CINCINNATI, NEW ORLEANS & TEXAS PAC. RY. CO. v. United States

• Decision Date: 24 April 1970
• Docket Number: No. 91-63.,91-63.
• Citation: 424 F.2d 563
• Parties: The CINCINNATI, NEW ORLEANS AND TEXAS PACIFIC RAILWAY COMPANY v. The UNITED STATES.
• Court: U.S. Claims Court

424 F.2d 563 (1970)

The CINCINNATI, NEW ORLEANS AND TEXAS PACIFIC RAILWAY COMPANY v. The UNITED STATES.

No. 91-63.

United States Court of Claims.

April 17, 1970.

As Amended April 24, 1970.

COPYRIGHT MATERIAL OMITTED

Daniel M. Gribbon, Washington, attorney of record, for plaintiff. Andrew W. Singer and Covington & Burling, Washington, D. C., of counsel.

Philip R. Miller, Washington, D. C., with whom was Asst. Atty. Gen., Johnnie M. Walters, for defendant. Ira M. Langer, Washington, D. C., of counsel.

Before COWEN, Chief Judge, LARAMORE, DURFEE, DAVIS, COLLINS, SKELTON and NICHOLS, Judges.

OPINION

PER CURIAM:^*

This is an income tax refund suit based upon the alleged improper assessment of deficiencies by the Commissioner of Internal Revenue for the taxable years 1947, 1948 and 1949. The assessments were paid, refunds claimed and denied in due course by the Commissioner, and this suit filed by the plaintiff within the statutory permissible period.

The material facts are set forth at length in the findings of fact accompanying this opinion and will be summarized here for consideration of the controlling legal principles.

Plaintiff, The Cincinnati, New Orleans and Texas Pacific Railway Company, during the period in question, operated a railroad as a common carrier in interstate commerce, and as such was subject to the supervision of the Interstate Commerce Commission (ICC). It has consistently reported its income for tax purposes in accordance with the accrual method on a calendar year basis.

In its regulation of rail carriers the ICC has long required that financial statements be prepared in compliance with its "General Instructions of Accounting Classifications." From January 1, 1921 to January 31, 1940, the ICC required that in accounting for purchases of property (other than track) of less than $100, the railroads should charge the expenditure to operating expenses rather than to a capital amount.¹ This procedure is referred to as a "minimum rule."

In 1940 the ICC, after consideration of the economic condition of the railroads, determined that the minimum rule should be raised from $100 to $500. This change was made in light of the ICC's overall duty to protect the public. In the setting of reasonable railroad rates in the public interest it is imperative that the accounting methods prescribed by the "General Instructions of Accounting Classifications" lead to financial statements that clearly reflect income. In accordance with this consideration, the ICC concluded that the $500 amount, when considered in relation to the railroads' volume of business and volume of small items acquired, would allow the elimination of detailed, expensive bookkeeping without adversely impairing the ability of the financial statements to clearly reflect income.²

The minimum rule in force during the years in question applied to the acquisition of property other than land, sections of track and "units of equipment" such as freight cars, locomotives, passenger cars or work cars. It further provided that:

* * * * * *

(b) The carrier shall not parcel expenditures or retirements under a general plan for the purpose of bringing the accounting therefor within this rule, neither shall it combine unrelated items of property for the purpose of excluding the accounting therefor from the rule.

General Instructions of Accounting Classifications (1943 ed.).

Upon auditing plaintiff's income tax returns for the years 1947, 1948 and 1949, the Commissioner of Internal Revenue disallowed the expense deduction taken for minimum rule items which cost in excess of $100 each.

Although the defendant has proffered a number of justifications for the disallowance by the Commissioner of the claimed deductions, the essence of its position seems to rest on a few specific arguments.³ Initially and with most force, defendant argues that the resolution of this litigation is controlled by section 24(a) (2) of the Internal Revenue Code of 1939 and Treas.Reg. 111, § 29.41-3(2). These pronouncements are as follows:

SEC. 24. ITEMS NOT DEDUCTIBLE.

(a) GENERAL RULE. — In computing net income no deduction shall in any case be allowed in respect of —

* * * * * *

(2) Any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate * * *.

Internal Revenue Code of 1939, § 24(a) (2).

Treas.Reg. 111 (1939 Code):

(2) Expenditures made during the year should be properly classified as between capital and expense; that is to say, expenditures for items of plant, equipment, etc., which have a useful life extending substantially beyond the year should be charged to a capital account and not to an expense account * * *.

Treas.Reg. 111, § 29.41-3(2).

It is argued that since the items accounted for by the minimum rule admittedly had a useful life longer than one year, they necessarily constitute permanent improvements or betterments, and, therefore, must be capitalized.

In furtherance of this position defendant points out that the capitalization of assets such as furniture, office equipment and other small items is in harmony with a long line of cases deciding this question with respect to specific assets.⁴ It is also noted that the Supreme Court has held in Old Colony R.R. Co. v. United States, 284 U.S. 552, 52 S. Ct. 211, 76 L.Ed. 484 (1932) that the accounting rules of regulatory agencies are not binding upon the Commissioner of Internal Revenue. In the same vein, it is defendant's position that under the Internal Revenue Code it is the nature of the property and not its cost which determines its classification as a capital expenditure or as a current operating expense.

Defendant's second major argument is that plaintiff cannot avail itself of the broad statements in section 41 of the Internal Revenue Code of 1939 and Treas. Reg. 111, § 29.41-(3), which are set out in the accompanying footnote⁵ because the minimum rule does not constitute a "method of accounting." Furthermore, assuming arguendo that the minimum rule constitutes such a method of accounting, defendant asserts that, "where the treatment of expenditures made to acquire depreciable capital assets is concerned, the method of accounting provisions play no part in the allocation between current and deferred deductions. The capital expenditure and depreciation deduction provisions § 24(a) (2) of the Code establish not only what may be deducted but also the timing of the deduction * * *."

For the following reasons these arguments of the defendant cannot be accepted.

The core of defendant's position that since the items in question admittedly have a useful life in excess of one year, the accounting for them must be in accordance with § 24(a) (2) which requires the capitalization of "permanent improvements or betterments" and with Treas.Reg. 111, § 29.41-3(2) which suggests the capitalization of items having a useful life which extends beyond the year in which they are purchased, is twofold. Primarily, it is an argument for an inflexible objective, ipso facto approach to the question of whether an asset is a capital item or one of current expense. That is to say, if an asset has a useful life greater than one year, or if it could be considered by itself to be a "permanent improvement" or "betterment", it must be capitalized automatically without consideration of any other factors. Secondly, defendant's position requires the conclusion that the method of accounting sections of the Code (sec. 41 of the 1939 Code and sec. 446 of the 1954 Code) are subordinate to the capital expenditure and depreciation sections of the Code (sec. 24 of the 1939 Code and sec. 263 of the 1954 Code).

Neither of these underlying precepts is acceptable. The first, the conclusiveness of the one year rule, simply does not square with basic philosophy concerning asset accounting as reflected in the regulations and in section 41. The opening sentence of section 41 permits the use of the taxpayer's regularly employed method of accounting in the computation of net income, as long as that method clearly reflects income. In harmony with this, Treas.Reg. 111, § 29.41-3 recognizes that "no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose." The determinative question, therefore, is not what is the useful life of the asset in question, although that inquiry is relevant, but does the method of accounting employed clearly reflect income.

A recent case decided by the United States Court of Appeals for the Tenth Circuit, United States v. Wehrli, 400 F. 2d 686 (1968), considers the weight that is to be given to the rule that if an asset has a useful life in excess of one year it should be capitalized.⁶ In his opinion Judge Murrah comments:

This concept the one year rule has received rather wide acceptance, and we are urged to make arbitrary application of it here. We think, however, that it was intended to serve as a mere guidepost for the resolution of the ultimate issue, not as an absolute rule requiring the automatic capitalization of every expenditure providing the taxpayer with a benefit enduring for a period in excess of one year. Certainly the expense incurred in the replacement of a broken windowpane, a damaged lock, or a door, or even a periodic repainting of the entire structure, may well be treated as a deductible repair expenditure even though the benefits endure quite beyond the current year. 400 F.2d at 689 — footnote omitted.

This position is in accordance with the intent of the Code and the regulations as expressed above, and one which this court adopts. Accordingly, in the resolution of the ultimate issue in this case, i.e., does the taxpayer's method of accounting clearly reflect income, the one year rule will be given adequate, though not conclusive, weight.

Apparently in order to prevent the...