Mountain Fuel Supply Company v. United States

• Decision Date: 03 December 1971
• Docket Number: No. 605-70.,605-70.
• Citation: 449 F.2d 816
• Parties: MOUNTAIN FUEL SUPPLY COMPANY, Appellee, v. UNITED STATES of America, Appellant.
• Court: U.S. Court of Appeals — Tenth Circuit

449 F.2d 816 (1971)

MOUNTAIN FUEL SUPPLY COMPANY, Appellee, v. UNITED STATES of America, Appellant.

No. 605-70.

United States Court of Appeals, Tenth Circuit.

October 15, 1971.

Rehearing Denied December 3, 1971.

Grant W. Wiprud, Atty., Tax Div., Dept. of Justice (Johnnie M. Walters, Asst. Atty. Gen., Meyer Rothwacks and Issie L. Jenkins, Attys., Tax Div., Dept. of Justice, and C. Nelson Day, U. S. Atty., of counsel, with him on the brief), for appellant.

J. Wendell Bayles and Edward J. McDonough, Salt Lake City, Utah (Joseph S. Jones and John Crawford, Jr., Salt Lake City, Utah, with them on the brief), for appellee.

Before SETH, ALDISERT,^* and McWILLIAMS, Circuit Judges.

SETH, Circuit Judge.

This is an action to recover income taxes paid by the Mountain Fuel Supply Company, for the years 1962, 1963, and 1964. The company is engaged in the business of producing natural gas and operating pipelines for the gathering, transmission, and distribution of natural gas. This appeal concerns two unrelated issues. One is the proper depletion base for the condensate produced by the taxpayer from wells or leases it owns or in which it has an interest. The second issue is whether or not it was proper for the taxpayer to have deducted, under section 162 of the Internal Revenue Code of 1954, as a necessary business expense, certain costs incurred by it in reconditioning portions of its pipeline.

The Pipeline Reconditioning

To consider first the issue relating to the deductions made for ordinary and necessary business expense, the record shows that the deductions in issue as made by the company in 1962 amounted to $360,117.81, in 1963 $253,869.47, and in 1964 $456,130.53. Of the total expenditures made by the company in reconditioning segments of its line, $1,070, 117.81 was deducted as expense, and $420,963.27 was treated as "new investment." The company operates some 900 miles of transmission lines, about 4,000 miles of distribution lines, and 400 miles of gathering lines. About forty miles of lines were reconditioned during the years in question in the manner hereinafter described. The segments reconditioned were in service at the time, and it was necessary to put them out of service, to remove the gas from the pipe, to dig up the pipe, and remove it from the ground. The trench was then temporarily backfilled. The pipe was then cut into thirty or forty foot sections and hauled to a central location where it was straightened. The old couplings, expansion joints, stubs, old valves, and defective welds which had not been cut out in the field were cut out. The remaining portions were cleaned by the removal with knives and sandblasting of the exterior coating which had been applied when they were originally laid. The interior of the pipe was also cleaned. Small corrosion pits and other small defects were spotwelded, but portions of the pipe which were in such condition that they could not be so repaired were cut out and were replaced by new sections. The pipe sections were beveled, transported back to the original trenches where they were bent where necessary to conform to the terrain, the trench reopened, the sections of pipe welded together, new valves inserted where needed, the pipe coated with coal tar and a fabric covering, replaced in the trench, tested, the trench backfilled, and the segment put into service.

The record shows that of the total length of pipe which was initially removed from the ground, approximately ten per cent thereof was replaced with new pipe and new valves. The new pipe, as indicated above, replaced the portions not considered repairable, the old expansion joints, and the fittings which had been removed. The new valves which were installed were plug valves to replace the original gate valves.

The taxpayer, for the years in question, handled the reconditioning costs on its books and records as follows: The cost of the new pipe to replace the footage discarded, and the cost of new valves was capitalized, as was the relaying cost and the company overhead applicable to such new portions. The cost of digging up and removing the portions of the line which were discarded, less salvage, was charged to depreciation reserve. The cost of recoating and wrapping the old pipe returned to service and the cost of coating and wrapping the replacement portions was capitalized. The cost of digging up, cutting, removing, hauling, straightening, cleaning, spotwelding the corrosion pits, removal of defective sections, beveling, bending, reopening trenches, rewelding, relaying, testing, and burying of all the old pipe returned to service was expensed. Much of the reconditioning was done by independent contractors.

The portions of the corporation's lines with which we are here concerned were laid in 1929, 1930, and 1931. The segments selected for reconditioning were portions of the lines which had a bad history of leaks. The company had engaged in some relatively limited reconditioning heretofore, but for the most part had handled leaks in the lines on an individual basis when they occurred. For depreciation the company accounting had placed the lines in a composite account with a useful life of twenty-five years.

The trial court found:

"The work was done to repair defects and leaks in the pipe, to remove potential defects and to maintain the reliability of the line. The segments upon which the work was done were selected because of the history of leaks in the line and the location of the line."

The trial court also found that the work done was not a part of any general plan of betterment, did not enhance the property's value, and did not adapt the property to a different use. The court also found that the portions charged to expense were not replacements but were incidental repairs which did not appreciably prolong the life of the pipe reused, but kept the segment in operating condition. The court thus concluded that the expensed costs were ordinary necessary expenses paid or incurred in carrying out the company's business, and gave judgment for the taxpayer.

As indicated above, the deductions were made as necessary expenses under section 162 of the Internal Revenue Code of 1954. This section provides in part without elaboration that "* * * all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business * *" may be allowed as a deduction. Section 263 of the 1954 Code provides that a deduction may not be made for the expenses incurred for the acquisition of any buildings, for permanent improvements, or for "betterments made to increase the value of any property. * * *" This same section also precludes deductions for amounts spent in "restoring property or in making good the exhaustion thereof for which an allowance is or has been made." Pursuant to the Code provisions, the Treasury Regulations provide in section 1.162-4 in part: "The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in ordinarily efficient operating condition, may be deducted as an expense * * *." This same section also states:

"Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with section 167 or charged against the depreciation reserve if such an account is kept."

The Treasury Regulations relating to capital expenditures, section 1.263(a)-1, provide that a deduction may not be allowed for betterments made to increase the value of the property nor for amounts paid to "substantially prolong the useful life" of property or equipment. This same subsection also states: "Amounts paid or incurred for incidental repairs and maintenance of property are not capital expenditures within the meaning" of the subparagraphs concerned.

As indicated in our decisions hereinafter cited, these regulations are of long standing and were early construed by the Board of Tax Appeals in the frequently cited case of Illinois Merchants Trust Co., 4 B.T.A. 103. There the Board indicated that the purpose for which the expenditures were made was an important factor and went on to state:

"A repair is an expenditure for the purpose of keeping the property in an ordinarily efficient operating condition. It does not add to the value of the property, nor does it appreciably prolong its life. It merely keeps the property in an operating condition over its probable useful life for the uses for which it was acquired."

The Board contrasted expenditures made for such purposes with those improvements or additions which prolonged the life of the property.

This court, in Hotel Kingkade v. Comm'r of Internal Revenue, 180 F.2d 310 (10th Cir.), considered expenditures which had been made in connection with the operation of a hotel. These expenditures were for carpets, kitchen equipment, appliances, fans, roofing, tile work, and a variety of other expenditures. We there said that the expenditures therein made were such as to materially add to the value of the property and appreciably prolong its life as an operating hotel. It was held that such expenditures were of a capital nature. In Denver & Rio Grande Western R. R. v. Comm'r of Internal Revenue, 279 F.2d 368 (10th Cir.), the issue concerned expenditures made by the taxpayer upon an old wooden viaduct. These expenditures consisted of installing new wooden floor planks over most of the viaduct and some new stringers for the support of the viaduct and to stiffen the structure. The railroad had expensed the entire amount, and the Tax Court had found that the expense should have been capitalized. We held that the Tax Court was correct and stated that:

"The expenditure resulted in a substantial restoration, strengthening and improvement of the viaduct. It was not for incidental repairs but for a replacement of a major portion of the viaduct which could no

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