Louisville & Nashville R. Co. v. C.I.R.

• Decision Date: 31 March 1981
• Docket Number: No. 78-1303,78-1303
• Citation: 641 F.2d 435
• Parties: 81-1 USTC P 9212 LOUISVILLE AND NASHVILLE RAILROAD COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Sixth Circuit

Page 435

641 F.2d 435

81-1 USTC P 9212

LOUISVILLE AND NASHVILLE RAILROAD COMPANY, Petitioner-Appellant, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 78-1303.

United States Court of Appeals Sixth Circuit.

Argued June 12, 1980.

Decided Feb. 16, 1981.

Rehearing Denied March 31, 1981.

George K. Dunham, Jacksonville, Fla., Joseph L. Lenihan, Louisville, Ky., for petitioner-appellant.

M. Carr Ferguson, Asst. Atty. Gen., Gilbert E. Andrews, Tax Div., U. S. Dept. of Justice, Gary Allen, Karl Fryzel, Stuart E. Seigel, Chief Counsel, Washington, D. C., for respondent-appellee.

Before BOYCE F. MARTIN, Jr., Circuit Judge, and CELEBREZZE and PHILLIPS, Senior Circuit Judges.

BOYCE F. MARTIN, Jr., Circuit Judge.

Louisville and Nashville Railroad Company (L&N) appeals from a Tax Court decision upholding the Commissioner's assessment of tax deficiencies for the years 1955-1964. 66 T.C. 962 (1976). In dispute are five issues. (1) Under the "retirement-replacement-betterment" method of accounting, the salvage value of "relay" (reusable) rail must be based upon fair market value instead of book value. (2) Certain overhead costs associated with the building and rebuilding of freight cars must be capitalized rather than deducted as current operating expenses. These overheads include: fringe benefit costs incurred on behalf of employees in the rebuilding program, payroll taxes under the Railroad Retirement Tax Act, and the "deadhaul" cost of transporting building materials on the taxpayer's own freight line. (3) Pursuant to Internal Revenue Code § 481, the court ordered a "year of change" adjustment in conjunction with the capitalization of overheads. (4) In its opinion of September 9, 1976, the court found as a fact that L&N had rebuilt 1,966 freight cars in 1964. More than a year later, at the Rule 155 computation hearing, the court entertained and, over L&N's objection, adopted the Commissioner's contention that L&N had actually rebuilt 3,620 cars in 1964. (5) Retirement deductions for grading and ballast characterized by L&N as "abandoned" were disallowed.

L&N makes the following allegations of error: (1) that the Commissioner's formula for determining salvage value was improper and that L&N's accounting method, required under Interstate Commerce Commission regulations, was presumptively acceptable for tax purposes; (2) that overhead costs, particularly payroll taxes, are deductible; (3) that no "year of change" adjustment was warranted; (4) that the court's revision of its original findings of fact constituted an abuse of discretion; and (5) that there was insufficient evidence to support the court's holding that certain grading and ballast continued to benefit the taxpayer.

I. Salvage Valuation of Relay Rail

As part of its Uniform System of Accounts for Railroad Companies, the Interstate Commerce Commission requires railroads to use the "retirement-replacement-betterment" method of cost accounting. Under Internal Revenue Code § 167(a), as interpreted by Revenue Ruling 67-145, 167-1 C.B. 54 and Revenue Procedure 68-46, 1968-2 C.B. 961, railroads may also use this method to calculate deductions allowable for cost recovery on their tracks.

The retirement-replacement-betterment system simplifies depreciation reserve accounting by treating a section of railroad track as a single, indivisible asset. The track is carried on the railroad's books at its historical cost; no depreciation is taken or deductions claimed until the track is physically removed. At the time of removal, one of three possible events occurs: the section of track may be "retired" from service altogether; the removed rail may be "replaced" with rail of like kind, as when 80-pound rail is replaced by 80-pound rail; or the section may be "bettered" if, for example, 80-pound rail is replaced by 100-pound rail.

These alternatives result in different tax consequences. If track is retired, its historical cost, reduced by its salvage value, is deducted as current operating expense. If track is replaced in kind, the cost of the replacement, less the salvage value of the rail removed, is expensed. If a betterment occurs, the prorated cost attributable to the betterment is capitalized and the balance, reduced by the salvage value of the rail removed, is deducted.

The condition of rail at the time of its removal determines its disposition. "Scrap" rail is suitable only for sale as scrap metal; its salvage value is, therefore, easily ascertained. "Relay" rail, on the other hand, if it is in sufficiently good condition may be reused ("relaid") in another section of track. It is the salvage valuation, for tax purposes, of relay rail which concerns us here.

Relay rail removed between 1955 and 1964 was carried on L&N's books at $40.00 per net ton. This $40.00 salvage value figure was also used for tax purposes. Thus, as the taxpayer replaced sections of rail, its replacement deductions, based on current costs, were reduced only to the extent of the "book" salvage value of the relay rail removed. In consequence, the Tax Court held, rail replacement deductions claimed by L&N were excessive. In order to reflect the taxpayer's income more accurately, the court ruled that the salvage value assigned to relay rail should approximate its current fair market value. According to the Service's recomputations, adopted by the court, "fair market value" is equal to one-half the sum of new rail replacement cost and the actual market price of scrap rail.

On appeal, L&N offers two arguments for reversal. First, it asserts that the retirement-replacement-betterment method of accounting is required by the Interstate Commerce Commission and is, therefore, in use throughout the industry. We are asked to infer from this circumstance that the accounting system does in fact accurately reflect income. Second, L&N points out that the Service raised the relay rail issue for the years 1955-1963 in its amended answer, thereby assuming the burden of proving the propriety of its recomputations. According to the taxpayer, the Commissioner failed to sustain this burden.

Before reaching the merits of the taxpayer's arguments, we recapitulate briefly our position on the scope of appellate review. L&N invites us to avoid the strictures of F.R.C.P. 52(a) by interpreting the Tax Court's ruling on this issue as one of law, or "ultimate fact." Despite some authority for that approach in other circuits, we remain convinced that the findings below are factual in nature and therefore subject to the "clearly erroneous" standard of review. In so deciding, we reaffirm our adherence to the views we have expressed in recent cases. See Case, et al. v. United States, 633 F.2d 1240 (6th Cir., 1980); Gartrell v. United States, 619 F.2d 1150 (6th Cir. 1980); Philhall v. United States, 546 F.2d 210 (6th Cir. 1976).

A. The Mandatory nature of the taxpayer's accounting method.

L&N argues that courts should accord considerable weight to the fact that the Interstate Commerce Commission requires railroads to use the accounting method which yielded the disputed tax consequences.

In Commissioner v. Idaho Power Co., 418 U.S. 1, 15, 94 S.Ct. 2757, 2765, 41 L.Ed.2d 535 (1974), the Supreme Court noted:

Although agency imposed compulsory accounting practices do not necessarily dictate tax consequences, Old Colony Ry. Co. v. Commissioner, 284 U.S. 552, 562, 52 S.Ct. 211, 214, 76 L.Ed. 484 ... they are not irrelevant and may be accorded some significance .... Nonetheless, where a taxpayer's generally accepted method of accounting is made compulsory by the regulatory agency and that method clearly reflects income, it is almost presumptively controlling of federal income tax consequences. (emphasis added)

See also Commissioner v. Seagram & Sons, 394 F.2d 738, 741 (2d Cir. 1968).

Thus, operation of the presumption sought by L&N is conditioned upon a finding that the accounting method at issue "clearly reflects income." No such finding exists here. On the contrary, in keeping with the broad discretion he enjoys under Internal Revenue Code § 446(b), the Commissioner has determined that one aspect of "retirement-replacement-betterment" accounting does not clearly reflect income. The Tax Court upheld that conclusion. We have seen no legal basis on which to disagree.

B. Whether the Commissioner has shown that retirement-replacement-betterment accounting does not "clearly reflect income."

L&N points out that the Commissioner must demonstrate that the disputed accounting practice does not "clearly reflect income." Failure to do so would mandate a reversal of the decision below, since "the Commissioner does not have the authority to change from a method of accounting which does clearly reflect income to a method which, in the Commissioner's opinion, more clearly reflects income." (emphasis added). Auburn Packing Company, Inc. v. Commissioner, 60 T.C. 794, 800 (1973); see also Thompson-King-Tate, Inc. v. United States, 296 F.2d 290, 294 (6th Cir. 1961). Our central inquiry, therefore, must be whether the Commissioner has sustained his burden of proof. We believe that he has.

Conventional depreciation reserve accounting and the retirement-replacement-betterment method present significant mechanical differences. They share, however, the common purpose of permitting tax-free recovery of the cost of certain business assets. Internal Revenue Code § 167; see Boston & Maine R. R. v. Commissioner, 206 F.2d 617 (1st Cir. 1953). The ratable depreciation model, which spreads a taxpayer's actual investment in an asset over the asset's expected useful life, fulfills its purpose of cost recovery without generating untaxed "income;" in other words, it "clearly reflects income." Massey Motors v. United States, 364 U.S. 92, 80 S.Ct. 1411, 4 L.Ed.2d 1592 (1960); Hertz Corp. v. United States, 364 U.S. 122, 80 S.Ct. 1420, 4 L.Ed.2d 1603 (1960); United States v. Chicago, Burlington & Quincy R. Co., 455 F.2d 993 (Ct.Cl., 1972), rev'd...