Opinion
Docket No. 16526.
1949-07-14
THE TOLEDO TERMINAL RAILROAD COMPANY, PETITIONER, v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT.
John J. Kendrick, Esq., and G. Charles Scharfy, Esq., for the petitioner. Lawrence R. Bloomenthal, Esq., for the respondent.
Since 1935 the petitioner, in computing depreciation for tax purposes, has divided its rolling stock into separate groups and has applied to each group a composite rate prescribed by the Interstate Commerce Commission. (Its annual deduction for depreciation consisted of the aggregate of the deductions so computed for each class.) Under this system the depreciation reserves accrued on the various groups by the end of 1946 closely approached, and in the case of two groups exceeded, the original cost of the assets therein. In August 1946 the Interstate Commerce Commission prescribed new and lower rates for each group, which rates the petitioner elected to apply as of July 1, 1946. Although petitioner's equipment was substantially obsolete and approaching the end of its economic useful life by the end of 1946, a large part of it has, for various reasons, remained in limited service since that time. Held:
(1) That with the exception of its ‘Miscellaneous Equipment‘ account, the method and rates prescribed by the Interstate Commerce Commission and used by the petitioner in computing its deductions for depreciation on its various groups of equipment for the years 1942 to 1944, inclusive, result in a reasonable allowance for depreciation in each year.
(2) That the petitioner may not under the method employed claim in any year depreciation on any group of equipment which would result in its recovering by way of deductions more than the full amount of the original cost of any group.
(3) The method and rates of depreciation applicable to the petitioner's ‘Miscellaneous Account‘ determined. John J. Kendrick, Esq., and G. Charles Scharfy, Esq., for the petitioner. Lawrence R. Bloomenthal, Esq., for the respondent.
The petitioner herein seeks a redetermination of the following deficiencies in income tax for the calendar years 1942 to 1944, inclusive:
+-----------------+ ¦1942 ¦$6,368.47 ¦ +-----+-----------¦ ¦1943 ¦6,010.70 ¦ +-----+-----------¦ ¦1944 ¦6,205.60 ¦ +-----+-----------¦ ¦Total¦$18,584.77 ¦ +-----------------+
The principal issue herein is whether the respondent was correct in disallowing $14,671.18, $15,134.27, and $15,134.26 of the total depreciation claimed by petitioner on its rolling stock in its Federal tax returns for the calendar years 1942, 1943, and 1944, respectively. Other adjustments made by respondent affecting petitioner's tax liability for the years involved are not contested by the petitioner.
The parties agree that the amount of an operating loss for 1946 and the amount of a net operating loss carry-back from that year to 1944 will be determined by the decision on the principal issue and will be computed under Rule 50. The case was submitted upon a stipulation of certain facts, oral testimony and exhibits. The facts stipulated are so found and additional facts from the record are found as set forth herein.
FINDINGS OF FACT.
The Toledo Terminal Railroad Co., hereinafter referred to as the petitioner, is a corporation existing under and by virtue of the laws of the State of Ohio, with its principal office located in Toledo, Ohio. During all times pertinent to the issues here involved, its books and records were maintained on the accrual system of accounting under and pursuant to the rules and regulations prescribed by the Interstate Commerce Commission, hereinafter sometimes referred to as the Commission. Its Federal income tax returns for the taxable years ended December 31, 1942, to 1946, inclusive, were filed with the collector of internal revenue for the tenth district of Ohio.
Petitioner is, and has been since 1907, engaged in the business of operating a belt line railroad in and around Toledo, servicing other railroads and industrial concerns in the area by the transportation of freight. Its stockholders consist of nine major railroad companies, each of which is represented on petitioner's board of directors by one director. Three members of petitioner's board of directors comprise a rotating audit committee which supervises and checks its records and accounts.
Pursuant to the orders of the Interstate Commerce Commission, petitioner, during all times pertinent to the issues here involved, maintained in its general ledger an account numbered 701 and entitled ‘Road and Equipment Property— Equipment,‘ which account was used as a ‘control‘ account for all of the rolling stock held and owned by petitioner, including locomotives, cabooses, work equipment, and miscellaneous equipment. At the direction of the Commission, petitioner also maintained a subsidiary ledger in which was carried the detailed accounting for all such rolling stock as follows:
+-----------------------------------------------------------------------------+ ¦Description of Account ¦Property Included ¦ +---------------------------+-------------------------------------------------¦ ¦Account numbered 51 ¦ ¦ ¦entitled “Steam ¦Steam locomotives ¦ ¦Locomotives” ¦ ¦ +---------------------------+-------------------------------------------------¦ ¦Account numbered 52 ¦ ¦ ¦entitled “Other ¦Diesel Electric Locomotives ¦ ¦Locomotives” (added in ¦ ¦ ¦1946) ¦ ¦ +---------------------------+-------------------------------------------------¦ ¦Account numbered 53 ¦ ¦ ¦entitled “Freight-Train ¦Cabooses ¦ ¦Cars” ¦ ¦ +---------------------------+-------------------------------------------------¦ ¦Account numbered 57 ¦Ballast cars, cinder cars, wreck tool cars, ¦ ¦entitled “Work Equipment” ¦bridge tool cars, flat cars, water cars, bunk ¦ ¦ ¦cars, hopper cars, and gondolas. ¦ +---------------------------+-------------------------------------------------¦ ¦Account numbered 58 ¦ ¦ ¦entitled “Miscellaneous ¦Automobiles ¦ ¦Equipment ¦ ¦ +-----------------------------------------------------------------------------+
Until January 1, 1945, the petitioner, pursuant to the orders of the Commissioner, maintained in its general ledger the following accounts:
+-----------------------------------------------------------------------------+ ¦Account No. ¦Caption ¦Purpose ¦ +-------------+-----------------------+---------------------------------------¦ ¦ ¦Accrued ¦ ¦ ¦776 ¦Depreciation—Road and ¦Accounting for depreciation on steam ¦ ¦ ¦Equipment—Steam ¦locomotives ¦ ¦ ¦Locomotives ¦ ¦ +-------------+-----------------------+---------------------------------------¦ ¦ ¦Accrued ¦ ¦ ¦776 ¦Depreciation—Road and ¦Accounting for depreciation on cabooses¦ ¦ ¦Equipment—Freight-Train¦ ¦ ¦ ¦Cars ¦ ¦ +-------------+-----------------------+---------------------------------------¦ ¦ ¦Accrued ¦Accounting for depreciation on ballast ¦ ¦ ¦Depreciation—Road and ¦cars, cinder cars, wreck tool cars, ¦ ¦776 ¦Equipment—Work ¦bridge tool cars, flat cars, water ¦ ¦ ¦Equipment ¦cars, bunk cars, hopper cars, and ¦ ¦ ¦ ¦gondolas ¦ +-------------+-----------------------+---------------------------------------¦ ¦ ¦Accrued ¦ ¦ ¦776 ¦Depreciation—Road and ¦Accounting for depreciation on ¦ ¦ ¦Equipment—Miscellaneous¦automobiles ¦ ¦ ¦Equipment ¦ ¦ +-----------------------------------------------------------------------------+
On or after January 1, 1945, petitioner, at the direction of the Commission, renumbered the accounts numbered 776, assigning them the number 702 1/2D. The title of each account was changed by eliminating therefrom all reference to the word ‘Road,‘ and in 1946 the petitioner opened in the general ledger an additional account numbered 702 1/2D entitled ‘Accrued Depreciation—Equipment— Other Locomotives.‘ In this latter account, petitioner entered the depreciation accounting with respect to the diesel locomotives which were carried in the account numbered 52 and entitled ‘Other Locomotives‘ in the subsidiary ledger.
From 1907 until 1920, petitioner depreciated its rolling stock on an annual composite rate of 2 per cent and from 1920 to 1935 used an annual rate of 4 per cent.
Pursuant to the Interstate Commerce Commission's Sub-Order No. 488,‘ entitled ‘Depreciation Charges of Steam Railroad Companies,‘ petitioner, in December 1935, and thereafter until July 1, 1946, applied the following composite rates of depreciation to the following equipment accounts:
+--------------------------------------------------+ ¦Account numbered 51—Steam Locomotives ¦3.94% ¦ +-------------------------------------------+------¦ ¦Account numbered 53—Freight-Train Cars ¦3.81% ¦ +-------------------------------------------+------¦ ¦Account numbered 57—Work Equipment ¦4.89% ¦ +-------------------------------------------+------¦ ¦Account numbered 58—Miscellaneous Equipment¦25.72%¦ +--------------------------------------------------+
On its Federal income tax returns for 1942, 1943, and 1944, petitioner computed the claimed depreciation deduction with respect to its rolling stock by applying the composite rates of depreciation specified in said Sub-Order No. 488 of the Interstate Commerce Commission to the various classifications of its rolling stock.
It was petitioner's practice, upon the retirement of a unit of its rolling stock, to credit its asset or investment account with the original cost of the unit, to charge the salvage recovered to an appropriate asset account, and to debit the reserve for depreciation with the difference, if any, between the original cost and salvage. No gains or losses with respect to such retirements have ever been claimed by petitioner in its Federal tax returns.
On June 6, 1942, petitioner requested information from the Bureau of Accounts of the Interstate Commerce Commission as to the proper rate to be used in depreciating an automobile carried in Account 58, ‘Miscellaneous Equipment,‘ and theretofore depreciated at a rate of 25.72 per cent per annum. In answer to petitioner's suggestion that the rate was too high, the Bureau of Accounts explained its policy as follows:
* * * It is contemplated that a composite rate, when once prescribed, shall remain in effect until such time as the changes are sufficient to produce a relatively important difference in the depreciation charges as a whole. * * * any change in the rate for account 58 would have only a negligible effect on the total charges, therefore the better procedure is to allow that rate to remain in effect * * *.
With respect to an adjustment of the reserve, it should not be overlooked that, for corporate ledger and balance sheet purposes, it is to be regarded and treated as a single composite reserve applicable to the equipment as a whole; and that the breakdown into component parts corresponding to the primary equipment accounts is for purposes of analysis only. It follows that it is not a matter of importance if the analysis shows a disproportionate balance for a particular primary account.
On June 26, 1946, petitioner informed the Commission that it had ordered two diesel locomotives and requested that a depreciation rate be set for this equipment. Petitioner also sought advice as to what adjustment or revision, if any, should be made to their equipment depreciation accounts at that time. Petitioner described the state of its equipment depreciation accounts as of April 30, 1946, as follows:
+-----------------------------------------------------------------+ ¦ ¦Investment ¦Rate ¦Reserve ¦ +----------------------------------+-----------+------+-----------¦ ¦(1) Locomotives (steam) ¦$611,960.29¦3.94% ¦$603,093.49¦ +----------------------------------+-----------+------+-----------¦ ¦(2) Freight cars (cabooses) ¦25,185.93 ¦3.81% ¦21,785.83 ¦ +----------------------------------+-----------+------+-----------¦ ¦(3) Miscl. equipment (Chev. sedan)¦851.05 ¦25.72%¦1,504.99 ¦ +----------------------------------+-----------+------+-----------¦ ¦(4) Work equipment ¦26,996.14 ¦4.89% ¦24,918.44 ¦ +----------------------------------+-----------+------+-----------¦ ¦Total ¦664,993.41 ¦ ¦651,302.75 ¦ +-----------------------------------------------------------------+
On August 21, 1946, the Commission notified petitioner as follows:
Date submitted and other available information result in annual composite rates as follows:
+------------------------------------+ ¦ ¦Account ¦Rate ¦ +-----+-----------------------+------¦ ¦No. ¦Name ¦(%) ¦ +-----+-----------------------+------¦ ¦51 ¦Steam locomotives ¦3.13 ¦ +-----+-----------------------+------¦ ¦52 ¦Other locomotives ¦3.88 ¦ +-----+-----------------------+------¦ ¦53 ¦Freight-train cars ¦3.40 ¦ +-----+-----------------------+------¦ ¦57 ¦Work equipment ¦2.93 ¦ +-----+-----------------------+------¦ ¦58 ¦Miscellaneous equipment¦13.33 ¦ +------------------------------------+
The Commission further directed that petitioner reduce its reserve by a credit of $70,000 to account 702 1/2C, ‘Accrued depreciation— Road,‘ and that the $70,000 should be allocated to the following primary accounts:
+---------------------+ ¦Account ¦Amount ¦ +---------+-----------¦ ¦51 ¦$63,137.41 ¦ +---------+-----------¦ ¦53 ¦Cr. 370.85 ¦ +---------+-----------¦ ¦57 ¦6,336.28 ¦ +---------+-----------¦ ¦58 ¦897.16 ¦ +---------+-----------¦ ¦Total ¦70,000.00 ¦ +---------------------+
The foregoing revised depreciation rates were made effective with the accounts for November 1946, but permission was granted to apply them retroactively, beginning as of July 1, 1946.
The cost basis and the amounts of the depreciation reserve for each group of petitioner's depreciable assets as reflected in its books for the years 1942 to 1946, inclusive, were as follows:
+-----------------------------------------------------------------------------+ ¦1942 ¦ ¦1943 ¦ ¦ ¦ +-------------+-----------+-------------------+-----------+-------------------¦ ¦ ¦Cost end of¦Depreciation ¦Cost end of¦Depreciation ¦ ¦ ¦year ¦reserve, end of ¦year ¦reserve, end of ¦ ¦ ¦ ¦year ¦ ¦year ¦ +-------------+-----------+-------------------+-----------+-------------------¦ ¦Steam ¦$611,960.29¦$522,722.72 ¦$611,960.29¦$546,833.95 ¦ ¦locomotives ¦ ¦ ¦ ¦ ¦ +-------------+-----------+-------------------+-----------+-------------------¦ ¦Freight train¦28,568.76 ¦21,250.18 ¦25,185.93 ¦19,546.83 ¦ ¦cars ¦ ¦ ¦ ¦ ¦ +-------------+-----------+-------------------+-----------+-------------------¦ ¦Work ¦25,909.76 ¦21,096.26 ¦25,909.76 ¦22,363.24 ¦ ¦equipment ¦ ¦ ¦ ¦ ¦ +-------------+-----------+-------------------+-----------+-------------------¦ ¦Miscellaneous¦1 851.05 ¦775.35 ¦1 851.05 ¦994.24 ¦ ¦equipment ¦ ¦ ¦ ¦ ¦ +-------------+-----------+-------------------+-----------+-------------------¦ ¦Total ¦667,289.86 ¦565,844.51 ¦663,907.03 ¦589,738.26 ¦ +-----------------------------------------------------------------------------+
1944 1945 Cost end of Depreciation Cost end of Depreciation year reserve, end of year year reserve, end of year Steam $611,960.29 $570,945.18 $611,960.29 $595,056.41 locomotives Freight train 25,185.93 20,506.41 25,185.93 21,465.99 cars Work equipment 25,146.14 23,207.34 26,996.14 24,478.40 Miscellaneous 1 851.05 1,213.13 1 851.05 1,432.02 equipment Total 663,143.41 615,872.06 664,993.41 642,432.82
+--------------------------------------------------------------------------+ ¦1946 2 ¦ ¦ ¦ +-----------------------+----------------+---------------------------------¦ ¦ ¦Cost end of year¦Depreciation reserve, end of year¦ +-----------------------+----------------+---------------------------------¦ ¦Steam locomotives ¦$580,917.67 ¦$585,997.55 ¦ +-----------------------+----------------+---------------------------------¦ ¦Other locomotives ¦158,351.99 ¦1,792.03 ¦ +-----------------------+----------------+---------------------------------¦ ¦Freight train cars ¦25,185.93 ¦22,373.92 ¦ +-----------------------+----------------+---------------------------------¦ ¦Work equipment ¦26,996.14 ¦25,533.93 ¦ +-----------------------+----------------+---------------------------------¦ ¦Miscellaneous equipment¦0.00 ¦1,369.33 ¦ +-----------------------+----------------+---------------------------------¦ ¦Total ¦791,451.73 ¦637,066.76 ¦ +--------------------------------------------------------------------------+
On its Federal income tax returns, petitioner claimed one over-all deduction for depreciation on its rolling stock and did not show the distribution of the total depreciation among its various groups or classes of equipment. The total amount of depreciation claimed by petitioner and the amount allowed by respondent in the deficiency notice for each of the years 1942 to 1944, inclusive, were as follows:
+-----------------------------------------------------+ ¦ ¦1942 ¦1943 ¦1944 ¦ +--------------------+----------+----------+----------¦ ¦Depreciation claimed¦$26,665.62¦$26,637.22¦$26,531.78¦ +--------------------+----------+----------+----------¦ ¦Depreciation allowed¦11,994.44 ¦11,502.95 ¦11,397.52 ¦ +--------------------+----------+----------+----------¦ ¦Amount disallowed ¦14,671.18 ¦15,134.27 ¦15,134.26 ¦ +-----------------------------------------------------+
Prior to the year 1942, respondent accepted both the method and composite rates of depreciation used by petitioner for income tax purposes.
On the basis of the petitioner's collateral accounts upon which were recorded the portions of the total annual depreciation attributable to each individual piece of equipment, respondent concluded that some of the items of equipment had been fully depreciated and had not been removed from the cost basis of petitioner's depreciable assets. In determining the deficiencies herein, respondent assigned a separate estimated life and salvage value to each individual item of rolling stock and thereafter computed depreciation for each of the years involved on an item or unit basis. Adjustments representing a loss of $211.03 in 1943 and a profit of $207.58 in 1944 were made by respondent in computing the deficiencies for those years. These adjustments were based by respondent on petitioner's scrapping of cabooses in 1943 and the sale of a hopper car in 1944.
In 1940 petitioner's president suggested a program of replacing its steam locomotives with diesel locomotives. Diesels are more economical to operate and as a general rule two will do the work of three steam locomotives. Due to the coal-hauling operations of some of petitioner's stockholders, the scarcity of diesel locomotives due to the war and the inability of the company to finance their purchase at that time, the first diesel was not ordered until April 1946. Since that time, five diesel locomotives have been placed in service, two in 1946, two in 1947, and one in 1948. Four more have been ordered, two for delivery in 1949 and two for delivery in 1950.
An inspection of petitioner's equipment in January 1945 disclosed that its steam locomotives were obsolete. Unlike modern steam locomotives, they were not equipped with such facilities as feed water pumps, stokers, modern air reversing gear, modern sanding equipment, siphons, circulators, roller bearings, automatic blowdown equipment or low water alarms. Petitioner's locomotives did not conform with the standards of the American Association of Railroads with respect to interchangeability, which prevented their operation on railroad lines other than the petitioner's.
Petitioner had approximately 15 of its original 20 steam locomotives in operation at the end of 1946. Of this number, all were obsolete and a substantial number were used only for emergencies or on rotating duty. Seven of petitioner's 20 original steam locomotives were scrapped in 1946 and 1947. Two were scrapped in 1948 and 2 more were scheduled to be scrapped during the winter of 1949. Two others had been rented out for use by industrial plants. Of the 7 steam locomotives unscrapped or not scheduled to be scrapped at the date of hearing, only three remained in active service.
On January 1, 1945, petitioner owned 16 cabooses, all of which were obsolete and non-interchangeable. As they were of wooden construction they were not used in switching operations, but were parked on adjoining sidings while such work was in progress. Two of these cabooses have been retired, one in March 1947 and one in March 1948.
Petitioner's work equipment, consisting of ballast cars, cinder cars, wreck tool cars, bridge tool cars, flat cars, water car, bunk car, and hopper cars, was, with minor exceptions, obsolete and non-interchangeable as of January 1, 1945. The cinder cars will eventually be eliminated by the introduction of diesel locomotives. Other items of this equipment are used only in the case of derailments and for paint storage, ‘idlers,‘ tie distribution, and general work. The water car was dismantled in 1945 and the bunk car dismantled in 1948. Of the hopper cars, one was dismantled in 1948 and four others have been replaced.
It has been petitioner's plan first to modernize its locomotive department by replacing its steam locomotives with diesels, and to replace as rapidly as possible the remainder of its obsolete freight cars and work equipment.
The Bureau of Locomotive Inspection of the Interstate Commerce Commission inspects petitioner's rolling stock equipment at least several times a year. During the war years, the Commission was more lenient with respect to compulsory retirements of the railroads' rolling stock.
During the years 1942 to 1946, inclusive, the petitioner railroad did repair repair work for other roads and charged back 50 per cent of any profit earned on such work to its own maintenance of equipment expense account and credited the other 50 per cent to proper overhead. The effect of this accounting practice was to reduce the cost of repairs on petitioner's own equipment. The following amounts represent petitioner's expenditures for gross repairs on its steam locomotives before credit for the profit realized on repairs to the cars and locomotives of other railroads in each of the years 1942 to 1947, inclusive, and the first nine months of 1948:
+------------------------------+ ¦1942 ¦$98,469.04¦ +-------------------+----------¦ ¦1943 ¦88,032.83 ¦ +-------------------+----------¦ ¦1944 ¦116,015.16¦ +-------------------+----------¦ ¦1945 ¦105,107.03¦ +-------------------+----------¦ ¦1946 ¦116,904.29¦ +-------------------+----------¦ ¦1947 ¦101,616.36¦ +-------------------+----------¦ ¦1948 (1/1 to 9/30) ¦50,691.77 ¦ +------------------------------+
The hourly wage for shop machinists rose during this period from 96 cents per hour in 1942 to $1.05 per hour in the years 1943 to 1945, inclusive, and $1.21 per hour in 1946.
On April 24, 1947, petitioner filed with the collector of internal revenue at Toledo, Ohio, its claim for refund on Form No. 843, wherein petitioner claimed that it was entitled to the refund of all the Federal income taxes paid by it for the year 1944, due to the deductibility from its gross income for the year 1944 of a net operating loss deduction to which it is entitled as the result of the carry-back of a net operating loss from the year 1946. Petitioner paid $42,547.94 Federal income tax for the year 1944 to the collector of internal revenue at Toledo, Ohio, in the amounts and on the dates indicated:
+-------------------------+ ¦March 3, 1945 ¦$10,686.18¦ +--------------+----------¦ ¦June 6, 1945 ¦10,686.18 ¦ +--------------+----------¦ ¦Sept. 6, 1945 ¦10,686.18 ¦ +--------------+----------¦ ¦Dec. 5, 1945 ¦10,489.40 ¦ +--------------+----------¦ ¦Total ¦42,547.94 ¦ +-------------------------+
OPINION.
ARUNDELL, Judge:
The sole question herein concerns the proper amount deductible by petitioner, as depreciation on its rolling stock in the calendar years 1942, 1943, and 1944. The parties agree that the method we prescribe herein for determining depreciation in those years will be followed in 1945 and 1946 and will be determinative of a net operating loss in 1946 and a net operating loss carry-back from that year to 1944.
Petitioner had used a composite system of determining its annual allowance for depreciation from its inception in 1907 until 1935. From 1907 to 1920 it used a rate of 2 per cent and from 1920 to 1935 a rate of 4 per cent on its rolling stock as a class. In 1935, pursuant to an order of the Interstate Commerce Commission, it adopted a method whereby it depreciated its rolling stock according to five separate classifications, each with a separate rate.
In accord with the Commission's rules and regulations, petitioner maintained in its general ledger a ‘control‘ account, numbered 701, for all its rolling stock, which disclosed the aggregate cost basis and accrued depreciation on all classes of rolling stock. It also kept in its general ledger and subsidiary accounts, records pertaining to each class of equipment which disclosed the cost, composite rate, and accrued depreciation on each class of property. In addition to the above accounts, which were required by the Interstate Commerce Commission, it dept ‘side‘ or collateral records which showed, for its own management purposes, the amounts of depreciation attributable to each individual item of equipment.
It appears that in each year petitioner would compute the allowable depreciation under the rate fixed by the Interstate Commerce Commission for each class of equipment and carry over the aggregate to the over-all depreciation reserve in its ‘control‘ account. When a unit of its equipment was retired, the investment account was decreased by the original cost of the unit, the salvage realized was credited to an appropriate asset account, and the difference between cost and salvage was eliminated from its depreciation reserve. No gains or losses with respect to such retirements have ever been claimed by petitioner in its Federal tax returns. This system appears to have complied with the procedure for depreciable property account set out in Bulletin ‘F.‘
The parties stipulated that the correct cost basis of the automobile carried in the “Miscellaneous Equipment” account is $616.03.
Additions and reductions.— The depreciable asset account should be charged with the cost or other basis of all depreciable property acquired, and credited with the cost or other basis of all assets disposed of through sale, retirement, abandonment, casualty, or otherwise.Depreciation reserve.— This account should be credited with depreciation and obsolescence allowed or allowable, whichever is greater, in each taxable year. The full cost or other basis of all normal retirements adjusted for salvage should be charged to the account. When assets are sold, transferred, or retired because of casualty or special obsolescence, the account should be charged only with the depreciation and obsolescence accrued.Salvage.— * * * In principle, the estimated net salvage should serve to reduce depreciation, either through a reduction in the basis on which depreciation is computed or a reduction in the rate. In either instance the amount of net salvage should actually, or in effect, be a credit to the depreciation reserve. * * *Losses.— Accounting losses from the normal retirement of assets are not allowable under any method of depreciation accounting unless, in the case of classified or group accounting, the depreciation rate is based on the expected life of the longest-lived asset in the group, and in item accounting only when the maximum expected life of the asset is used, since correct item accounting required an accurate determination of the life of each individual asset, which is a practical impossibility until near the end of its life.Losses resulting from casualty are allowable in the year when the casualty occurred. 2. Composite Accounts.— All depreciable assets are included in one account with a single depreciation reserve. In computing depreciation an over-all composite rate is applied to the cost or other basis of all depreciable property. The depreciation rate is determined by applying the appropriate component rate to the cost or other basis of each classification or group included in the composite account and dividing the total amount thus obtained by the total cost of all depreciable property. Under this method, it is necessary to redetermine the composite rate whenever substantial changes occur in the relative proportions of different groups of assets. The method has the merit of extreme simplicity in application, and if the rate is adjusted to material changes in composition of the plant account, it is acceptable. 3. Group Accounts: Assets similar in kind which have approximately the same average useful lives are included in one account. This method is considered accurate and satisfactory for use in determining depreciation allowances, especially where large investments in depreciable property, containing many items of widely differing estimated useful lives, are involved. A separate reserve is carried for each group and computation of depreciation is simplified since the same depreciation rate is applicable to all items in the group. The greater the number of items that, because of life characteristics, fall in the same group, the more accurate are the results.
Respondent had tacitly approved this method of computing depreciation for tax purposes prior to 1942, and even now does not appear seriously to challenge its propriety for a business such as petitioner conducts. The difference between the parties is essentially over the extent to which such a procedure may be carried.
The principal controversy herein arises from the fact that under the method used by petitioner at least two classes of its equipment, namely, ‘steam locomotives‘ and ‘miscellaneous equipment‘ would by the end of 1946 be overdepreciated in that petitioner would by that time, applying the rates prescribed by the Interstate Commerce Commission, have recovered by way of depreciation more than the original cost of the equipment in these accounts.
For this reason respondent, on the basis of petitioner's collateral records which disclosed the amount of depreciation attributed by petitioner of each piece of equipment, recomputed the allowable depreciation for the years 1942 to 1944, inclusive, by determining for each individual item of its rolling stock the remaining or unrecovered cost, an estimated salvage value, and an estimated remaining life. In short, respondent completely abandoned the composite system and based depreciation in those years on the straight-line unit or item method of depreciation. In this respect, we believe respondent was clearly in error. A recognized system, once established and operative over a long period of years, should not be abandoned unless there is a cogent reason for a change. Lake Charles Naval Stores, 25 B.T.A. 173; Copifyer Lithograph Corporation, 12 T.C. 728. In our opinion, any adjustments to depreciation necessary in the instant case may be accomplished by a determination of new rates for the respective groups, a procedure which is in harmony with the system used by petitioner.
Petitioner, on the other hand, claims that it may properly recover more than its original cost on its various classes of equipment so long as in its ‘control‘ account its depreciation reserve, representing the accrued depreciation on all classes, does not exceed the original cost of its entire rolling stock. Petitioner bases this argument on the premise that the depreciation accounts it has maintained since 1935 are of the type characterized as ‘composite accounts‘
by Bulletin ‘F.‘ However, a distinction exists between petitioner's system and ‘composite accounts‘ in that all of its depreciable assets were not included in one account and no over-all composite rate was applied to the cost or other basis of petitioner's entire depreciable property. Petitioner computed its depreciation by simply adding the depreciation computed under the separate rate for each of its five classes of equipment and on its general ledger credited the aggregate to its over-all depreciation reserve. Under our interpretation of the language of Bulletin ‘F‘ outlining the various depreciable property accounts available to taxpayers, petitioner's method more closely conforms to the so-called ‘group accounts.‘
The depreciation accounts in 1946 do not reflect the adjustments made to the reserves at the order of the Interstate Commerce Commission in 1946.
Petitioner, citing Union Co., 14 B.T.A. 1310, states that ‘it is implicit in composite depreciation accounting that the composite rate is an average rate, and that if such rate would be applied to the longer-lived individual units in the composite category, such units would be fully depreciated prior to the termination of their actual useful life, while conversely the shorter-lived assets would no longer be in use at a time when depreciation would still continue to be taken on them. It is the experience of the group which is important * * *.‘
Insofar as the principle stated by petitioner is concerned, we have no doubt that it is correct. However, we find that as of the end of 1946 (Steam Locomotives‘ and ‘Miscellaneous Equipment,‘ as groups, have been overdepreciated, petitioner on that date having recovered, by way of deductions for depreciation on its tax returns, amounts in excess of the original cost of the assets in each group.
Within the group it is possible, in fact necessary if an average life instead of a maximum life is used in computing the rate, that some individual items are over-depreciated‘ to compensate for similar items in the class which are retired prior to the estimated average useful life of the group. It is for this reason that where a rate is based on an average life of the group, no loss is allowed on a premature retirement. However, we do not believe that a class of assets may be overdepreciated merely because many of its composite units remain in service after the original cost of the class has been completely recovered or because there exist other groups or classes depreciated at different rates where complete cost has not yet been recovered. Alpin J. Cameron, 8 B.T.A. 120, 129; affd., Cameron v. Commissioner, 56 Fed.(2d) 1021. Cf. Pittsburgh Brewing Co., 37 B.T.A. 439; reversed on another point, 107 Fed.(2d) 155. The inevitable result of allowing petitioner to continue depreciation at the normal rates on these classes would be to overdepreciate the ‘other locomotives‘ account as, upon the retirement of the overdepreciated classes, all of the excessive depreciation taken in respect thereto would remain in the depreciation reserve.
Since 1935 petitioner has computed its depreciation for tax purposes under the method and rates prescribed by the Interstate Commerce Commission. The fact that such procedure is generally acceptable to the respondent is shown by the following language of Bulletin ‘F‘:
.2866 Steam railroad property. In general, the rates of depreciation of physical property of common carriers by rail under the jurisdiction of the Interstate Commerce Commission will be governed by the action taken by the Commission in its application of the provisions of section 20, paragraph 5, of the Interstate Commerce Act, as amended by the Transportation Act of 1920. However, the basis of depreciable property must conform to the limitations of cost of other allowable value as prescribed by the Internal Revenue Code.
However, it is clear that the respondent is not bound to abide by the method used to compute depreciation for the purposes of the Interstate Commerce Commission. Old Colony R. Co. v. Commissioner, 284 U.S. 552; Atlantic Coast Line R. Co., 31 B.T.A. 730; affd., 81 Fed.(2d) 309; certiorari denied, 298 U.S. 656. The Interstate Commerce Commission, for its own purposes, adjusted petitioner's allowance for depreciation in 1946 by assigning new and lower rates on each class of equipment and transferring $70,000 of the depreciation accrued on its various classes of rolling stock to the depreciation account for its ‘road‘ properties. The transfer of the $70,000 between accounts did not represent a retroactive reduction in depreciation, but merely a shifting of depreciation between petitioner's primary group accounts. The petitioner was instructed by the Commission to retain this amount as ‘a margin against unforeseen retirements.‘
Although a revision of this nature effectuates the purposes of the Interstate Commerce Commission, it clearly does not offer a solution to the tax problem involved, which requires an annual determination of a ‘reasonable allowance‘ for depreciation which the petitioner may use as a deduction in computing its Federal tax liability. Therefore, it is our opinion that the amount of depreciation to which the petitioner is entitled in the years in issue must be determined solely on the basis of the evidence presented in the instant proceeding.
The record before us demonstrates that by the end of 1946 petitioner's rolling stock, exclusive of its newly acquired diesel-electric locomotives, had reached the end of its economic useful life. Although the record shows that it possessed some usefulness and in fact was used by the petitioner after that date, it is not an uncommon experience to find property fully depreciated for tax purposes used to some extent after the expiration of its estimated useful life. This is especially true in the instant case, where obsolete equipment was and is being used on an emergency or rotating basis and in many instances for purposes other than those for which it was designed. Inasmuch as most of petitioner's rolling stock was approaching the end of its useful life during the years before us, it is not surprising to find that its depreciation reserves on such classes of equipment had reached a point approximating its original cost.
Although our decision herein will permit the petitioner to deduct, with the exception of the ‘Miscellaneous Equipment‘ account hereinafter discussed, depreciation in the amount claimed for each group of equipment in 1942, 1943, and 1944, it may not in later years continue to claim depreciation on a group once it has recovered the full amount of the original cost thereof by way of deductions taken in its Federal income tax returns.
From the evidence herein, it is also clear that the useful life of the automobile carried in the ‘Miscellaneous Equipment‘ account was greatly underestimated, which resulted in the selection of an excessive rate. This fact is evidenced by the ratio of the depreciation reserve to the original cost of the property in 1942 and the continued use and overdepreciation of the property after that date. The property remedy in such a case is to reduce the rate so that recovery of cost will more closely conform with what experience has shown to be the actual exhaustion of the property. We are of the opinion that the composite rate of 13.33 per cent fixed by the Interstate Commerce Commission in 1946, if applied to the ‘Miscellaneous Equipment‘ account for 1942 and subsequent years until such time as its original cost is recovered, would result in a reasonable allowance for its depreciation.
To permit a recomputation of petitioner's tax liability for the years 1942, 1943, and 1944, inclusive, in accordance with our opinion herein,
Decision will be entered under Rule 50.
Reviewed by the Court.