Marsh Fork Coal Co. v. Lucas

• Decision Date: 14 June 1930
• Docket Number: No. 2887.,2887.
• Citation: 42 F.2d 83
• Parties: MARSH FORK COAL CO. v. LUCAS, Commissioner of Internal Revenue.
• Court: U.S. Court of Appeals — Fourth Circuit

42 F.2d 83 (1930)

MARSH FORK COAL CO. v. LUCAS, Commissioner of Internal Revenue.

No. 2887.

Circuit Court of Appeals, Fourth Circuit.

June 14, 1930.

Theodore B. Benson and Sidney P. Simpson, both of Washington, D. C., for petitioner.

A. D. Sharpe, Sp. Asst. to the Atty. Gen. (G. A. Youngquist, Asst. Atty. Gen., Sewall Key, Sp. Asst. to the Atty. Gen., and C. M. Charest, Gen. Counsel, Bureau of Internal Revenue, and Robert L. Williams, Sp. Atty., Bureau of Internal Revenue, both of Washington, D. C., on the brief), for respondent.

E. L. Greever, of Tazewell, Va. (Hines, Rearick, Dorr, Travis & Marshall, of New York City, A. M. Belcher, of Charleston, W. Va., O. W. Carlson, of Salt Lake City, Utah, A. J. Curran, of Baltimore, Md., Charles A. Goodwin, of Morgantown, W. Va., Goodykoontz & Slaven, of Williamson, W. Va., Lindsay, Young & Young, of Knoxville, Tenn., A. M. Liveright, of Clearfield, Pa., W. H. McGinnis, of Beckley, W. Va., E. J. McVann, of Washington, D. C., and T. S. Taliaferro, Jr., of Rock Springs, Wyo., on the brief), as amici curiæ, on behalf of National Coal Association and others.

Before PARKER and NORTHCOTT, Circuit Judges, and HAYES, District Judge.

PARKER, Circuit Judge.

This is a petition to review a decision of the Board of Tax Appeals reported in 11 B. T. A. 685. A number of questions were decided by the Board, but only one is presented to us by the petition, i. e., whether the Board was correct in refusing to allow petitioner to deduct from gross income for the year 1920 expenditures amounting to $28,895.85 for electric locomotives, mine cars, and steel rails. The Board held that these were capital expenditures, and refused to allow their deduction. Petitioner contends that they were not capital expenditures, as they did not increase output, decrease cost of production, or add to the value of the mine, but were made solely to maintain normal production, and were properly treated as maintenance items which should be charged to operating expense and deducted from gross income.

At the time of the expenditures, petitioner's mine had been fully developed, and had been operated for a number of years. Workings had reached a distance of one and one-half miles from the head house, and more cars, locomotives, and trackage were necessary to maintain the normal output. The normal life of all of the equipment purchased exceeded one year, that of the cars being about five years, and that of the electric locomotives from eight to ten years. Petitioner contends that, although this is true, the purchase of the equipment did not add, and was not intended to add, anything to the value of the mining property, that its purchase was made necessary by the removal of the coal and the recession of the working faces; and that its installation was nothing more than an expense incident to the removal of the coal. We agree with the contention of petitioner.

Section 234(a) (1) of the Revenue Act of 1918 (40 Stat. 1077) provides that in computing net income there shall be deducted from gross income "all the ordinary and necessary expenses paid or incurred" during the year in carrying on the business. Section 215(b), 40 Stat. 1069, throws light on what is to be considered as ordinary and necessary expense by specifying among items not deductible "any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate." In determining, therefore, whether an expenditure should be classed as an item of expense and deducted from gross income or as an improvement or betterment and charged to capital, regard should be had to whether the expenditure was made "to increase the value of any property or estate." This criterion is not only implied in the language of the act, but is in accord with established accounting practice. Mr. Paul Joseph Esquerre, in his Applied Theory of Accounts, p. 226 (quoted in the opinion in the appeal of Goodell-Pratt Co., 3 B. T. A. 30, 35), says:

"Capital Expenditures. When subjected to a theoretic analysis, this term capital expenditures appears to apply to such expenses as, in the aggregate, represent the cost of the increased earning capacity of the enterprise as a whole or of particular parts thereof, which has been secured over the earning capacity known to exist before the said expenses were incurred."

And the bulletin of the Federal Reserve Board on the "Verification of Financial Statements," as revised in 1929, at page 12, lays down the following practical rule:

"(b) The auditor, before approving additions, should satisfy himself that they were made with the object of increasing the earning capacity of the plant and that they are not repairs or replacements of fixed property. Changes in the product and capacity of the plant should receive careful consideration."

Ordinarily it is true that the purchase of machinery having a life greater than one year is to be charged to capital and not to expense, for ordinarily such machinery is purchased either to increase production or to decrease cost and in either event to add to the value of the property. Expenditures such as those here involved, however, are not made either to increase production or to decrease cost of operation. They do not add to the value of the property, and are not made for that purpose. They are made solely for the purpose of maintaining the capacity of the mine as the working faces of the coal recede. They represent the cost, as it were, of bringing forward the working plant of the operator, which is made necessary as the coal is removed from the mine and the tunnels increase in length.

It is possible, of course, to think of the increased trackage and the increased number of mine cars and locomotives made necessary by the lengthening tunnels as an increase of the capital investment in the mine; but the trouble is that this theory leads to the ridiculous result that, with the increase of investment, the property becomes less valuable, and that, when the investment is complete, the property is practically worthless. It is much more reasonable, we think, to consider expenditures for trackage, cars, and locomotives to maintain normal output as being an expense necessitated by the removal of the coal which has lengthened the tunnels, and an expense which, in any fair system of accounting, should be charged against the coal so removed.

When an operator has removed sufficient coal to extend his tunnels so that he cannot maintain production with the equipment which he has, he must as a matter of course lay down more track and put in more cars and locomotives. The question is, Shall the expense thereby incurred be charged against the coal, the removal of which necessitated the expenditure to maintain normal operation, or against the coal yet unmined? We think it is but fair to charge against the coal which has been mined the expense which its removal has necessitated. We think, also, that this is the only practicable method of accounting. To capitalize the expenditures made to maintain normal output means that the cost of removal is pyramided against the coal farther back in the mine, with the result that the coal nearest the head house will appear to have been mined at abnormal profit and that farther back at a loss.

The fact that the trackage laid and the cars and locomotives installed may last for a number of years is, we think, immaterial. However long they may last in the mine, they are but maintaining the mine's capacity, which would otherwise have been impaired by the lengthening of the tunnels due to the removal of the coal. While not repairs, they are in the nature of repairs, in that they are necessary to maintain the operation of the mine at the level of normal production. As suggested by counsel, a new axle on an automobile is no less a repair and chargeable to expense because it has a normal life of more than a year.

In considering what should be charged to expense and what to capital investment, regard should be had for established accounting practice. This is recognized by the statute itself, which provides in section 212(b), 40 Stat. 1064, that the income of the taxpayer shall be computed "in accordance with the method of accounting regularly employed in keeping the books of such taxpayer," except where "the method employed does not clearly reflect the income." Article 23 of Regulations 45, adopted pursuant to the statute, provides that "approved standard methods of accounting will ordinarily be regarded as clearly reflecting net income." And, in applying the statute, the Board of Tax Appeals has repeatedly resorted to standard accounting practice in determining what is properly chargeable as an expense item and what as a capital expenditure. See Sneath Glass Co., 1 B. T. A. 736; Goodell-Pratt Co., 3 B. T. A. 30; American Seating Co., 4 B. T. A. 649; Libby & Blouin, Ltd., 4 B. T. A. 910.

Looking then to the authorities on accounting, we find that the Committee on Standard System of Accounting and Analysis of Production of the National Coal Association, on page 8 of its report in 1919, covered the matter here involved in the following language:

"The drawing of distinctions between capital and operating expenditures, in the accounting involved in permanent enterprises, is a favorite field for discussion among accountants, but in the case of coal mining or other wasting enterprises, experience teaches that the field for discussion, if indeed there be any, is extremely limited.

"After a coal mine has been developed and equipped to its contemplated or possible capacity, it is a constant consumer of material and supplies and equipment, which, though nominally of a durable nature, are subject to destructive wear and tear, by reason of the uses to which they are put, and all these appliances must be kept in repair to do their work or the output can not be maintained.

"Mules and pit cars are constantly worn out, and have to be replaced, and...