American Refrigerator Transit Co. v. Commissioner

*465 Respondent determined deficiencies in petitioner's income taxes, of $25,849.98 for 1929, $23,216.31 for 1930, and $28,231.23 for 1931. Petitioner attacks these determinations as erroneous, asserting that respondent has failed to make deductions of reasonable allowances for exhaustion, wear and tear, including obsolescence, of its refrigerator cars. The proceedings were consolidated for hearing.

FINDINGS OF FACT.

Petitioner, a New Jersey corporation with its principal office at St. Louis, Missouri, owns a large number of refrigerator cars which are used in transporting perishable commodities over railroads. Its income is derived principally from the hire of its cars on a mileage basis and from refrigeration services.

In 1912 the Master Car Builders Section of the American Railway Association recommended that annual depreciation charges to operating expenses, with respect to refrigerator cars, be computed at 5 percent of their diminishing value, *1084 and that such depreciation charges, with respect to any particular car, be discontinued when the aggregate thereof became equal to 60 percent of cost or original book value. Petitioner adopted that recommendation in its fiscal year ended June 30, 1912, and uniformly applied it, for its own accounting purposes, to and including 1928. Depreciation deductions taken in prior income tax returns have been computed accordingly, and they have been allowed by respondent. In 1926 or 1927 the Master Car Builders Section recommended that the annual depreciation charges be computed thereafter on a straight line basis instead of a diminishing value basis. In 1929 petitioner, believing that its newer type of cars would become obsolete within the same period of time that its *466 older type of cars had, and probably within a shorter period, because of advances already made in mechanical refrigeration, and having found that prior depreciation charges were not sufficiently large to return its full investment, less salvage, changed its method of computing depreciation on new cars only, to conform with the last recommendation of the Master Car Builders Section. Petitioner did not deem it necessary*1085 to make any change in the method of computing depreciation on its older type of cars, since their value was only a small proportion of the total book value of all cars, and prior depreciation charges with respect thereto aggregated substantially 60 percent of their cost or original book value. Thus, the depreciation charges on petitioner's books and the deductions taken in its tax returns for the years in controversy were computed in the case of the older type of cars on the basis of 5 percent of their diminishing value, and in the case of the newer type of cars on the basis of 5 percent of their cost or original book value, with no depreciation claimed with respect to any cars 60 percent of the cost or original book value of which had already been returned to petitioner through prior depreciation charges. These deductions in tax returns were $1,045,947.27 for 1929, $1,104,721.80 for 1930, and $1,198,072.41 for 1931. Respondent, having determined that the average useful life of petitioner's cars is 30 years, computed depreciation, with respect to all cars, on the basis of 3 1/3 percent of average total cost or original book values, as of the beginning and close of each tax year, *1086 and has allowed deductions of $810,947.44 for 1929, $911,399.83 for 1930, and $963,554.83 for 1931.

The petitioner owned 10,979 refrigerator cars at the close of 1928, of which 9,393 were less than 20 years old and 1,586 were more than 20 years old; 11,842 cars at the close of 1929, of which 10,268 were less than 20 years old and 1,574 were more than 20 years old; 12,814 cars at the close of 1930, of which 11,261 were less than 20 years old and 1,553 more than 20 years old; and 12,567 cars at the close of 1931, of which 10,305 were less than 20 years old and 2,262 were more than 20 years old. Of the 12,567 cars on hand at the close of 1931, 4,589 were acquired prior to 1922 and are designated in these proceedings as "older cars", while the remaining 7,978, designated "newer cars", were acquired in and after 1922. A physical and historical description of these 12,567 cars is fairly descriptive of the cars owned by petitioner in all of the three tax years in controversy.

In 1919 a new United States standard refrigerator car was introduced by the United States Railroad Administration, which revolutionized the construction of that type of cars and rendered all prior types of construction*1087 obsolete. All cars acquired by petitioner in and after 1922 were patterned from this new standard car. In these *467 newer cars, basket type bunkers with all-metal bulkheads have replaced the slatted front wooden bulkhead bunkers of the older cars; increased refrigeration efficiency has been obtained by changes in air circulation; ice capacity of bunkers has been increased from 8,500 to 10,500 pounds; carrying capacity has been raised from 60,000 to 80,000 pounds; metal roofs have been substituted for wooden roofs; heavier steel underframes have been installed; archbar construction of trucks on the older cars has given way to heavy, steel, sidetruck frames; body length has been increased 6 inches; hatches are equipped with better ventilating devices than those on the older cars; floors have been improved to better withstand seepage of water from melting ice; and all devices and appliances required by the American Railway Association have been installed.

Petitioner's cars are used principally for shipping perishables, such as spinach, carrots, beets, lettuce, peaches, radishes, corn, broccoli, peas, and cantaloupes. The cubical contents of the older cars will not permit*1088 of the minimum loading of leafy vegetables required by railroad tariffs; and this condition has become more and more acute in the last 10 years, through increasing requirements of top-icing. While these cars are large enough to contain the minimum loadings of canned goods prescribed by tariffs, they are not large enough for loading the larger units in which these commodities are usually sold.

With the coming into service of the newer cars, in 1922, the demand for the older cars rapidly diminished. Shippers objected to using the older cars, claiming that they did not afford proper protection to their perishable shipments and that their capacity was insufficient for loading the minima required by tariffs, while the railroads demanded newer cars be furnished because of the lesser claim hazard involved in transporting them. In the taxable years use of the older cars was only occasional and extremely limited. Some 300 to 400 of them were used by the railroads in hauling ice from ice-manufacturing plants to icing docks within the same switching district, but petitioner derived no revenues from such use of its cars. They were occasionally used for shipping commodities, such as onions*1089 and potatoes, which do not require refrigeration and may be moved under ventilation only. Infrequently, a shipper used one of these cars for shipping less than a carload lot, and the railroads used them in what is known as less than carload protective service. For the greater part of the time, they were stored and wholly unused. The number of older cars owned at the close of 1928, 1929, and 1930 was 4,991, 4,864, and 4,825, respectively. The average earnings of these cars for several years prior to 1929 and later years was less than 8 percent of petitioner's total mileage revenue, while practically no refrigeration revenues were earned by them.

*468 The regulations of the American Railway Association forbid the interchange movement on and after January 1, 1936, of cars equipped with archbar trucks, such as petitioner's older cars are equipped with. These archbar trucks can be replaced with modern type trucks at a cost of about $250 or $300 per car, but, because of the advanced age and state of obsoleteness which these older cars have reached, as well as their limited use, such replacements would be uneconomical, and petitioner's policy is not to expend any substantial*1090 sum for repairs or betterments to these cars. For the same reasons it would not be economical to install the new basket type bunkers in these older cars, at a cost of $400 or $500 per car.

Petitioner's cars are transported in express trains which move much faster than the ordinary freight trains. Statistics of the American Railway Association show that ordinary freight cars move on an average of about 28 miles per day. Petitioner's cars average about 55 miles per car per day; cars of the Fruit Growers Express Co., which is engaged in the same business as petitioner, average about 40 to 50 miles per car per day; and the cars of the Pacific Express Co., also engaged in the same business as petitioner, average between 85 and 90 miles per car per day. Wheel manufacturers guarantee their wheels for 60,000 and 80,000-pound capacity box cars, against manufacturers' defects, for 6 and 5 years, respectively, while the same guaranty for refrigerator car wheels is limited to 2 1/2 years.

The practice of body-icing is prevalent to a large extent and is increasing from year to year. Water from the melting ice seeps through the floor borads and insulation down to the steel underframes, *1091 causing rapid deterioration of insulation and corrosion of underframes. Water damage to petitioner's cars is increasing in proportion to the increasing practice of body-icing.

Refrigerator cars in which refrigeration is being mechanically produced with gas and axle-driven machinery are in operation and are increasing in number from day to day, and further experimentation work is being carried on by manufacturers of such cars in that direction, along several lines.

In a preliminary report of "Depreciation Studies" promulgated in January 1931 the Bureau of Internal Revenue suggested, "solely as a guide or starting point from which correct rates may be determined in the light of the experience of the property under consideration and all other pertinent evidence" and without regard for "an extended or indefinite term of usefulness due to maintenance and replacement policy", a depreciation rate of 5 percent for refrigerator cars, based upon an assumed life of 20 years from date of acquisition. Under the same conditions, the Bureau suggested depreciation rates *469 of 4 and 5 percent for ordinary steel freight cars and ordinary wood freight cars, respectively, based upon assumed*1092 lives of 25 and 20 years, respectively, from date of acquisition.

Depreciation rates used by other companies operating refrigerator cars comparable to the types operated by petitioner, as reported by the Interstate Commerce Commission in Ex-Parte 104, are: Fruit Growers Express Co., 6 percent; Pacific Fruit Express Co., 5 percent; and American Tanker Co., 5 percent.

The cost of petitioner's cars, as reflected by the books of account, was $22,913,954.58 at the close of 1928, $25,742,891.80 at the close of 1929, $28,941,097.79 at the close of 1930, and $28,872,192.04 at the close of 1931. The average cost of the older cars was approximately $1,200 per car.

In 1912, when petitioner adopted its first depreciation policy, the salvage value of cars approximated 40 percent of their cost. This high salvage value was due to the interchangeability of parts, which gave them a substantial secondhand value, and the prevailing high prices for scrap. This situation, however, has materially changed in the past 10 years. Parts of older cars cannot be used for repairs and maintenance of the newer cars, and scrap prices have reached a much lower level. Ten years ago realized salvage*1093 amounted to as high as $276 per car. On 100 cars voluntarily retired in 1929, the average salvage realized amounted to $146.16 per car; and on 12 cars voluntarily retired in 1930, the average salvage realized amounted to $127.11 per car. In November 1933 the scrap value of voluntarily retired cars amounted to $45 per car. The following statement shows, for the period 1924 to 1931, inclusive, the annual charges to operating expenses for voluntary car retirements, the charges representing the excess of depreciated book value of cars retired over realized salvage.

The useful life of petitioner's cars is 20 years from date of acquisition.

OPINION.

ARUNDELL: For 16 years prior to the tax years in controversy the petitioner computed its annual depreciation charges to operating expenses on the basis of 5 percent of the diminishing value of its cars, that is, 5 percent of 100 percent of cost in thf first year, 5 percent of 95 percent of cost in the second year, 5 percent of 90 percent of cost in the third year, and so on, until the aggregate depreciation deductions*1094 *470 with respect to any particular car amounted to 60 percent of cost or book value, when depreciation deductions with respect to that car were discontinued. By this method, 60 percent of the cost or book value of petitioner's cars was written off in 18 years. The remaining 40 percent of cost or book value was carried on the books undiminished as representing the salvage value at the end of useful life. It must be assumed that these annual depreciation charges were reasonable allowances for exhaustion, wear and tear, including obsolescence, of petitioner's cars, in the light of conditions then existing, for, notwithstanding that they were computed by a method which, from an income tax standpoint, is highly unsatisfactory, , they were allowed by respondent as deductions in computing taxable net income. Thus, the importance of the method by which petitioner computed the depreciation deductions claimed in earlier returns becomes obscure, as it inevitably must, for after all the question is not one of methods, but rather the reasonableness of the deductions claimed. *1095 .

In the tax years in controversy petitioner claimed depreciation deductions which were computed by the same method as was used in computing the deductions of the prior 16 years, except that depreciation on new cars was computed on the straight line basis, that is, at 5 percent of cost. The respondent rejected these deductions and, having determined that 30 years is the average usefull life of petitioner's cars, allowed deductions equivalent to 3 1/3 percent of the average book values as of the beginning and close of each year.

Unless there be present unusual circumstances which justify a departure from the rule, a proportional part, based upon estimated useful life, of cost less salvage value will reflect a reasonable allowance for depreciation of wasting assets. This is what the parties are contending for here. They disagree, however, as to what are the useful life of petitioner's cars and the base or cost less salvage value.

We have found as a fact that the average useful life of petitioner's cars is 20 years. To support that finding, we have the uncontroverted testimony of three expert witnesses, who, by*1096 training and years of practical experience, are peculiarly fitted to express opinions on the subject. They knew the state of condition of petitioner's cars, as to wear and tear, obsolescence, availability and usefulness, for, in their respective positions of auditor, superintendent of transportation, and mechanical superintendent in petitioner's employ, they were required to keep themselves informed on the subject. They testified that obsolescence, brought on by advances made and being made in the art of refrigerating cars for the transportation *471 of perishable shipments and improvements in the construction of refrigerator cars, has substantially lessened the usefulness of petitioner's cars to a period much shorter than their physical life, and that it is the largest single factor to be reckoned with in estimating useful life; and to that factor they have assigned the greatest weight in their estimates of useful life. There is extrinsic evidence to support their judgment in that respect. In 1919 the United States Railroad Administration introduced a new United States standard refrigerator car that, in every important feature of construction, method of refrigeration, and*1097 efficiency in protecting perishable shipments, was a radical departure from the cars then in use. The introduction of that new standard type of car sounded the death knell of the older types of cars, or so circumscribed their sphere of usefulness that their employment as transportation facilities has been reduced to only occasional use and is a matter of much difficulty. In 1922, when petitioner first commenced the replacement of its older type of cars with the newer type, the older cars constituted 100 percent of its entire car equipment, while six years later, in 1928, they represented but 46 percent of all the cars owned. Thus, within the short period of six years, more than one half of petitioner's older cars were supplanted with the newer type; and though the older cars represented 46 percent of all the cars owned, their mileage earnings represented less than 8 percent of petitioner's total mileage revenues. Furthermore, the petitioner is now confronted with a further advance in the art of refrigerating cars, that of producing refrigeration with mechanical devices, and the testimony is that the ice bunkers of petitioner's cars must give way, before the end of physical life, *1098 to the new mechanical means of refrigeration.

Further confirming the opinions of these witnesses are the facts pertaining to the age of cars owned in the taxable years. Less than 15 percent of the cars, on the average, were more than 20 years old. Of course, this situation largely reflects the replacements of older cars with newer cars since 1922; but, confronted now with a further revolutionary change in methods of refrigeration, it is not at all likely that any great error would result in basing the estimate of useful life upon the petitioner's actual experience. True, a large number of this 15 percent are substantially older than 20 years; but the fact that they are still being carried in petitioner's capital accounts is best explained by the auditor's testimony as to the reluctance of the board of directors to charge them off in years of low earnings, which is confirmed by the mechanical superintendent's statement that his repeated requests or recommendations to retire these older cars have been ignored by the board of directors.

*472 The determination that 20 years is the useful life of petitioner's cars necessarily precludes from consideration, in determining*1099 the annual depreciation deductions, all cars in excess of that age, and the base should be reduced accordingly. The evidence shows that the average cost of the older cars is $1,200. The elimination of all cars over 20 years old will, therefore, reduce the cost basis, as of the close of 1928, 1929, 1930, and 1931, by the amounts of $1,903,200, $1,888,800, $1,863,600, and $2,714,400, respectively.

A further factor to be considered in fixing the depreciation base is the estimated salvage value of cars at the end of useful life. Consistently since 1912, the petitioner has carried 40 percent of cost on the books as representing estimated salvage value. However, the facts set forth in the findings indisputably show that while 40 percent of cost was a fair estimate of salvage value in 1912, when petitioner first adopted a depreciation policy, it is much too high under the circumstances existing in the taxable years in controversy. Interchangeability of parts and high scrap prices gave high values to salvaged materials in the years immediately following 1912. In the taxable years in controversy that interchangeability of parts had been largely lost, while scrap prices had materially*1100 declined from the high levels of earlier years. Comparing the salvage actually realized within the cost of cars retired in the taxable years, we conclude that 12 percent of cost is the maximum salvage value that may be ascribed to petitioner's cars. The cost basis of cars under 20 years old, as of the close of 1928, 1929, 1930, and 1931, should be reduced, therefore, by the amounts of $2,521,290.55, $2,862,491.02, $3,249,299.73, and $3,138,935.04, respectively, representing salvage values.

After giving effect to the above adjustments for elimination of cars over 20 years old and salvage values, the bases, as of the close of 1928, 1929, 1930, and 1931, are $18,489,464.03, $20,991,699.78, $23,828,198.06, and $23,018,857.00; and the average bases are $19,740,532.40 for 1929, $12,409,899.42 for 1930, and $23,423,527.52 for 1931. Applying a rate of 5 percent, based on a useful life of 20 years, to these average bases, we conclude that reasonable allowances for depreciation of petitioner's cars are $987,026.62 for 1929, $1,120,494.97 for 1930, and $1,171,176.38 for 1931.

Decision will be entered under Rule 50.