On Petition for Review of Decision of the United States Board of Tax Appeals.
Before SPARKS and MAJOR, Circuit Judges, and LINDLEY, District Judge.
This petition for review challenges the decision of the Board of Tax Appeals rendered on April 22, 1936, determining deficiencies in taxable income for the years 1926, 1927, 1928, and 1929.
The taxable income was that of the Yazoo & Mississippi Valley Railroad Company, a subsidiary of the Illinois Central Railroad Company, which latter company filed a consolidated return for both companies for each of the years in question. Any additional taxes or refunds are payable or recoverable by the Illinois Central Railroad Company.
Several items were in controversy, but the only one now involved is with reference to the liability accrued on the lessee's books growing out of the retirement of certain equipment, i.e., locomotives and cars, owned by the Alabama & Vicksburg Railway Company and the Vicksburg, Shreveport & Pacific Railway Company, the respective properties of which companies are leased to and operated by the Yazoo & Mississippi Valley Railroad Company.
On March 31, 1925, the latter company, herein called the lessee, entered into separate agreements with the Alabama & Vicksburg Railway Company and the Vicksburg, Shreveport & Pacific Railway Company, herein called the lessors, by the terms ofwhich it leased the properties of the two last-mentioned companies until July 1, 2282, with options to renew the leases for an additional period of 999 years. The lessee agreed that it would keep up, maintain, repair, replace, and renew the leased properties during the terms of the leases, so that such properties would at all times be in substantially as good repair, working order, and condition as they were at the effective date of the lease agreements; and that, whenever during the terms of the leases any part of the leased properties, including rolling stock and equipment, should be damaged, destroyed, or otherwise become unfit for its appropriate use and purpose, to cause the same to be repaired, renewed, rebuilt, or replaced by property of equal value. These covenants were to be performed at the lessee's sole cost and expense. The agreements also provided that the lessee should have the right to make such additions and extensions to, and betterments and improvements of, the leased properties as it deemed necessary, for which it was to be reimbursed by the lessors. The leases became effective on June 2, 1926, and the lessee took over the leased properties on that day.
During the taxable years and 1930, the lessee retired 1,464 units of leased equipment, such as locomotives and freight train cars, having a depreciated book value as of June 2, 1926, as agreed upon by the lessee and the lessors, of $1,157,752.92. These retirements took place as follows: 1926, 81 units valued at $72,785.86; 1927, 757 units valued at $356,371.48; 1929, 164 units valued at $161,026.82; and 1930, 73 units valued at $70,273.43. Under the lease agreements, the lessee was required to replace these units with others of like values. As each equipment unit was retired, the lessee recorded its liability for replacement thereof on its books, in an amount equal to its depreciated book value at June 2, 1926, by a credit to the account of the lessor owning the unit. These retired units were replaced by the lessee with equipment furnished by the Illinois Central, as guarantor under the lease agreements, as follows: 577 units in 1929, and 29 units in 1930, a total of 606 units; but title thereto was not conveyed to the lessors at the times of replacement. The value of these replacement units on the lessee's books, which was cost less depreciation previously allowed, was $1,020,121.99, but for the purposes of the replacements, the lessee and lessors agreed upon values of $1,103,579.22 for the 1929, replacements, and $60,408.60 for the 1930, replacements, a total of $1,163,987.22.
In August, 1929, it was agreed that the lessee should convey to the lessors title to all such equipment replacements and to such other equipment as was necessary to replace all units of leased equipment that had been and would be retired up to December 31 of that year, in order that all such equipment might be brought immediately within the liens of the lessors' mortgages. By reason of the delay in agreeing upon the values and classes of replacement units that were to be conveyed to the lessors, the conveyances of titled were not formally made to the lessors until 1932. The accounting for the transfer of the replacement units was made on the books of the lessee and lessors in 1932.
The Board decided that the expenditures were not ordinary and necessary expenses within the meaning of paragraph 1, section 214 (a), of the Revenue Act of 1926, c. 27, 44 Stat. 9, 27,*fn* but were for permanent additions and betterments to the leased properties, as defined in section 215 of the same act*fn** and thereupon denied the lessee the right to deduct the full amount in the respective tax years.
This matter has twice been before the Board of Tax Appeals, in the first instance apparently having been decided favorable to the contention of the petitioners in so far as the law applicable was concerned, but later the Board decided in favor of the respondent. In its first opinion of June 29, 1934, it found: "Under the lease agreements, the lessee was required immediately to replace all units of equipment retired from service. Therefore, as and when the lessee retired a unit of equipment, liability in praesenti, to make replacement, was created. The amount of the lessee's liability was measurable, under the terms of the lease agreements, by the value as of June 2, 1926, of the equipment units retired. Consequently, the lessee's liability to replace was fixed and determined at the time each unit of equipment was retired and was definitely ascertainable in amount. The lessee's books were kept on an accrual basis, and at the accounting for its liability to the lessors was made at the time the equipment units were retired. Under the circumstances the amount to be deducted from the lessee's income of any taxable year on account of its replacements of equipment is the aggregate value, as of June 2, 1926, of the equipment units retired during that particular taxable year. Cf. Lucas v. American Code Co., 280 U.S. 445, 50 S. Ct. 202, 74 L. Ed. 538, 67 A.L.R. 1010. While the number of equipment units retired in each taxable year is shown, there is no evidence upon which we can determine the amount of the lessee's liability as to each of such taxable years. Accordingly, the issue must be resolved against the Petitioners."
Subsequently, on motion of the petitioners, the case was reopened so that petitioners might prove the exact amount of liability in each of the years in question. On March 4, 1936, the Board promulgated its second opinion stating: "Upon reconsideration of the entire record, we are now convinced that our earlier opinion is wrong in several respects and should be set aside. Accordingly, the following opinion is substituted for the earlier one promulgated on June 29, 1934."
And in which opinion the Board found: "The expenditures represented by these replacements are not 'ordinary and necessary expenses paid or incurred during the taxable year(s) in carrying on any trade or business', within the meaning of section 214 (a) (1) of the 1926 Act and section 23 (a) of the 1928 Act [26 U.S.C.A. § 23 and note] but were for permanent additions and betterments to the leased properties, such as would, if made by the owners of these properties, come within the provisions of section 215 (a) (2) of the 1926 Act and section 24 (a) (2) of the 1928 Act [26 U.S.C.A. § 24 and note] 'that no deduction shall in any case be allowed in respect of any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property." 'They constituted, not upkeep, but investment; not maintenance or operating expenses, but capital, subject to annual allowances for exhaustion or depreciation.' Duffy v. Central Railroad Co., supra [268 U.S. 55, 45 S. Ct. 429, 69 L. Ed. 846]. The Petitioners' contention that they are deductible in computing the lessee's taxable net income, is, therefore, denied."
We are of the opinion the Board erred in the conclusion it finally reached and that petitioners were entitled to deduct from their income in each of said years the aggregate value as of the effective dates of the leases in question, the equipment units retired during each year, as accrued upon the books of the lessee company. The Board quotes from and apparently bases its opinion upon the case of Duffy v. Central R.R. Co., 268 U.S. 55, 45 S. Ct. 429, 430, 69 L. Ed. 846; but the facts in that case are quite dissimilar to those in the present situation. There the lease required the lessee "to acquire and pay for the interest of private owners in an old pier and to construct a new one in its place." Such expenditures by the lessee were not for the purpose of maintaining the corpus of the leased estate, but to increase its value by buying the interest of private owners in the old pier and then constructing a new one in its place. The court held (268 U.S. 55, at page 62, 45 S. Ct. 429, 430, 69 L. Ed. 846): "Clearly the expenditures were not 'expenses paid within the year in the maintenance and operation of its (respondent's) business and properties'; but were for additions and betterments of a permanent character, such as would, if made by an owner, come within the proviso in subdivision Second, 'that no deduction shall be allowed for any amount paid out for new buildings, permanent improvements, or betterments ...