.30 as interest on said bonds, which amounts Union Pacific reported as income in said years, respectively, upon its books of account and in its consolidated income tax return for said years. Respondent has included the full amount of said interest for each of said years, i.e., $27,225, in Union Pacific's and its affiliated railroad companies' consolidated gross income for each of said years.
The balance of said interest at the full 4 1/2 per cent rate, i.e., $13,609.47 for 1938, and $20,411.70 for 1939, was paid to Union Pacific in installments during the years 1942, 1943, 1944, and 1945.
During the year 1936 the total assets of Lehigh Valley Railroad Co. decreased from $243,160,137 to $242,949,246.
During the year 1937 the total assets of Lehigh Valley Railroad Co. decreased from $242,949,246 to $234,983,473.
During the year 1936 the railway operating revenues of Lehigh Valley Railroad Co. amounted to $49,156,379, and during the year 1937 amounted to $48,618,849, while the railway operating expenses during said years were $35,247,646 and $37,179,197. respectively.
Lehigh Valley Railroad Co. failed to earn its fixed charges in each of the years 1931 to 1937, inclusive, except 1936, and for the first six months of 1938 income available for fixed charges was $1,227,523 against fixed charges of $3,478,652.
There were reasonable grounds for believing during the years 1938 and 1939 that the deferred interest on the general consolidated mortgage bonds would be paid.
Baltimore & Ohio Railroad Co. Bonds.
At all times pertinent hereto, except as hereinafter stated, Union Pacific owned the following bonds of the Baltimore & Ohio Railroad Co. (hereinafter called ‘B. & O.‘):
(a) $4,000,000 face amount refunding and general mortgage 5% bonds, series A, due December 1, 1995, acquired by Union Pacific on December 24, 1915, at at cash cost of $984.89 per bond;
(b) $2,000.00 face amount Southwestern Division first mortgage 5% gold bonds, due July 1, 1950, acquired by Union Pacific on April 30, 1925, at a cash cost of $977.50 per bond.
(c) $1,614,000 face amount 30-year 4 1/2% convertible gold bonds, due February 1, 1960, acquired by Union Pacific on March 11, 1930, at a cost basis of $1,012.50 per bond.
(d) $11,000 face amount of first mortgage 5% gold bonds, due July 1, 1948, acquired by Union Pacific on September 16, 1924, at a cash cost of $985 per bond.
The B. & O. on August 15, 1938, proposed a plan ‘For Modification of Interest Charges and Maturities‘ covering its funded debt, including the bonds owned by Union Pacific. Pursuant to the plan, the bonds herein involved were altered in general as follows:
(a) The Refunding and General Mortgage 5% Bonds, Series ‘A‘, were altered by the reduction of the interest rate to 1% for a period of eight years from December 1, 1938, which was to remain as a fixed charge, the remainder of the original rate to be contingent upon earnings and cumulative; by the holders of such bonds consenting to the modification of the covenants of the mortgage so as to remove a restriction therein by providing that the company may at any time extend any bonds of any issue which are secured by a lien superior to that of the mortgage, or of any senior bonds of any later maturities; by a limitation on the issue of additional bonds under the mortgage; and by an option to convert the bonds into common stock of the company on the basis of $100 per share, with provision for price adjustment under certain conditions.
(b) The Southwestern Division 5% Bonds were altered by the reduction of the interest rate to 3 1/2% for a period of eight years from January 1, 1939, which was to remain as a fixed charge, the remainder of the original rate to be contingent upon earnings and cumulative.
(c) The Convertible 4 1/2% Bonds were altered by making all interest contingent upon earnings and cumulative for a period of eight years from August 1, 1938, and by an option to convert the bonds into common stock of the company on the basis of $100 per share, with provision for price adjustment under certain conditions.
(d) The First Mortgage 5% Gold Bonds were altered by the reduction of the interest rate to 4% for a period of eight years from October 1, 1938, which was to remain as a fixed charge, the remainder of the original rate to be contingent upon earnings and cumulative.
In consideration of the extension of maturity dates of certain issues of bonds and the change of part of the interest rates from fixed to contingent, the plan provided for installment payments from income to be paid in to a sinking fund for the year 1939 and subsequent years until the contingent interest was paid and $100,000,000 aggregate principal amount of obligations was paid.
In accordance with the provisions of the plan, which was approved and confirmed on November 8, 1939, by the District Court of the United States for the District of Maryland (application for writ of certiorari denied January 29, 1940), supplemental indentures were executed January 1, 1940. Thereafter, in 1940, pursuant to the decree of the court and in accordance with the supplemental indentures, Union Pacific's bonds were stamped with a legend indicating the alterations that had been made in the bonds so stamped and returned to Union Pacific.
On the respective effective dates of said alterations in Union Pacific bonds, the fair market value, including the right to receive the contingent interest accrued to those dates, of each bond of each issue after such alteration was as follows:
+---------------------------------------------------------------+ ¦Refunding and general mortgage, series A bonds¦$265.00¦per bond¦ +----------------------------------------------+-------+--------¦ ¦Southwestern division first mortgage 5% bonds ¦431.25 ¦per bond¦ +----------------------------------------------+-------+--------¦ ¦Convertible 4 1/2% gold bonds ¦114.375¦per bond¦ +----------------------------------------------+-------+--------¦ ¦First mortgage 5% gold bonds ¦687.50 ¦per bond¦ +---------------------------------------------------------------+
On December 9, 1941, Union Pacific sold the following bonds:
(a) One of the refunding and general mortgage 5% bonds, stamped to indicate the alterations made, as aforesaid, receiving therefor $333.24;
(b) One of the Southwestern Division first mortgage 5% gold bonds, stamped
(c) One of the 30-year 4 1/2% convertible gold bonds, stamped to indicate the alterations made, as aforesaid, receiving therefor $333.24.
(d) One of the first mortgage 5% gold bonds, stamped to indicate the alterations made, as aforesaid, receiving therefor $624.48.
Union Pacific, in its consolidated income tax return for the year 1941, deducted $2,353.19 as a capital loss incurred in the sale of the bonds as aforesaid. That amount was erroneously computed due to the use of the incorrect cost of the first mortgage 5 per cent gold bond, viz., $1,082.50. The correct cost of that bond was $985, such being the cost to Salt Lake, from which Union Pacific acquired it. The aggregate cost of said bonds was $3,959.89, and the aggregate sales price was $1,704.20, and said capital loss, if allowable, was $2,255.69.
Respondent has disallowed the aforesaid capital loss and has determined a capital gain in the amount of $378.06, computed upon the difference between the correct fair market value of the bonds on the date of the alterations thereof in 1940 (including the right to receive the contingent interest accrued to that date) and the aggregate sales price thereof, as aforesaid. Respondent has further reduced Union Pacific's basis of said bonds by the amount of contingent interest accrued to the date said alterations were made which was subsequently received by Union Pacific.
Retirement of Ways and Structures.
The petitioners throughout the years 1934 to 1941, inclusive, and prior years and for a period antedating the enactment of the Federal income tax laws, respectively owned and operated railroads as common carriers in interstate commerce.
The petitioners have kept their accounting records in accordance with the Uniform Classifications of Accounts prescribed for steam railroads by the Interstate Commerce Commission from time to time.
At all times prior to July 1, 1914, Union Pacific, Short Line, Salt Lake, Navigation Co., and Grand Island used the retirement method of accounting in respect of their ways and structures and never included in their accounts any charges for depreciation computed on the straight line method.
Effective July 1, 1914, the Interstate Commerce Commission prescribed the following accounting regulations applicable to steam railroads subject to its jurisdiction, including petitioners:
Classification of Investment in Road and Equipment of Steam Roads.
Classification of Operating Revenues and Operating Expenses of Steam Roads.
Classification of Income, Profit and Loss, and General Balance Sheet Accounts for Steam Roads.
The foregoing classifications, effective July 1, 1914, remained in effect throughout the years involved and thereafter up to and including 1942, with certain modifications not material herein.
Under said accounting regulations of the Interstate Commerce Commission, effective July 1, 1914, steam railroads were given an election to compute depreciation on ways and structures under the usual straight line method and deduct such depreciation from income, or to forego depreciation and continue to sue the existing retirement method of accounting.
The retirement method of accounting prescribed by the Interstate Commerce Commission for steam roads exercising the option so given to be continued to use that method is prescribed by the aforesaid classifications.
Pursuant to the option so given, Union Pacific, Short Line, Salt Lake, Navigation Co., and Grand Island elected to continue to keep their accounts in respect of ways and structures on the retirement method of accounting. At all times pertinent hereto, they continued to keep said accounts in accordance with said method and have never included in their accounts any charges for depreciation computed on the straight line method.
The retirement method of accounting has been recognized by the respondent.
During the years 1934, 1935, 1936, 1937, 1938, 1939, and 1941 the petitioners retired from service many units of fixed property constituting part of their ways and structures.
The aggregate of the retirement charges made by each of the petitioners, both to operating expense accounts and to profit and loss account, were taken as deductions from gross income in the tax returns filed by the petitioners for the years 1934, 1935, 1936, 1937, 1938, 1939, and 1941 as and for the adjusted basis of the aforesaid units of ways and structures so retired, as prescribed by section 113(b) of the applicable revenue act and of the Internal Revenue Code, before any allowance or adjustment for depreciation sustained prior to March 1, 1913, with respect to individual units of property so retired which were acquired prior to March 1, 1913.
The deductions claimed by the petitioners in their tax returns filed for the years 1934, 1935, 1936, 1937, 1938, 1939, and 1941 were reduced by the respondent in his notices of deficiency by the amount of depreciation which he determined had been sustained prior to March 1, 1913, with respect to assets so retired which were acquired prior to said date.
The dollar amount of ways and structures owned by Union Pacific, as shown by annual reports to the Interstate Commerce Commission, was $228,773,871 as at June 30, 1907; $258,686,874 as at June 30, 1913; and $336, 974,864 as at December 31, 1941.
The dollar amount of ways and structures owned by Short Line, as shown by annual reports to the Interstate Commerce Commission, was $60,856,775 as at June 30, 1907; $83,268,221 as at June 30, 1913; and $120,609,714 as at December 31, 1941.
The dollar amount of ways and structures owned by Salt Lake, as shown by annual reports to the Interstate Commerce Commission, was $60,692,700 as at June 30, 1907; $69,045, 575 as at June 30, 1913; and $108,483,838 as at December 30, 1941.
The dollar amount of ways and structures owned by Navigation Co., as shown by annual reports to the Interstate Commerce Commission, was $111,935,797 as at December 23, 1910 (date of acquisition by that company); $129,980,191 as at June 30, 1913; and $156,912,987 as at December 31, 1941.
The dollar amount of ways and structures owned by Grand Island, as shown by annual reports to the Interstate Commerce Commission, was $17,303,585 as at June 30, 1907; $17,800,619 as at June 30, 1913; and $19,447,966 as at December 31, 1941.
OPINION.
JOHNSON, Judge:
The first issue relates to interest due Union Pacific on certain general consolidated 4 1/2 per cent bonds of Lehigh Valley Railroad Co. which it owned during the taxable years 1938 and 1939. Under a plan and agreement of the latter company, dated August 25, 1938, and approved by the District Court on August 7, 1940, provision was made for the extension of certain interest maturities on its bonds, including the bonds owned by Union Pacific. As to the general consolidated bonds, the plan provided that the semiannual interest due November 1, 1938, and for each period up to November 1, 1940, would be paid to the extent of 25 per cent and the remaining 75 per cent would be paid within five years of the respective due dates. No part of the interest was canceled. In accordance with the provisions of the plan, 25 per cent of the interest on the bonds was paid on the original due dates and the remaining 75 per cent of the deferred interest was paid to Union Pacific during the years 1942, 1943, 1944, and 1945. Union Pacific, in its returns for the years 1938 and 1939 reported only the interest which it had actually received. It kept its books and filed its returns on the accrual basis.
The respondent added to the income reported by petitioner for each year the balance of the full interest due on the bonds for each year. He contends that where, as here, the obligation to pay the full amount of the interest was absolute and there was a reasonable expectancy of receipt of all the interest, the deferment in payment of a portion of such interest does not serve to postpone the accrual thereof.
The petitioner contends that the bond interest not actually paid by Lehigh Valley Railroad Co. in 1938 and 1939 was properly not accrued as income for those years. It urges that events in the taxable years indicated that, because of business difficulties of the obligor, payment of the deferred interest might never be made.
Where a taxpayer keeps accounts and makes returns on the accrual basis, it is the right to receive and not the actual receipt that determines the inclusion of an amount in gross income. Spring City Foundry Co. v. Commissioner, 292 U.S. 182; Continental Tie & Lumber Co. v. United States, 286 U.S. 290; Lucas v. American Code Co., 280 U.S. 445; and American National Co. v. United States, 274 U.S. 99. But where there exists reasonable grounds for believing, at the time the right to receive income becomes fixed, that such income will never be received, it need not be included in gross income. O'Sullivan Rubber Co., 42 B.T.A. 721; affd., 120 Fed.(2d) 845.
The evidence produced indicates that the Lehigh Valley Railroad Co.'s operations resulted in deficits for several years prior to 1938, and that it failed to earn its fixed charges in each of the years 1931 to 1937, inclusive, except 1936, and for the first six months of 1938, but the plan stated that it was ‘the belief of the System's management, shared by insurance companies and savings banks holding large amounts of the System bonds and by its bank creditors, that the present situation may be temporary.‘ Its gross operating revenues showed a gradual increase from $38,177,450 in 1933, to $39,866,526 in 1934, to $40,641,557 in 1935, to $49,156,379 in 1936; a slight decline to $48,618,849 in 1937; and for the first six months of 1938 amounted to $19,997,882. There is nothing in the record to indicate that it was insolvent during the years 1938 and 1939. An examination of the evidence presented does not convince us that there was reasonable ground in 1938 and 1939 for believing that the deferred interest on the bonds owned by Union Pacific would not be paid, and it was in fact paid during the years 1942, 1943, 1944, and 1945. We hold that the respondent correctly determined that the deferred interest was accruable by petitioner in the years 1938 and 1939 when its right to receive it became fixed.
The second issue relates to the proper basis to be used in computing the gain or loss resulting to Union Pacific as the result of the sale in 1941 of certain B. & O. R.R. bonds.
Prior to 1930 Union Pacific acquired B. & O. bonds, designated as refunding and general mortgage 5 per cent bonds, series A, Southwestern Division first mortgage 5 per cent bonds, convertible 4 1/2 per cent bonds, and first mortgage 5 per cent gold bonds. It sold in 1941 one bond of each of the foregoing issues and in its return for that year claimed a capital loss. In determining such loss it used as the basis for each bond the cost of the bond when acquired. The respondent disallowed the claim loss and determined a capital gain on the ground that the modification in the terms of the bonds in 1940 resulted in a taxable exchange in that year, and, therefore, the proper basis for such bonds was their fair market value at the date of exchange, adjusted for interest accrued to the date of exchange and subsequently received by Union Pacific.
The narrow question is whether the modification of the terms of the B. & O. bonds resulted in a taxable exchange to the holders thereof. The respondent contends that the modification of the terms of the bonds was so material as to amount to the issue of new securities, giving rise to taxable gain or deductible loss to Union Pacific when such changes were made, and that the transaction entered into pursuant to the plan of B. & O. for ‘Modification of Interest Charges and Maturities‘ is not a ‘recapitalization‘ within the meaning of section 112(g)(1)(E) of the Internal Revenue Code and hence, not within the nonrecognition provisions of section 112(b)(3) of the code.
On brief the respondent recognizes that the decisions in Commissioner v. Neustadt's Trust, 131 Fed.(2d) 528, affirming 43 B.T.A. 848, and Mutual Fire, Marine & Inland Insurance Co., 12 T.C. 1057, are authority for the petitioner's contention that the B. & O. plan of August 15, 1938, resulted in a recapitalization, and hence a reorganization within the meaning of section 112(g), and that the alterations made in 1940 pursuant thereto in the B.&O. bonds owned by Union Pacific amounted to an exchange in which no gain or loss was recognized. Upon the authority of the cited cases, we hold that the basis for gain or loss of the B.&O. bonds sold by petitioner in 1941 is cost.
The third issue is whether or not the petitioners, who use the retirement method in respect of their ways and structures, are required to make an adjustment under section 113(b)(1)(C) of the Revenue Acts of 1934, 1936, and 1938 and the Internal Revenue Code, respectively,
with respect to depreciation sustained prior to March 1, 1913, on individual units of ways and structures retired in a given year which had been acquired prior to March 1, 1913.
The following pertinent language of sections 113(b) and 114(a) was unaltered from 1934 through 1941:‘SEC. 113. ADJUSTED BASIS FOR DETERMINING GAIN OR LOSS.‘(b) ADJUSTED BASIS.— The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis determined under subsection (a), adjusted as hereinafter provided.‘(1) GENERAL RULE.— Proper adjustment in respect of the property shall in all cases be made—‘(A) for expenditures, receipts, losses, or other items, properly chargeable to capital account, including taxes and other carrying charges on unimproved an unproductive real property, but no such adjustment shall be made for taxes or other carrying charges for which deductions have been taken by the taxpayer in determining net income for the taxable year or prior taxable years;‘(C) in respect of any period to March 1, 1913, for exhaustion, wear and tear, obsolescence, amortization, and depletion, to the extent sustained;‘‘SEC. 114. BASIS FOR DEPRECIATION AND DEPLETION.‘(a) BASIS FOR DEPRECIATION.— The basis upon which exhaustion, wear and tear, and obsolescence are to be allowed in respect of any property shall be the adjusted basis provided in section 113(b) for the purpose of determining the gain upon the sale or other disposition of such property.‘
The respondent contends that authority for the deductions claimed by petitioner must be found in the statute and that, under the specific language of the statute, an adjustment is required for depreciation sustained prior to March 1, 1913, with respect to assets acquired prior to that date.
The petitioners concede that section 113 provides adjustments ‘for expenditures, receipts, losses, or other items, properly chargeable to capital account‘ in subsection (b)(1)(A), and ‘in respect of any period prior to March 1, 1913, for exhaustion, wear and tear, obsolescence, * * * to the extent sustained‘ in subsection (b)(1)(C). They contend, however, that under the provisions of the statute these adjustments are to be made only when they constitute ‘proper‘ adjustments, and they urge that it is not proper for a taxpayer employing the retirement method of accounting to make either the ‘upward‘ adjustment specified in subsection (b)(1)(A) or the ‘downward‘ adjustment specified in subsection (b)(1)(C).
In Los Angeles & Salt Lake Railroad Co., 4 T.C. 634 (appeal dismissed, C.C.A. 2, May 27, 1946), where a similar question was presented by the taxpayer, one of the petitioners herein, we held that it was not required to adjust its ledger ‘cost‘ to eliminate depreciation prior to 1913.
The respondent on brief attempts to distinguish the instant proceedings from the cited case on the ground that therein the parties stipulated that the amounts deducted represented the ‘cost‘ of the assets retired, reduced only by the value of the salvage recovered. He urges that in the instant case there is no such stipulated fact; that the petitioners admit that the amounts which they deducted in their returns represent the ‘adjusted basis‘ of the retired assets except for depreciation sustained prior to March 1, 1913; and that, in view of this admission, the adjustment for depreciation sustained prior to March 1, 1913, is proper, since the admission as the the ‘adjusted basis‘ indicates that adjustment has been made for ‘expenditures, receipts, losses or other items properly chargeable to capital account.‘
We are unable to agree with the respondent. The petitioners, at all times material herein, used the retirement method of accounting in respect of their ways and structures and kept their accounts in accordance with this method. This accounting method has been judicially recognized in a number of cases, Central Railroad Co. of New Jersey, 35 B.T.A. 501, 503 (appeal dismissed C.C.A. 3); Chicago & Northwestern Railway Co., 39 B.T.A. -61; affd., 114 Fed.(2d) 882, 887; certiorari denied, 312 U.S. 692; Cincinnati Union Terminal Co., 44 B.T.A. 905; Los Angeles & Salt Lake Railroad Co., supra, and has been recognized by the respondent in Bureau of Internal Revenue Bulletin F (revised January 1931, effective in 1934) and in the January 1942 revision of the bulletin.
The obvious purpose of the provisions of section 113(b) in so far as they relate to March 1, 1913, adjustments, was, as stated in Los Angeles & Salt Lake Railroad Co., supra, to arrive at the amount of investment incorporated in the property on that date. They provide that ‘proper‘ adjustment in respect to property ‘whenever acquired‘ be made ‘for expenditures, receipts, losses, or other items, properly chargeable to capital account‘ (subsection (b) (1) (A)), and for pre-1913 depreciation sustained (subsection (b) (1) (C)). Under systems of accounting where the cost of every item having a life of more than one year is charged to capital account and depreciation is taken on a straight line basis, the figures necessary to make the foregoing adjustments and to arrive at the amount of investment in the property as of March 1, 1913, are readily ascertainable. But under the railroad retirement system of accounting certain expenditures for maintenance, including restorations and renewals, which under other systems would be capitalized, are charged to operating costs. The justification for this system, as started by the Circuit Court of Appeals for the Fourth Circuit in Southern Railway Co. v. Commissioner, 74 Fed.(2d) 887, 890, is that:
* * * It would be inconvenient, if not impractical, in railroad accounting to charge every item having a life of more than one year to capital account and allow depreciation on it as a deductible item of expense; and in a great business where thousands of similar replacement or repair items are involved nothing would be gained by such a system of accounting, since, on the law of averages, expenditures for such items during a give year would substantially balance the depreciation for that year. * * *
The petitioners have stipulated that the amounts taken as deductions in their returns for each of the taxable years on account of retirement of ways and structures acquired prior to March 1, 1913, are the aggregate adjusted basis of the individual units of property retired in each year, except for pre-1913 depreciation, which the respondent determined was sustained and which petitioners do not dispute. The respondent construes this stipulation of the petitioners as to the ‘adjusted basis: to mean that for income tax purposes the amounts deducted embraced the subsection (A) ‘upward‘ adjustments, and therefore the compensating subsection (C) ‘downward‘ adjustments should be made. Such a construction ignores the agreed fact that petitioners kept their accounts in accordance with the railroad retirement method of accounting. Under this accounting method the amount deducted when a unit of property is retired is the amount carried in the railroad's accounts as the ‘ledger value‘ (less salvage) of that unit upon its retirement,
which amount is the equivalent of its ‘adjusted basis,‘ and ‘ledger value‘ does not include expenditures for renewals and replacements charged to operation expenses prior to March 1, 1913.
‘Ledger value‘ is defined by section 6 of the Classification of Investment in Road and Equipment of Steam Roads prescribed by the Interstate Commerce Commission as * * * the value at which the property is carried in the property investment account in the general ledger of the carrier.‘
This method of accounting, as we pointed out in the Los Angeles case, is not ‘capable of producing a figure which will fairly reflect the March 1, 1913, investment as to both positive and negative figures, and we do not regard it as proper to make an adjustment in one direction while recognizing the impossibility of others of a compensating character.‘ We therefore hold, as we did in that case, that an adjustment for pre-1913 depreciation would be inconsistent with the retirement system and is not ‘proper.‘ The respondent erred in reducing the amount of the deductions taken by petitioners in their returns for the years 1934 to 1939, inclusive, and 1941 by depreciation sustained prior to March 1, 1913.
Inasmuch as our holding on the pre-1913 depreciation issue is for the petitioners, no useful purpose would be served by discussing or deciding whether or not our decision in Los Angeles & Salt Lake Railroad Co., supra, is res judicata as to the pre-1913 issue in all of the dockets herein involved.
Decisions will be entered under Rule 50.