Fribourg Navigation Company v. Commissioner of Internal Revenue, 23

• Decision Date: 07 March 1966
• Docket Number: No. 23,23
• Citation: 86 S.Ct. 862,383 U.S. 272,15 L.Ed.2d 751
• Parties: FRIBOURG NAVIGATION COMPANY, Inc., Petitioner, v. COMMISSIONER OF INTERNAL REVENUE
• Court: U.S. Supreme Court

383 U.S. 272

86 S.Ct. 862

15 L.Ed.2d 751

FRIBOURG NAVIGATION COMPANY, Inc., Petitioner,

v COMMISSIONER OF INTERNAL REVENUE.

No. 23.

Argued Nov. 10, 1965.

Decided March 7, 1966.

[Syllabus from pages 272-273 intentionally omitted] James B. Lewis, New York City, for petitioner.

Jack S. Levin, Dept. of Justice, Washington, D.C., for respondent.

Mr. Chief Justice WARREN delivered the opinion of the Court.

The question presented for determination is whether, as a matter of law, the sale of a depreciable asset for an amount in excess of its adjusted basis at the beginning of the year of sale bars deduction of depreciation for that year.

On December 21, 1955, the taxpayer, Fribourg Navigation Co., Inc., purchased the S. S. Joseph Feuer, a used Liberty ship, for $469,000. Prior to the acquisition, the taxpayer obtained a letter ruling from the Internal Revenue Service advising that the Service would accept straight-line depreciation of the ship over a useful economic life of three years, subject to change if warranted by subsequent experience. The letter ruling also advised that the Service would accept a salvage value on the Feuer of $5 per dead-weight ton, amounting to $54,000. Acting in accordance with the ruling the taxpayer computed allowable depreciation, and in its income tax returns for 1955 and 1956 claimed ratable depreciation deductions for the 10-day period from the date of purchase to the end of 1955 and for the full year 1956. The Internal Revenue Service audited the returns for each of these years and accepted the depreciation deductions claimed without adjustment. As a result of these depreciation deductions, the adjusted basis of the ship at the beginning of 1957 was $326,627.73.

In July of 1956, Egypt seized the Suez Canal. During the ensuing hostilities the canal became blocked by sunken vessles, thus forcing ships to take longer routes to ports otherwise reached by going through the canal. The resulting scarcity of available ships to carry cargoes caused sales prices of ships to rise sharply. In January and February of 1957, even the outmoded Liberty ships brought as much as $1,000,000 on the market. In June 1957, the taxpayer accepted an offer to sell the Feuer for $700,000. Delivery was accomplished on December 23, 1957, under modified contract terms which reduced the sale price to $695,500. Prior to the sale of the Feuer, the taxpayer adopted a plan of complete liquidation pursuant to the provisions of § 337 of the Internal Revenue Code of 1954, which it thereafter carried out within 12 months. Thus, no tax liability was incurred by the taxpayer on the capital gain from the sale of the ship. As it developed, the taxpayer's timing was impeccable—by December 1957, the shipping shortage had abated and Liberty ships were being scrapped for amounts nearly identical to the $54,000 which the taxpayer and the Service had originally predicted for salvage value.

On its 1957 income tax return, for information purposes only, the taxpayer reported a capital gain of $504,239.51 on the disposition of the ship, measured by the selling price less the adjusted basis after taking a depreciation allowance of $135,367.24 for 357 1/2 days of 1957. The taxpayer's deductions from gross income for 1957 included the depreciation taken on the Feuer. Although the Commissioner did not question the original ruling as to the useful life and salvage value of the Feuer and did not reconsider the allowance of depreciation for 1955 and 1956, he disallowed the entire depreciation deduction for 1957. His position was sustained by a single judge in the Tax Court and, with one dissent, by a panel of the Court of Appeals for the Second Circuit. 335 F.2d 15. The taxpayer and the Commissioner agreed that the question is important, that it is currently being heavily litigated, and that there is a conflict between circuit courts of appeals on this issue. Therefore, we granted certiorari. 379 U.S. 998, 85 S.Ct. 717, 13 L.Ed.2d 700. We reverse.

I.

The Commissioner takes the position here and in a Revenue Ruling first published the day before the trial of this case in the Tax Court¹ that the deduction for depreciation in the year of sale of a depreciable asset is limited to the amount by which the adjusted basis of the asset at the beginning of the year exceeds the amount realized from the sale. The Commissioner argues that depreciation deductions are designed to give a taxpayer deductions equal to the 'actual net cost' of the asset to the taxpayer, and since the sale price of the Feuer exceeded the adjusted basis as of the first of the year, the use of the ship during 1957 'cost' the taxpayer 'nothing.' by tying depreciation to sale price in this manner, the Commissioner has commingled two distinct and established concepts of tax accounting depreciation of an asset through wear and tear or gradual expiration of useful life and fluctuations in the value of that asset through changes in price levels or market values.

Section 167(a) of the Internal Revenue Code of 1954 provides, in language substantially unchanged in over 50 years of revenue statutes: 'There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)—(1) of property used in the trade or business, or (2) of property held for the production of income.' In United States v. Ludey, 274 U.S. 295, 300—301, 47 S.Ct. 608, 610, 71 L.Ed. 1054 the Court described depreciation as follows:

'The depreciation charge permitted as a deduction from the gross income in determining the taxable income of a business for any year represents the reduction, during the year, of the capital assets through wear and tear of the plant used. The amount of the allowance for depreciation is the sum which should be set aside for the taxable year, in order that, at the end of the useful life of the plant in the business, the aggregate of the sums set aside will (with the salvage value) suffice to provide an amount equal to the original cost.'

See also Detroit Edison Co. v. Commissioner of Internal Revenue, 319 U.S. 98, 101, 63 S.Ct. 902, 903, 87 L.Ed. 1286. In so defining depreciation, tax law has long recognized the accounting concept that depreciation is a process of estimated allocation which does not take account of fluctuations in valuation through market appreciation.²

It is, of course, undisputed that the Commissioner may require redetermination of useful life or salvage value when it becomes apparent that either of these factors has been miscalculated. The fact of sale of an asset at an amount greater than its depreciated basis may be evidence of such a miscalculation. See Macabe Co., 42 T.C. 1105, 1115 (1964). But the fact alone of sale above adjusted basis does not establish an error in allocation. That is certainly true when, as here, the profit on sale resulted from an unexpected and shortlived, but spectacular, change in the world market.

The Commissioner contends that our decisions in Massey Motors, Inc. v. United States, 364 U.S. 92, 80 S.Ct. 1411, 4 L.Ed.2d 1592, and Hertz Corp. v. United States, 364 U.S. 122, 80 S.Ct. 1420, 4 L.Ed.2d 1603, confirm his theory. To the extent these cases are relevant here at all, they support the taxpayer's position. In Massey and Hertz we held that when a taxpayer, at the time he acquires an asset, reasonably expects he will use it for less than its full physical or economic life, he must, for purposes of computing depreciation, employ a useful life based on the period of expected use. We recognized in those cases that depreciation is based on estimates as to useful life and salvage value. Since the original estimates here were admittedly reasonable and proved to be accurate, there is no ground for disallowance of depreciation.

II.

This concept of depreciation is reflected in the Commissioner's own regulations. The reasonable allowance provided for in § 167 is explained in Treas. Reg. § 1.167(a)—1 as 'that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan * * * so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the depreciable property, equal the cost or other basis of the property * * *. The allowance shall not reflect amounts representing a mere reduction in market value.' Treas.Reg. § 1.167(a)—1(c) defines salvage value as the amount, determined at the time of acquisition, which is estimated will be realizable upon sale or when it is no longer useful in the taxpayer's trade or business. That section continues: 'Salvage value shall not be changed at any time after the determination made at the time of acquisition merely because of changes in price levels. However, if there is a redetermination of useful life * * * salvage value may be redetermined based upon facts known at the time of such redetermination of useful life.' Useful life may be redetermined 'only when the change in the useful life is significant and there is a clear and convincing basis for the redetermination.' Treas.Reg. § 1.167(a)—1(b). This carefully constructed regulatory scheme provides no basis for disallowances of depreciation when no challenge has been made to the reasonableness or accuracy of the original estimates of useful life or salvage value. Further, from 1951 until after certiorari was granted in this case, the regulations dealing with amortization in excess of depreciation contained an example expressly indicating that depreciation could be taken on a depreciable asset in the year of profitable sale of that asset.³

The Commissioner relies heavily on Treas.Reg. § 1.167(b)—0 providing that the reasonableness of a claim for depreciation shall be determined 'upon the basis of conditions known to exist at the end of the period for which the return is made.' He contends that after the sale the taxpayer 'knew' that the Feuer had 'cost' him 'nothing' in 1...