Illinois Cereal Mills, Inc. v. C.I.R.

Decision Date28 April 1986
Docket NumberNo. 85-1485,85-1485
Parties-1342, 54 USLW 2592, 86-1 USTC P 9371 ILLINOIS CEREAL MILLS, INC., Appellee, v. COMMISSIONER OF INTERNAL REVENUE, Appellant.
CourtU.S. Court of Appeals — Seventh Circuit

William A. Whitledge, Dept. of Justice, Tax Div., Washington, D.C., for Commissioner.

David J. Duez, McDermott, Will & Emery, Springfield, Ill., for ICM.

Before BAUER, WOOD and ESCHBACH, Circuit Judges.

BAUER, Circuit Judge.

This is an appeal by the Commissioner of Internal Revenue from a decision of the United States Tax Court. The Commissioner argues the Tax Court erred in holding that ninety-five percent of the cost of Illinois Cereal Mill's factory electrical system qualified for the investment tax credit. We affirm.

I.

Illinois Cereal Mills ("ICM") conducts a corn milling business in Paris, Illinois. In 1976, ICM completed construction of a new speciality mill. The electrical distribution system that provides power to the specialty mill is contained in a separate room within the mill building. The system consists of circuit breakers, transformers, power panels, switchboards, motor control centers, and associated wiring. It functions to break down the 4,160 volts received from the electric utility into voltages usable in the mill. Ninety-five percent of the electrical load entering the system is used to run mill machinery. The remaining five percent is used for lighting and other general building needs.

In its tax return filed for its fiscal year ending September 30, 1976, ICM treated the entire cost of the electrical system as an expenditure qualifying for the investment tax credit. The Commissioner determined that none of the cost qualified and claimed a deficiency on that basis. The Tax Court held that ninety-five percent of the cost of the electrical distribution system qualified for the investment tax credit because ninety-five percent of its function was to supply usable power to mill machinery qualifying for the investment tax credit. The Commissioner appeals. We affirm.

II.

This case concerns the investment tax credit ("ITC"). The ITC was added to the Internal Revenue Code in 1962. Pub.L. 87-834, 76 Stat. 967 (1962). It is designed to increase economic productivity, output, and growth by creating a tax incentive for the purchase of machinery, equipment, and other property used to produce goods or run a business. Comdisco v. United States, 756 F.2d 569, 572 (7th Cir.1985); CIR v. Schuyler Grain Co., 411 F.2d 649, 652 (7th Cir.1969); See, H.R.Rep. No. 1447, 87th Cong., 2d Sess. 11 (1962); S.Rep. No. 1881, 87th Cong., 2d Sess. 11 (1962).

The ITC is established in Sec. 38 of the Internal Revenue Code. To qualify for ITC treatment, property must meet the definition of "section 38 property" found at Sec. 48 of the Code. In 1976, the relevant tax year for this appeal, Sec. 48 read in pertinent part as follows.

Sec. 48. Definitions; special rules

(a) Section 38 property--

(1) In general.--Except as provided in this subsection, the term "section 38 property" means--

(A) tangible personal property, or

(B) other tangible property (not including a building and its structural components)....

26 U.S.C. Sec. 48(a)(1) (1976). Thus, the Code establishes two ways for property to qualify as ITC property: (1) by meeting the definition of "tangible personal property" or (2) by meeting the definition of "other tangible property" and qualifying as something other than a building or structural component of a building.

The labyrinthian analysis developed in the statute, regulations, cases, and legislative history to determine whether property qualifies as "tangible personal property" or "other personal property" (and thus as Sec. 38 property given ITC treatment) is a meandering path of many steps. We first chart the course, then venture down it with the facts of this case in tow.

A.

The test for "tangible personal property" focuses on whether the property in question is an "inherently permanent structure." Treas.Reg. Sec. 1.48-1(c) (26 C.F.R.); H.R.Rep. No. 1447, 87th Cong., 2d Sess. 11-12 (1962); S.Rep. No. 1881, 87th Cong., 2d Sess. 11-12 and 16 (1962). Thus cases and Treasury rulings have determined that property that is easily removable, such that it is likely to accompany the business if it should leave the premises, is Sec. 38 property and qualifies for the ITC. 1

If property fails to qualify as tangible personal property under Sec. 38 because that property is found to be inherently permanent, all is not lost for the taxpayer. Such property may still qualify as Sec. 38 property under the test for "other tangible property." Congress added this separate category to insure that some property classified as non-personal under state law (such as, heavy immovable machines classified as fixtures and, therefore, technically real property) would still qualify for the ITC. Kramertown Co. v. Commissioner of Internal Revenue, 488 F.2d 728, 731 (5th Cir.1974); H.R.Rep. No. 1447, 87th Cong., 2d Sess. 11-12 (1962); S.Rep. No. 1881, 87th Cong., 2d Sess. 16 (1962).

The test for "other tangible property" has three distinct components. First, property must qualify initially as tangible property of the type intended by Congress to be covered. Second, it must not be a building. Third, it must not be a structural component of a building.

Congress intended to allow ITC treatment of property, even if that property is "inherently permanent," if the property relates to the taxpayer's specific business rather than being generally adaptable to most commercial uses. As the Senate report phrased it, Congress wanted to allow ITC treatment of "[a]ssets accessory to the operation of a business." S.Rep. No. 1881, 87th Cong., 2d Sess. 11-12 (1962). Examples of ITC property cited in the Senate report and incorporated into the regulations include "machinery, printing presses, transportation or office equipment, refrigerators, individual air-conditioning units, grocery counters, testing equipment, display racks and shelves, etc." Id.; Treas.Reg. Sec. 1.48-1(c). Cases and Treasury rulings have established other examples. 2

Property that qualifies initially as the type of "other property" intended by Congress must also qualify as something other than a building. The test for whether property is a building focuses on the appearance of the property, whether the property functions as a building (such as by providing everyday working space), and, if the property is a structure housing other property, whether that structure is closely related to the property it houses. 3 The courts have applied these factors to determine whether property is a building. 4

Even if property qualifies as "other property" and is not a building, it still may not be Sec. 38 property if it is a structural component of a building. The test for "structural components" set out in the regulations and legislative history focuses on whether the property in question is property "relating to the operation and maintenance of a building." Treas.Reg. Sec. 1.48-1(e)(2) (26 C.F.R.); S.Rep. No. 1881, 87th Cong., 2d Sess. 11-12 (1962). Thus, if property relates to building operation and maintenance, it is a structural component not qualifying for ITC treatment. 5 The courts have applied this analysis in determining whether property is a "structural component." 6

B.

We now turn to the task of applying this established law to the facts of this case. We keep in mind that the ITC should be construed liberally in light of its purposes, Comdisco v. United States, 756 F.2d 569, 577 (7th Cir.1985); Commissioner of Internal Revenue v. Schuyler Grain Co., 411 F.2d 649, 652 (7th Cir.1969), and that the purpose of the ITC is to promote investment. Comdisco at 572-73; Schuyler Grain at 652. The burden is on ICM, however, to prove it is entitled to the ITC. Lockhart Leasing Co. v. United States, 446 F.2d 269, 271 (10th Cir.1971).

ICM does not contend that its electrical distribution system is "tangible personal property" under Sec. 48. The components of the system are not easily removable such that ICM would be expected to take them along should it vacate the premises. The system is inherently permanent and only qualifies for ITC treatment if the requirements of "other tangible property" are met.

The primary disagreement between ICM and the Commissioner is over whether the ninety-five percent of ICM's electrical distribution system that powers ICM's equipment is the type of "other tangible property" intended by Congress to be allowed ITC treatment. The Commissioner argues that that portion of the system is not an asset accessory to ICM's business because it is generally adaptable to any business utilizing heavy equipment compatible with the voltage output of ICM's system. The Commissioner points out that the components of ICM's electrical distribution system are not custom made specialty items, but rather are common "off-the-shelf" goods. ICM admits that the five percent of the system that supplies power to the building is certainly not accessory to ICM's business and would serve any enterprise that might subsequently occupy the premises, but contends the only reason ninety-five percent of its system was installed was to power ICM's machines. ICM concludes from this that ninety-five percent of its system must be accessory to its business. ICM points out that under the Commissioner's broad adaptability test, even the machines themselves would be disqualified from ITC treatment because they are adaptable to the business of another milling enterprise. Finally, ICM agrees that custom made electrical components would present a clearer case, but argues that ICM's ability to purchase its electrical items from a manufacturer's inventory is otherwise irrelevant to the question of whether the equipment is special equipment accessory to ICM's business.

The question is obviously one of determining how wide to cast the net of...

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