Armco, Inc. v. Comm'r of Internal Revenue

• Decision Date: 20 April 1987
• Docket Number: Docket No. 20037-85,45229-85.
• Parties: ARMCO, INC., (FORMERLY ARMCO STEEL CORPORATION AND SUBSIDIARIES), Petitionerv. COMMISSIONER OF INTERNAL REVENUE, Respondent
• Court: U.S. Tax Court

88 T.C. 946

88 T.C. No. 51

ARMCO, INC., (FORMERLY ARMCO STEEL CORPORATION AND SUBSIDIARIES), Petitionerv. COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket No. 20037-85

45229-85.

United States Tax Court

Filed April 20, 1987.

1. P is engaged in the production of steel and steel products. For its 1976 and 1977 taxable years, P elected to apply the percentage repair allowance (PRA) for ferrous metals. Under the PRA, an electing taxpayer could deduct currently, as a repair expense, a prescribed percentage of the unadjusted basis of the property within a specified class of assets without challenge from R if it agreed to capitalize any remaining repair expenses attributable to that class. Rev. Proc. 72-10 provided an eight percent PRA for ferrous metals during the years in issue. R knew the methodology used to derive the PRA was flawed and that the eight percent PRA for ferrous metals was too low when it was initially promulgated. A 1977 Treasury study recommended a PRA of 18 percent. In 1979 the 18 percent PRA was adopted. HELD, P is not foreclosed by its PRA election for 1976 and 1977 from challenging the validity of the PRA. HELD FURTHER, Rev. Proc. 72-10, insofar as it prescribed the eight percent PRA for ferrous metals for 1976 and 1977, is invalid because it did not ‘reasonably reflect the anticipated repair experience of the industry‘ in those years, as required by section 263(e).

2. R accepted P's Forms 870-AD, one for the taxable years 1975 and 1976 and another for the taxable years 1977, 1978 and 1979, settling disputes over the current deductibility of incidental items used in the steel making process and not subject to the PRA but reserving the right to make adjustments to items subject to the PRA. R concedes that he is barred from making adjustments for 1976 on the ground that the cost of certain incidental items must be capitalized for reasons independent of the PRA because he did not reserve that issue in the Form 870-AD for 1975 and 1976. The Form 870-AD executed for the taxable years 1977, 1978 and 1979 contains substantially identical language. HELD, the Form 870-AD executed for the taxable years 1977, 1978 and 1979 bars R from arguing that costs incurred for incidental items in 1977 must be capitalized for reasons independent of the PRA. James P. Holden, Kenneth I. Jonson and Joseph P. Esposito, for the petitioner.

Joseph R. Goeke and Genevieve K. Murtaugh, for the respondent.

WILLIAMS, JUDGE:

The Commissioner determined deficiencies in petitioner's Federal income tax for the taxable years 1975, 1976 and 1977 as follows:

+----------------+
                ¦Year¦Deficiency ¦
                +----+-----------¦
                ¦1975¦$1,038     ¦
                +----+-----------¦
                ¦1976¦6,763,836  ¦
                +----+-----------¦
                ¦1977¦6,432,232  ¦
                +----------------+
                

The year 1975 is before the Court only because certain adjustments in 1976 affect the computation of the tax for 1975. The deficiencies for 1976 and 1977 include increased deficiencies by respondent in his Second Amendment to Answer in docket No. 20037-85 and Third Amendment to Answer in docket No. 45229-85. Petitioner claims an overpayment of tax of not less than $695,932.00 for 1975, of not less than $6,493,165.00 for 1976 and of not less than $10,324,247 for 1977. ¹

After concessions, the issues we must decide are (1) whether the eight percent percentage repair allowance for ferrous metals ‘reasonably reflect(ed) the anticipated repair experience‘ of the industry in 1976 and 1977, as required by section 263(e); ² and (2) whether respondent is barred from requiring petitioner to capitalize certain incidental assets not subject to the percentage repair allowance because he failed to reserve that issue in the Form 870-AD executed for the taxable years 1977, 1978 and 1979. ³

FINDINGS OF FACT

Some of the facts have been stipulated and are so found. Petitioner, Armco, Inc., is a corporation organized under the laws of the State of Ohio. At the time the petitions in these consolidated cases were filed, petitioner's principal office was located at Middletown, Ohio. Petitioner is a diversified manufacturing and service corporation engaged in the integrated production of steel and steel products at various facilities in the United States. Petitioner maintained its books and records and timely filed consolidated Federal income tax returns for the taxable years 1975, 1976 and 1977 on an accrual method of accounting.

At petitioner's Middletown Works, petitioner operates a hot strip mill and cold rolling mill which convert large, thick pieces of steel into thin sheet steel. The sheet steel is sold to customers for use in the manufacture of appliances, automobiles and other products. The parties have agreed that petitioner's Middletown Works provides representative data for all of petitioner's hot and cold rolling manufacturing operations in 1976 and 1977.

In the hot strip mill, slabs of molten steel heated to red hot temperatures are run through a series of stands, each of which supports cylindrical rolls that apply 1,000 to 2,500 tons p.s.i. of force on the steel slab, compressing and reducing the slab passing between them to the desired thickness. At the end of the hot strip mill, the sheet steel is coiled. Some of the coiled steel is then further processed in the cold mill to produce thinner, longer sheets.

The mill stands in both the hot strip mill and the cold mill consist of work rolls which apply pressure to the steel passing between them, bearings at the end of each roll which enable the roll to rotate, chocks which hold the bearings, and the housing which supports the rolls and chocks. There are usually two work rolls, through which the steel actually passes, and two backup rolls that prevent the pressures from excessively deforming the work rolls and press evenly on the work rolls to uniformly reduce the thickness of the steel. The work rolls are driven in opposite directions, and the steel is drawn between them by their rotating movement.

Rolls become worn and deformed in the rolling process. Because deformities on the surface of the work rolls are transferred to the sheets of steel, rendering them unacceptable to customers, the work rolls must be changed frequently. Backup rolls are also worn in the rolling process but less quickly than the work rolls. When rolls are removed from the mills they are taken to the roll shop for grinding and turning. In the grinding process, part of the surface layer of the roll is removed, reducing the diameter of the roll, to achieve a perfectly smooth surface. Depending on the type of roll and the depth of the wear and deformities on the roll, the average amount of surface layer removed in the grinding process ranges from six to fifty one-thousandths of an inch. Rolls may be reground numerous times but once the diameter of a work roll is reduced approximately two and one-half inches and the diameter of a backup roll is reduced approximately six inches, they must be discarded.

Petitioner includes the salaries and employee benefits of the employees working in the roll shop, as well as utilities and other costs, in roll shop costs on its books and records. During the years in issue petitioner did not report roll shop costs as repair and maintenance expenses on line 14 of its corporate income tax returns.

During all periods relevant to this case, petitioner has treated replacement rolls and bearings consistently as a production cost incurred in the ordinary course of manufacturing and charged to inventory for financial accounting and tax purposes. Petitioner has never characterized the cost of rolls and bearings as a repair and maintenance expense on the Securities and Exchange Commission Form 10-K, which requires separate identification of all repair and maintenance expenses.

The percentage repair allowance (‘PRA‘) concept originated in 1971 as part of the Asset Depreciation Range (‘ADR‘) system, which provided a liberalized system of depreciation for machinery, equipment and certain other property. The PRA was intended to end controversies over whether certain expenditures for the repair, maintenance or improvement of property are deductible in the year incurred or must be capitalized. If a taxpayer elected to apply the PRA, it could deduct currently, as a repair expense, a prescribed percentage of the unadjusted basis of the property within a specified class of assets without challenge from respondent, provided that it agreed to capitalize any remaining repair expenses attributable to that class. Proposed Income Tax Regs., section 1.167(a)-11, 36 Fed. Reg. 4885 (March 13, 1971) (‘the proposed regulations ‘), under the ADR system were published on March 13, 1971 and provided a PRA election. The repair allowance was computed by multiplying the reciprocal of the asset guideline class useful life by the unadjusted basis of the assets within that class. The result was a repair allowance equal to one year's depreciation computed on a straight line basis.

After the proposed regulations were published, individuals at the Treasury Department questioned whether the procedures provided for setting percentage repair allowances reliably measured actual industry repair experience. Among them was Dr. Seymour Fiekowsky, an economist who was at that time Chief of Business Taxation and is currently Assistant Director of the Office of Tax Analysis (Business Taxation) at the Treasury Department. Fiekowsky has a Ph.D. in economics and has been employed with the Treasury Department since 1967. Fiekowsky evaluated the repair allowance described in the proposed regulations and was responsible for developing the methodology used for recommending the repair allowances provided in Rev. Proc. 71-25, 1971-2 C.B. 553, which was issued with the final ADR regulations. The proposed regulations provided a repair allowance of 6.8 percent for ferrous metals. Based on his study, Fiekowsky determined that the repair allowance should have been at least 8.7 percent. Rev. Proc. 71-25, which...