*3178 1. Held, that reproduction cost as of March 1, 1913, does not establish actual value of machinery and equipment, as of that date.
2. Held, that petitioner is entitled to only such depreciation as will recover the cost of property and not such as will provide for cost of replacement of such property.
3. Respondent's determination of asset values for purposes of invested capital upheld.
4. Held, that an amount for contractual amortization should be excluded from income.
*802 These are proceedings under Docket Nos. 14055 and 14056, duly consolidated for hearing and decision, for the redetermination of deficiencies in income and profits taxes.
Under Docket No. 14055, covering the year 1917, the taxes in controversy amount to $6,645.24. For this year the respondent rejected the petitioner's claim for abatement in the amount of $3,997.08 to the extent of $2,503.35.
Under Docket No. 14056, covering the years 1918 to 1920, inclusive, the taxes in controversy amount to $46,956.53. The respondent*3179 found *803 a deficiency for the year 1918 in the amount of $52,170.04, an overassessment for the year 1919 in the amount of $6,235.54, and a deficiency for the year 1920 in the amount of $1,022.03.
The errors assigned as to each of the years in controversy relate to the action of the respondent in (1) refusing to allow, for purposes of computing depreciation, the value of depreciable assets as of March 1, 1913, as claimed by the petitioner; (2) refusing to allow rates of depreciation as claimed by the petitioner; and (3) reducing the invested capital of the petitioner on account of alleged insufficient depreciation in prior years.
An assignment of error peculiar to Docket No. 14056 is the failure of the respondent to exclude from gross income of the petitioner for the year 1919 an amount received by petitioner from the Federal Government as contractual amortization.
The petition in Docket No. 14055 alleged error of the respondent in failing to consider the case under section 210 of the Revenue Act of 1917, and in Docket No. 14056 alleged error of the respondent in failing to consider the case under sections 327 and 328 of the Revenue Act of 1918, but at the hearing*3180 these contentions were abandoned by the petitioner.
FINDINGS OF FACT.
The petitioner was incorporated in 1902 and took over the plant, machinery and tools of the Badger Manufacturing Co., with the exception of the machinery and tools pertaining to the manufacture of lamps.
In 1911, the petitioner sold the plant which it occupied to the Chicago Brass Co. and bought a new plant into which it moved in the latter part of 1912.
Petitioner has been engaged in the business of manufacturing brass goods ever since its organization except for a period during the World War, when it manufactured steel products under Federal Government contracts.
When the petitioner moved into its new plant in 1912, it took practically all of its machinery. The majority of this machinery was overhauled and put in efficient working order. New bearings and boxes were installed where necessary, and new lineshafting, steel pulleys, and belting were installed. The general overhauling given the machinery amounted to more than incidental repairs.
The expenses incurred were charged to the machinery and tool repair account as follows:
| Belting | $154.80 |
| Replacement of a Kempsmith miller | 950.00 |
| A tumbler barrel, plating dynamo, plating apparatus, and drop hammer | 795.87 |
| Labor and material charged for overhauling machinery in August, 1912 | 247.53 |
*3181 *804 The last item contains charges for pulleys and parts for machines. Charges were also made to tool repairs account for labor and material and putting tools back into good condition, in the amount of $257.26. There was also a further item for October, 1912, of $246.51, making a total of $2,631.97. None of these were capitalized. At this time numerous minor items were charged to expenses. Some of these were as follows:
| Freight and drayage account increased over the normal annual charge about | $500 |
| Factory equipment account increased about | 300 |
| Pattern repair account increased about | 500 |
The cost of moving, repairing and rehabilitating the machinery and equipment and the cost of many new assets were not capitalized upon the company's books but were charged to operating expenses. A reserve account of $3,000 was set up to provide for moving expenses and moving expenses were charged thereto. This reserve was taken out of the amount received from the sale of the plant. The charges were for labor and material totaling $2,457.21, leaving a balance in the account. This was charged off by further credit to machinery and tools account, foundry equipment*3182 account and the sale of factory equipment which was obsolete.
At the time of moving certain assets were disposed of and were charged off from the account of the petitioner. Following is a list of the accounts of the petitioner showing the amounts charged off and balances reflected:
| Account | Charged | Balanced | Balanced | Balanced |
| off | Jan. 1, 1911 | Sept. 16, 1911 | Jan. 1, 1912 | |
| Machinery and tools | None. | $58,468.49 | $63,648.75 | $63,648.75 |
| Foundry equipment | $1,000.00 | 3,763.13 | 2,763.13 | 2,763.13 |
| Factory equipment | 6,042.27 | 13,314.70 | 7,272.43 | 7,272.43 |
| Flasks | None. | 669.93 | 669.93 | 669.93 |
| Office fixtures | 1,193.24 | 1,193.24 | None. | None. |
| Electros and woodcuts | None. | 658.24 | 658.24 | 658.24 |
| Office equipment | None. | 857.05 | 1,006.43 | 1,006.43 |
| Traveling equipment | None. | 90.29 | 90.29 | 90.29 |
The cost of assets on hand at December 31, 1912, and their depreciated value as of that date, both as shown by the books of the petitioner, are as follows:
| Account | Cost | Depreciated value Dec. 31, 1912 |
| Tools and machinery | $69,615.86 | $64,096.37 |
| Foundry equipment | 6,201.64 | 5,201.64 |
| Factory equipment | 24,992.45 | 24,143.92 |
| Office fixtures | 3,548.20 | 2,354.96 |
| Patterns | 7,479.52 | 7,479.52 |
| Flasks | 675.58 | 675.58 |
| Electros and woodcuts | 661.03 | 661.03 |
| Traveling equipment | 90.29 | 90.29 |
| 113,264.57 | 104,703.31 |
*3183 *805 The same rates of depreciation were used on the books of the petitioner as were used on the returns for the years 1917 to 1920, inclusive. In 1917 the petitioner revised its rates of depreciation. Entries were first made in June or July, 1917, and were made effective as of January 1, 1917.
The cost of properties of the petitioner on hand at December 31, 1916, the depreciation taken up to December 31, 1916, and the depreciated value as shown by the petitioner's books as of that date were as follows:
| Assets | Cost | Amount of depreciated | Depreciated |
| Sept. 16, 1911 | Value | ||
| Machinery and tools | $74,493.09 | $12,701.54 | $61,791.55 |
| Foundry equipment | 6,447.13 | 1,033.14 | 5,413.99 |
| Patterns | 9,053.39 | 1,706.13 | 7,347.26 |
| Flasks | 915.61 | 130.75 | 784.86 |
| Factory equipment | 33,355.36 | 5,679.68 | 27,675.68 |
| Office furniture and fixtures | 3,369.55 | 734.36 | 2,635.19 |
| Electros and woodcuts | 665.28 | None. | 665.28 |
| Traveling equipment | 108.29 | None. | 108.29 |
| 128,407.70 | 21,985.60 | 106,422.10 |
In 1918 petitioner was refunded $801.72, corporation income taxes for the years 1909 to 1916, based upon claims filed in September, 1917, whereby petitioner claimed*3184 additional depreciation for the years 1911 to 1916. The amount refunded was based in part upon the allowance of the additional depreciation claimed. The depreciation shown in the return, the additional depreciation claimed and allowed on the basis of the refund claims, and the total depreciation allowed are set forth below:
| Year | Original | Additional | Total |
| 1909 | $600.00 | $600.00 | |
| 1910 | 600.00 | 600.00 | |
| 1911 | 1,200.00 | $11,015.99 | 12,215.99 |
| 1912 | 1,200.00 | 13,206.19 | 14,406.19 |
| 1913 | 5,273.39 | 10,586.12 | 15,859.51 |
| 1914 | 5,784.00 | 10,790.46 | 16,574.46 |
| 1915 | 5,477.40 | 11,062.83 | 16,540.23 |
| 1916 | 5,123.81 | 12,736.97 | 17,860.78 |
| Total | 25,258.60 | 69,398.56 | 94,657.16 |
The petitioner had some war contracts with the Federal Government in 1918 and 1919. Upon the termination of these a settlement or agreement was entered into between the petitioner and the Government on May 27, 1919, and the petitioner was awarded $10,384.41. That award included an amount of $5,285.39 for contractual amortization. It was included in the return for 1919 as income. The respondent has deducted the contractual amortization received from *806 the cost of the assets upon*3185 which amortization has been allowed but has failed to exclude the same from the petitioner's income for the taxable year 1919.
The petitioner caused the Manufacturers' Appraisal Co. to make an appraisal of its machinery and equipment as of March 28, 1914. An inspection of the property was made and age was not considered as a factor in determining depreciation. The basis of valuation used was the cost of new reproduction as of the date of the appraisal. From this was deducted depreciation expressed in percentage. The appraisal report discloses a new reproduction cost for the properties of $117,092.50. There is deducted therefrom in the report, depreciation in the amount of $12,941.49, leaving a value of $104,151.01. This appraisal was made between November 17, 1913, and March 28, 1914.
The petitioner, in 1924, caused the Manufacturers' Appraisal Co. to revise its appraisal made as of March 28, 1914, to show valuation and depreciation as of March 1, 1913. This was done by eliminating the items purchased and adding the assets disposed of between March 1, 1913, and March 28, 1914, repricing the items at prices prevailing at March 1, 1913, and lowering the depreciation for*3186 a one-year period. The report showed a new reproductive cost of machinery and equipment on hand as of March 1, 1913, of $115,023.34. From this was deducted depreciation in the amount of $8,736.04, leaving a value as of March 1, 1913, of $106,287.30. In making the appraisal the marketability of the assets was not taken into consideration.
The respondent has accepted the new reproductive cost of $115,023.34 as correct. The book value of the machinery and equipment of the petitioner on March 1, 1913, was $105,156.57. The total cost of machinery and equipment owned by the petitioner on December 31, 1912, amounted to $113,246.57. The depreciated book value of machinery and equipment on December 31, 1912, was $104,703.31.
In 1917, the petitioner engaged a public accountant to make an investigation of its plant for the purpose of installing a cost accounting system. This accountant found that the depreciation written on the books of the petitioner from 1912 to 1916 had been written off without any material or particular basis and had been written off of the asset values rather than set up in reserves. He recommended that depreciation on original values be replaced and set into*3187 surplus and that additional rates of depreciation be used, segregated and separated as to plant divisions, which rates varied according to the equipment in question. Many of the tools had been owned by the petitioner for several years and many were obsolete. No investigation was made as to individual items. The proposed depreciation rates which were figured upon 1912 book valuations *807 were adopted in June or July of 1917, and were made effective as of January 1, 1917. The following are rates of depreciation claimed by the petitioner and the rates allowed by the respondent during the years in controversy:
| Rates of depreciation | ||
| Assets | Claimed by petitioner | Allowed by respondent |
| Per cent | Per cent | |
| Electros and woodcuts | 25 | 16 2/3 |
| Machinery | 7 1/2 | 6 1/2 |
| Tools | 25 | 16 2/3 |
| Jigs and dies | 25 | 16 2/3 |
| Motors and electrical equipment | 10 | 5 |
| Power equipment | 7 1/2 | 6 2/3 |
| Pipe and fittings | 7 1/2 | 5 |
During the years 1917 to 1920 the petitioner was confronted by abnormal conditions which increased the depreciation of machinery and equipment. The World War brought on conditions which caused a large labor turnover requiring the petitioner*3188 to break in new help and the depreciation on machinery and equipment was considerably greater than it would have been in the hands of experienced workmen. This condition arose before the United States entered the war. One of the causes of the labor situation was the large demand for labor in munitions factories.
OPINION.
SIEFKIN: At the hearing of this proceeding counsel for the respondent moved that the petition under Docket No. 14056 be dismissed in so far as it relates to the year 1919. Since the respondent asserted no deficiency for that year, but found an overassessment, the motion is herewith granted.
The questions to be decided are whether the respondent erred in (1) refusing to allow, for purposes of computing depreciation, the value of depreciable assets as of March 1, 1913, as claimed by the petitioner; (2) refusing to allow rates of depreciation during the years 1917, 1918, and 1920 claimed by the petitioner; (3) reducing the invested capital of the petitioner for each of the years in question on account of alleged insufficient depreciation in prior years; and (4) failing to exclude from gross income of the petitioner for the year 1919 an amount received by petitioner*3189 from the Federal Government as contractual amortization.
(1) The petitioner caused an appraisal company to make an appraisal of its machinery and equipment as of March 28, 1914. The appraisal report discloses a new reproduction cost of the properties *808 of $117,092.50. There was deducted therefrom in the report depreciation in the amount of $12,941.49, leaving a value of $104,151.01. In 1924 the petitioner caused the appraisal company to revise its appraisal of March 28, 1914, and show valuation and depreciation as of March 1, 1913. A new reproduction cost of machinery and equipment on hand as of March 1, 1913, was found to be $115,023.34. The respondent agrees that this was the new reproduction cost. Depreciation in the amount of $8,736.04 was deducted from this leaving an alleged March 1, 1913, value of the machinery and equipment of $106,287.30. But, as we said in :
Even though we accept the appraisal made in 1914 as establishing the reproduction cost as of March 1, 1913, we are unable to determine the actual value of the buildings on March 1, 1913, as replacement cost gives no dependable index to actual*3190 value.
We hold that the petitioner has failed to overcome the presumption of correctness of the respondent's valuation of the depreciable assets as of March 1, 1913.
(2) The rates of depreciation allowed by the respondent during the years 1917, 1918, and 1920, and the rates claimed by the petitioner during those years are as follows:
| Rates of depreciation | ||
| Assets | Claimed by petitioner | Claimed by respondent |
| Per cent | Per cent | |
| Electros and woodcuts | 25 | 16 2/3 |
| Machinery | 7 1/2 | 6 1/2 |
| Tools | 25 | 16 2/3 |
| Jigs and dies | 25 | 16 2/3 |
| Motors and electrical equipment | 10 | 5 |
| Power equipment | 7 1/2 | 6 2/3 |
| Pipe and fitting | 7 1/2 | 5 |
During the years 1917 to 1920 the petitioner was confronted by abnormal conditions which increased the depreciation of machinery and equipment. The World War brought on conditions which caused large demands for labor in munitions factories and, as a result of this, the petitioner lost many of its experienced workmen. The consequence was that the machinery and equipment of the petitioner was damaged to an unusual extent by inexperienced help which petitioner had to employ.
The rates of depreciation set forth above*3191 were recommended to the petitioner by an accountant who figured the rates upon 1912 book valuations. Many of the tools had been owned by the petitioner for several years and many were obsolete. No investigation was made as to the condition of individual items.
*809 W. J. Frost, president of the petitioner, who controlled the policy of writing off depreciation of the petitioner, testified as follows:
Q. Do you know whether or not the rates claimed during the years 1917 to '20 are higher than the rates of depreciation used in computing depreciation entered upon the books of the corporation prior to the year 1917?
A. Yes, they were higher - or are higher. Higher today.Q. You had some reason, I assume, for increasing the rates of depreciation during those years '17 to '20 over and above the rates used in previous years?
A. I did. I considered it a very good reason. Q. What was the reason?A. The fact that depreciation was figured on low valuations or previous costs. Beginning with the earlier years of the war the cost of all of our equipment advanced tremendously. Now, a depreciation which would take care of and replace cost value based on what we*3192 paid for the material would be entirely inadequate to replace it at the increased values.
* * *
Q. Assuming that they have allowed additional depreciation because of overtime operations, did you consider that in spite of that fact the normal depreciation rates during the years 1917 to 1920 should be higher than those theretofore used?
A. Yes, I do, for this reason. Assuming that the Government did allow additional depreciation, that would be simply for the additional time of use, and that would not affect the point that I mentioned before, the necessity for higher rates of depreciation to cover the new cost or the cost of replacing that machinery.
In , we stated:
* * * The theory of depreciation is that the taxpayer should be allowed, during the useful life of property used in his business, to recover the cost of such property. .
We are, therefore, led to the opinion that the depreciation claimed by the petitioner was based upon an improper conception of the theory of depreciation and that such claimed rates are excessive. The respondent's determination of rates*3193 of depreciation will not be disturbed.
(3) The petitioner contends that the book value of its assets as of December 31, 1916, in the amount of $106,422.10, should be included in invested capital as of that date. The evidence discloses that these assets were, in the main, equipment owned by petitioner since its organization in 1902. The books of petitioner show that the amount of depreciation taken up to December 31, 1916, was $21,985.60. This indicates that over this period an average depreciation of only slightly over 1 per cent was taken on the assets, the cost of which amounted to $128,407.70.
On page 44 of the deposition, Frost testified as follows:
Q. In your opinion, Mr. Frost, do you believe that the consideration of such depreciation as was written off in years prior to 1917 and the items which were charged to expenses which might properly have been capitalized, would give a result comparable to that arrived at by using the rates which you entered *810 upon your books and claimed in your tax returns for the years 1917 to 1920?
A. Yes, I do. I think that is borne out by what followed in 1914. You see when we moved over here we wrote off quite an item. *3194 I don't recall the exact amount, but it was a considerable item - wiped it off entirely - so that when we were in full operation here we felt that we had the full value that was reflected by our books; but at that time in order to confirm that question I had an appraisal made, and the sound value of that appraisal showed a slightly higher figure than our books, I think that would in itself justify the practice that we had followed in the previous years.
However, we have been presented with insufficient evidence to determine whether or not items charged to expense should have been properly capitalized, nor were the amounts of such items placed in evidence. As already pointed out, the appraisal made was based upon cost of reproduction as of date of the appraisal and such appraisal is entitled to little weight. The petitioner contends that such appraisal, which was approximately the same as the values shown upon the books, proves that the book values were proper. We cannot agree with this contention. It is our opinion that insufficient depreciation was taken in years prior to the taxable years in question and the respondent's determination of asset values for invested capital*3195 purposes will not be disturbed.
(4) On May 27, 1919, a settlement or agreement was entered into between the petitioner and the Federal Government, whereby petitioner was awarded an amount of $5,285.39 for amortization of war contracts which had been entered into in 1918 and 1919. This amount was included by the petitioner in its return for the year 1919 as income. The respondent has deducted the contractual amortization received from the cost of the assets upon which amortization has been allowed but has failed to exclude the same from the petitioner's income for the taxable year 1919. In failing to exclude this amount from the petitioner's income for this year the respondent has erred.
Judgment will be entered under Rule 50.