1935 BTA LEXIS 919">*919 1. An owner who leases property for a shorter period than its probable physical life, under a lease not requiring the lessee to return property to the lessor at the end of the term of the physical equal of the property when the lease was made, but merely requiring the lessee to maintain the leased property in a good and safe condition and to make necessary repairs and replacements, is entitled to deductions for exhaustion, wear, and tear, including a reasonable allowance for obsolescence.
2. The evidence establishes that at the time they were leased terminal buildings and tracks had a probable physical life which was longer than the term of the lease, and that a few years after the lease was made obsolescence had set in and that the property would become obsolete not less than 18 years later, or when the lease expired. Held, that the deductions for exhaustion, wear, and tear for the years prior to the beginning of obsolescence should be computed on the basis of the probable physical life of the property, and that the deductions for exhaustion, wear, and tear, including a reasonable allowance for obsolescence, for the years after the beginning of obsolescence, should be computed1935 BTA LEXIS 919">*920 on the basis of one eighteenth of the unexhausted cost of the property at the time obsolescence began.
3. The petitioner issued its common stock to four traction companies in consideration of the conveyance by them of certain property and of their agreement to become the lessees of all of the petitioner's property at a cash rental, among other things, of a fixed amount necessary to redeem and retire the preferred stock of the petitioner over the period of the lease. The part of the rental so fixed was apportioned to each of the lessees in proportion to the amount of common stock which each owned. Held, that the portion of the rental so paid was in fact rental and income of the petitioner, and not a capital contribution by the lessees on account of their common stock.
32 B.T.A. 623">*624 The Commissioner determined deficiencies as follows:
| Docket No. | Year | Deficiency |
| 43766 | 1924 | $1,613.33 |
| Do | 1926 | 3,661.76 |
| Do | 1927 | 3,693.75 |
| 50762 | 1928 | $6,184.80 |
| 60596 | 1929 | 5,583.00 |
| 71157 | 1930 | 6,171.54 |
The issues raised1935 BTA LEXIS 919">*921 by the pleadings are (1) whether or not the petitioner is entitled to a deduction for each year representing an allowance for the exhaustion, wear and tear of its property used in its trade or business; (2) whether or not for the years 1928, 1929 and 1930 it is entitled to an amount representing an allowance for obsolescence of its property used in its trade or business; (3) whether or not there should be included in the petitioner's income $11,200 for 1926, $22,400 for 1927, $22,400 for 1928, $22.600 for 1929, and $22,600 for 1930, representing amounts paid to it in those years and used by it in the retirement of its preferred stock; (4) in what year there should be included in its income the amounts paid to it by lessees to discharge its income taxes.
FINDINGS OF FACT.
The petitioner is and during all of the taxable years was a corporation organized and existing under the laws of the State of Indiana, having its principal office and place of business in Indianapolis. It kept its books on an accrual basis.
Four traction companies having electric railway lines entering Indianapolis desired to have a common freight terminal in that city. The petitioner was organized in 1923. 1935 BTA LEXIS 919">*922 It took over from a subsidiary 32 B.T.A. 623">*625 of one of the traction companies a terminal building which had been erected in 1917. It constructed another larger terminal building and additional terminal tracks. It continued to own these properties throughout the taxable years. The building constructed in 1917 was acquired by the petitioner in 1923 at a cost of $59,058.45. Up to January 1, 1924, new structures had cost $16,255. Additions cost in 1924, $171,332.99; in 1925, $400.21; and in 1927, $2,292.74. Thereafter the cost of buildings remained constant. On January 1, 1924, the cost of tracks amounted to $108,776.12. Additions cost in 1924, $35,013.74; in 1925, $17,479.14; and in 1926, $4,099.60. Thereafter, the cost of the tracks remained constant.
The articles of incorporation of the petitioner provided:
The common stock shall be issued to the Union Traction Company of Indiana, Terre Haute, Indianapolis and Eastern Traction Company, Interstate Public Service Company and Indianapolis and Cincinnati Traction Company in consideration of the conveyance by the Terminal Realty Company of said Outlot 133 and the improvements thereon and of said real estate condemned in the1935 BTA LEXIS 919">*923 Marion Circuit Court and in consideration for said companies entering into a contract of lease for all the property of the corporation for a term ending July 1, 1946 at a rental which will provide not only for all operating expenses and taxes and the dividends on nine hundred thousand dollars ($900,000.00) of the first preferred stock of the company but also for the retirement and redemption of all such preferred stock thereby causing said stock to have an actual paid up value at the close of said lease of more than seven hundred fifty thousand dollars ($750,000.00).
Preferred stock of the total par value of $900,000 was sold and a part of the proceeds was used to acquire the terminal properties already described. The petitioner was required to retire $11,200 par value of its preferred stock semiannually, beginning July 1, 1926, and on January 1, 1929, the amount was increased by $100.
Seventy-five hundred shares of common stock were issued, one third to the Terre Haute, Indianapolis & Eastern Traction Co., one third to the Union Traction Co. of Indiana, one sixth to the Indianapolis & Cincinnati Traction Co., and one sixth to the Interstate Public Service Co. No other stock1935 BTA LEXIS 919">*924 was ever issued during the period here in controversy.
The four traction companies mentioned leased the petitioner's property for a period beginning on August 2, 1923, and to end on July 1, 1946. The form of this lease was approved by the board of directors of the petitioner at a meeting on July 16, 1923, by a resolution which provided in part as follows:
RESOLVED, Further, that in consideration of the fact that under the terms of said lease, lessees will provide funds to retire all of the preferred stock of this company and thereby will pay into capital account more than the total value of the common stock of this company, and, in consideration of the fact that through the efforts of said interurban companies, this company will be enabled 32 B.T.A. 623">*626 to procure property owned by the Terminal Realty Company at a cost much less than will be its actual value for freight terminal purposes, that there be issued to said four interurban companies or to such person or persons or trustees as they may designate, all the common capital stock of this company other than the qualifying shares of the directors, such stock to be issued in such proportions and subject to such conditions and1935 BTA LEXIS 919">*925 restrictions among themselves selves as said interurban companies may agree.
The provisions of the lease in regard to rental were "In consideration thereof and as rental for said property the lessees jointly and severally agree to pay cash rental as follows:" (a) Such sum as may be required to pay the dividends on the outstanding preferred stock; (b) the amount necessary to redeem and retire the preferred stock in accordance with the provisions for semiannual retirement; (c) amounts sufficient to meet all taxes and assessments of every kind or character imposed upon the lessor or its properties by any authority whatsoever. "The amount of such taxes and assessments shall be paid to the lessor not less than five days before the same must be paid to avoid delinquency"; (d) any insurance premiums which may be necessary to provide insurance against loss by fire, tornado or storm; (e) "such sums as may be necessary to defray the expenses of the lessor in connection with its corporate affairs."
The lessees were to save the lessor harmless from all damage to property or persons growing out of the use or occupancy of the premises. The lease further provided:
The lessees jointly and1935 BTA LEXIS 919">*926 severally covenant and agree to keep and maintain the demised property in a good and safe condition, equally as good and safe as the same may be at this time, or may be put at any time during the continuance of this lease, loss by fire and tornado alone excepted, and as to such loss by fire or tornado the obligation of the lessees shall be as hereinabove defined.
It is expressly understood and agreed that having provided the facilities and equipment hereinabove referred to, which the lessor has agreed to provide, the lessees shall be solely responsible for the upkeep and maintenance thereof and the lessor shall be under no duty to make any repairs or replacements on account of such property except to the extent that insurance moneys may be received in case of loss by fire or tornado as hereinabove provided.
The lessor had the right to terminate the lease on thirty days' notice after failure of the lessees to pay any of the amounts due under the lease.
The probable physical life of the building constructed in 1917 was, in 1923, 25 years, and a reasonable annual allowance for depreciation on that building is 4 percent of its cost. The probable physical life of the new building1935 BTA LEXIS 919">*927 constructed by the petitioner was 35 years and a reasonable annual allowance for depreciation on that building is one thirty fifth of its cost. The probable physical life of the tracks of the petitioner in 1923 was 25 years, and a reasonable 32 B.T.A. 623">*627 annual allowance for depreciation on the tracks is 4 percent of their cost. It became apparent about the beginning of 1928 that the probable useful life of the buildings and tracks of the petitioner would be less than their probable physical life and for the years 1928, 1929, and 1930 a reasonable annual allowance for exhaustion, wear, and tear, including a reasonable allowance for obsolescence of the buildings and tracks is one eighteenth of the unexhausted cost of the buildings and tracks on January 1, 1928.
The petitioner claimed deductions for depreciation and obsolescence on its returns. The Commissioner disallowed in their entirety the amounts claimed by the petitioner on its returns for exhaustion, wear and tear, and obsolescence of its property.
The portion of the rental based upon the amount necessary to pay dividends and operating costs of the petitioner was apportioned among the lessee companies in proportion to1935 BTA LEXIS 919">*928 the use which each made of the terminal facilities. The portion of the rental based upon the amount necessary for the purpose of retiring preferred stock was apportioned to each of the lessees in proportion to the amount of common stock which each owned. The lease provided that the lessees should pay on or before the second day of each calendar month, beginning July 2, one twelfth of the sum required to retire the amount of preferred stock due for retirement during the following twelve months. The petitioner billed each of the traction companies monthly by a bill which showed in detail the amounts due from the particular company under the various provisions of the lease. Each of the traction companies paid the petitioner by a check for the total amount shown on the petitioner's bill for the month. The following table shows the amount which the petitioner received in each year for the purpose of retiring its preferred stock:
| 1926 | $22,400 |
| 1927 | 22,400 |
| 1928 | 22,500 |
| 1929 | $22,600 |
| 1930 | 22,600 |
The petitioner did not include in its income account the amounts received from the traction companies for the purpose of retiring the petitioner's preferred stock, but1935 BTA LEXIS 919">*929 made an appropriate credit to the account of the respective companies showing the amount received from them for this purpose. The petitioner did not report in its income any of the amounts received from the lessees for the purpose of retiring its preferred stock. The Commissioner made no adjustment in the petitioner's returns for 1926 and 1927 in this connection, but in determining the deficiencies for 1928, 1929, and 1930 he added $22,400, $22,600, and $22,600, respectively.
The Terre Haute, Indianapolis & Eastern Traction Co. and the Union Traction Co. accounted for the payments made by them for 32 B.T.A. 623">*628 the purpose of retiring the petitioner's preferred stock as investments in the petitioner's common stock. The Interstate Public Service Co., prior to 1929, charged the payments which it made for this purpose to expense, but in 1929 reversed these entries, charged the amounts to investment account, and thereafter charged these payments to investment. The record does not show how these payments were accounted for by the Indianapolis & Cincinnati Traction Co.
The petitioner reported the following amounts on its returns for the respective years as tax due:
| 1923 | $1,475.99 |
| 1924 | 6,318.30 |
| 1925 | 5,978.98 |
| 1926 | 4,901.49 |
| 1927 | $4,859.30 |
| 1928 | 4,032.87 |
| 1929 | 3,560.65 |
| 1930 | 3,636.27 |
1935 BTA LEXIS 919">*930 The amount shown on the return for a particular year was collected by the petitioner from the lessees in monthly payments during the year following the one for which the return was made. The petitioner did not report in its income any of the amounts collected by it from the lessees for the purpose of paying its income tax. The Commissioner included in income for each of the respective years an amount which he determined by computing the amount of tax which would be due on the income for that particular year, excluding from income the amount to be collected from the lessees on account of income tax. He then determined the deficiencies on income as thus increased. No portion of the amount of the deficiencies has been demanded from the lessees or their successors in interest and no portion of these amounts has been received by the petitioner.
OPINION.
MURDOCK: The first question is whether or not the petitioner is entitled to any deductions during the period of the lease on account of depreciation or obsolescence of the physical properties which it owned and leased to the traction companies. The Commissioner has allowed no deductions whatever. 1935 BTA LEXIS 919">*931 He argues that the petitioner is not entitled to any deduction for depreciation because the lessees were required to offset by repairs and replacements any exhaustion, wear and tear which might otherwise result from the use of the property. He relies entirely upon the provision of the lease requiring the lessees to "maintain" the "property in a good and safe condition, equally as good and safe" as it was at the beginning. He cites , and ; affirmed on this point, .
The statutes provide for a deduction of "a reasonable allowance for the exhaustion, wear and tear of property used in the trade or business, including a reasonable allowance for obsolescence" based 32 B.T.A. 623">*629 upon the cost of the property. The Supreme Court said in :
The amount of the allowance for depreciation is the sum which should be set aside for the taxable year, in order that, at the end of the useful life of the plant in the business, the aggregate of the sums set aside will (with the salvage value) suffice to1935 BTA LEXIS 919">*932 provide an amount equal to the original cost.
Deductions for depreciation are allowed for the purpose of restoring the cost of exhausting property over the period of its use from untaxed earnings derived from its use. The annual allowance is made pursuant to some plan for distributing the total cost of the plant over the period of its usefulness. It is to be "a reasonable allowance" with relation to the whole life period of the asset and need not be an exact measure of the actual wearing out of the property in the particular year. Under the "straight line" method it may be assumed that depreciation proceeds at some average rate based upon an estimate of the number of years that the property will probably last. Practical judgment based upon experience should be used in making the estimate. The annual allowance may be computed by dividing the cost of the property by the number of years of its estimated life. If the probable salvage value can be estimated, it should be first deducted from cost, but if it can not be reasonably estimated, adjustment may be made for it later. Some later adjustment may also be necessary to make up for errors in the estimate. A reasonable allowance1935 BTA LEXIS 919">*933 is thus merely the equitable share of the expense of ultimate retirement of the plant assignable to each year. 1
The provision of the lease upon which the Commissioner relies must be properly interpreted. It required the lessees to maintain the property; that is, it made them responsible for the upkeep, repairs, and replacements which the property might need during the period of the lease. If a part of the property wore out or broke, the lessees were required to make the necessary repairs and replacements. Buildings may be kept in a good and safe condition, equally as good and safe as they were in the beginning, for a limited time only. Experience has taught that at the end of some period of time physical properties will be worn out despite all that can be done to them in the meantime. Proper maintenance may keep them in a condition equally as good and safe as they were in the beginning almost, if not quite, up to the end of their physical life. Indeed, their life ends when they can be maintained1935 BTA LEXIS 919">*934 in a good and safe condition no longer. The probable physical life of the properties in question was somewhat longer than the period of the lease. No doubt, by proper maintenance, they could be kept throughout the period of the lease in a condition equally as good and safe as they were at the beginning 32 B.T.A. 623">*630 of the lease. Still they were wearing out. In 1930, for example, they were no longer new. They were somewhat deteriorated from age and worn from use. Some depreciation had actually taken place. Their probable future physical life was shorter than it was at the beginning of the lease. The respondent does not contend that the lessees were required to pay cash to the lessors at the end of the lease, or at any other time, to offset this depreciation. It seems clear that the lessees were not required by the terms of the lease to replace at the end of the lease the partially worn out buildings with new ones. Thus the lessor can expect to have returned to it, at the termination of the lease, property having a probable future physical life at that time of only a few years. Must the lessor recover the entire cost of this property through deductions from income from the1935 BTA LEXIS 919">*935 use of the property during those few remaining years of usefulness, or is it reasonable to spread this cost over the entire period of usefulness of the property, including the period of the lease? Since the property was actually wearing out during the period of the lease, it seems reasonable to deduct from the annual rental a proportionate part of the cost of the property. Cf. . If obsolescence were taking place, it is even more clear that the petitioner should have a deduction. Obviously no provision of the lease would save the petitioner from loss if at the end of the lease the property, though still sturdy physically, were about to become obsolete. In such case the petitioner could recover the cost of its property only through deductions from its income during the period of the lease. The petitioner is entitled to deductions for depreciation, including obsolescence, for the years for which it has claimed deductions in its pleading and to the extent that it has proven facts from which the amount of such deductions can be determined.
The two cases cited by the respondent are distinguishable on their facts from the present1935 BTA LEXIS 919">*936 case. The A. Wilhelm Co. leased its entire plant and assets as a going concern, subject to its liabilities, for a five-year period, with an option to purchase at a fixed price. The lessee was required to maintain the plant and to pay all costs of new construction. Furthermore, it was required at the expiration of the lease to return the property to the lessor in the same condition and equal in book value and actual value to its value at the beginning of the lease. A deduction for depreciation was denied the lessor during the term of the lease because "no allowance could be justified as reasonable under the circumstances." In the Terre Haute Electric Co. case the lease was for a period of 999 years, during which time the lessee was to maintain the property. There was to be an appraisal at the beginning, as well as at the termination, of the lease and the value of the lessor's property at the time the lease was executed 32 B.T.A. 623">*631 was to be restored to it at the time the lease expired. Likewise the case of , is distinguishable from the present case by a difference in the facts. The lease there was for a term of1935 BTA LEXIS 919">*937 999 years. The lessees were to maintain the property and at the end of the lease to return it to the lessors in good order and condition, "ordinary wear and tear excepted." The lessor's claim for a deduction for depreciation in that case seems to have been an afterthought. The Board disallowed it, stating that any loss which the lessor might expect because of the excepted "ordinary wear and tear" had neither been alleged nor shown.
The next question is to determine from the evidence the amount of the deductions. The proof in regard to the probable physical life of the properties is clear enough and is not seriously assailed by the respondent. The property would probably have no salvage value. Likewise, it is fairly well established that a period of obsolescence began about the beginning of the year 1928. The indications then were that the property would probably lose its usefulness prior to the end of its physical life. However, the period of obsolescence is not so clearly established by the evidence. One witness testified that in 1927 or early in 1928 he became convinced from the rapid decline in business of the traction companies, caused by the increased use of automobiles1935 BTA LEXIS 919">*938 and trucks, that within ten or fifteen years the terminal facilities would have lost their usefulness. In addition to the testimony of this witness there is evidence of the decline in earnings of some of the companies, evidence of the abandonment of some of the lines, evidence of bankruptcy of some of the companies, and perhaps some other evidence bearing upon the subject. If the opinion of this witness were absolutely binding, then the holding would have to be that the period of obsolescence began at the beginning of 1928 and would end not later than the beginning of 1943. However, some of the other evidence indicates a slightly longer period of obsolescence. The property had been leased until 1946 and the lessees would be liable for the rental until that time. Although there were some changes in some of the companies, there was no evidence of any of them having defaulted up to the time of trial. Taking into consideration all of the evidence, we hold that the period of obsolescence began in 1928 and will end in 1946. Thus one eighteenth of the cost of the property depreciated to January 1, 1928, should be allowed as a deduction for exhaustion, wear, and tear, including obsolescence1935 BTA LEXIS 919">*939 for each of the years 1928, 1929, and 1930.
The next question is whether or not the portion of the rental fixed at the amount necessary to retire the preferred stock is income to the petitioner or a capital contribution. The petitioner claims that this item was not truly rental and was not income, but instead was a capital contribution representing the payments which the lessees 32 B.T.A. 623">*632 were making for their common stock. The lessees were also the common stockholders. They paid no cash for stock in 1923. The petitioner points to statements in the articles of incorporation and in the resolution accepting the lease relating to how the value of the common stock was to be paid into capital account, to the fact that the total paid was apportioned and billed to the lessee companies not in proportion to their use of the terminal facilities, but in proportion to the amount of common stock held by each lessee, and to the method of accounting for these items employed by the lessor and lessee companies. It therefore argues that, despite the name which was given to the item, the parties have shown by their action that it was capital and not income to the lessor. It says that the case1935 BTA LEXIS 919">*940 of is in point and controlling. However, the facts in that case were materially different. The agreement in that case provided that whenever the railway companies should make any payments to the bridge company to reduce the principal of the bonds of the bridge company then the bridge company should issue its preferred stock to the railroad companies equal in par value to the par value of the bonds retired. Those payments were not called rental. The differences in the facts serve to distinguish the two cases. This case must be decided upon its own facts.
The name which the parties gave to this item, while not controlling, is nevertheless important. They always called it rental. Furthermore, there was nothing about the payments themselves which would show that they were not rental. The single fact that they were apportioned in accordance with stockholdings rather than in accordance with the use of the facilities is not inconsistent with a holding that they were rental. In case of default, suit would lie against the lessee for rent, not against the stockholder for money due on stock or for an assessment on the stock. 1935 BTA LEXIS 919">*941 Not only has the petitioner failed to show that the payments in question were not in fact rental and income, but the evidence indicates that they were in fact rental. ; affd., . The actual collections of the petitioner during the year 1926 and the year 1928 were larger than the amounts which the respondent contends should be included in the petitioner's income for those years. The contentions of the respondent on this point are sustained to the extent of the amounts claimed in his pleadings.
The last issue is decided for the respondent upon authority of , which we now think correctly reversed the Board on the point.
Reviewed by the Board.
Decision will be entered under Rule 50.
Footnotes
1. See discussion of the depreciation charge by Mr. Justice Brandeis in a dissenting opinion in , et seq.↩