*2509 Rates of depreciation and obsolescence determined.
*841 In these proceedings, duly consolidated for hearing and decision, petitioner asks redetermination of income and profits taxes for the period September 1, 1920, to December 31, 1920, and the years 1921, 1922, 1923, 1925, and 1926, as to which respondent has found deficiencies of $126,280.12, $56,183.81, $30,450.01, $16,213.39, $618.68, and $28,562.53, respectively. No deficiency being determined for 1924, that year is not before us. The sole issue urged is that respondent erred in determining the amount of the deduction allowable in the several years on account of depreciation, exhaustion, wear and tear, including obsolescence.
FINDINGS OF FACT.
Petitioner is a New York corporation organized about September 1, 1920. The incorporators of petitioner had purchased in July, *842 1920, two steamships, the Robin Hood and the Robin Adair, at a price of $1,500,000, each, or approximately $145 per ton dead weight. On September 1, 1920, the*2510 two ships were sold and transferred to petitioner at the price paid for same by the incorporators - $1,500,000 each.
On February 1, 1921, petitioner acquired by purchase two sister ships, the Robin Goodfellow and Robin Gray, at a price of $936,000, each, or approximately $90 per ton dead weight.
Petitioner placed all of these vessels in the South American trade and from the time of their purchase up to December 31, 1926, has continued to operate them in that or other trade up to the time of the hearing in these proceedings.
The four ships are all of like design and equipment and were built by Skinner & Eddy of Seattle. Two were completed in December, 1919 and two in January, 1920, and all were in operation when purchased by petitioner. They are steel, oil-burning steamers, shelter-deck type of 10,400 tons dead weight. They are 424 feet long, 55 feet beam, 33 feet deep and are equipped with Scotch boilers designed for 210 pounds working pressure with single General Electric 3,000 horsepower turbine engines. The lines of the hulls are full, being a type frequently referred to as "box-type boats." This type of boat was built as a standard type under contracts with*2511 the Shipping Board during the War. They have a speed of about 10 knots per hour. The purchase price of the ships - $1,500,000, each, for the Robin Hood and Robin Adair and $936,000, each, for the Robin Goodfellow and Robin Gray - was a fair and reasonable price at the time of purchase. At that time there was no established market price in the United States for such ships. The Shipping Board was asking $160 to $185 per ton dead weight for similar ships, but no sales were being made by it. This price also was being asked by the Shipping Board when the second two ships were purchased.
At the time of the purchase of the first two ships ocean cargo rates were steady. They ranged from $17 to $19 per ton on ore from Brazil to United States ports north of Hatteras and about $13 per ton on coal from Hampton Roads to Rio de Janeiro. There was a constant demand for cargo space and the rates on other freight were correspondingly steady. In October, 1920, cargo rates began to decline. Foreign vessels released from war service and other foreign commerce began to come into competition with American ships at all ports, the demand for cargo space fell off, and freight rates*2512 declined accordingly.
In September and early October, 1920, petitioner closed two ships at $13 per ton for coal from Hampton Roads to Rio de Janeiro; in November and December two were closed at $7.50 per ton; in February, 1921, one was closed at $5.87 1/2 per ton; in March one *843 was closed at $5.75 per ton; in June one was closed at $3.50 per ton; and in February, 1922, one was closed at $3.25 per ton. Except during the time of the coal strike in England in 1926, freight rates on coal have not since exceeded $4 per ton. The rates on other freight have been correspondingly low and these rates fairly represent the general trend.
Beginning in the fall of 1920, foreign-flag ships of a new type came into competition. These were boats of finer lines, capable of 13 to 14 knots speed, powered with either high-pressure steam turbine engines and water-tube boilers or with Diesel engines. The Diesel engine is an internal combustion engine requiring no boilers and occupies less space than the Scotch boiler and turbine equipment of petitioner's ships, with a resulting increase in cargo space. These ships also had superior deck equipment, enabling them to load and discharge*2513 more rapidly and cheaply than petitioner's ships. The oil consumption of the Scotch boilers on petitioner's ships was 1.3 pounds per horse power per hour. The high-pressure engines with water-tube boilers used 0.8 pound of oil per horse power per hour while the Diesel engine used only 0.4 pound of oil per horse power per hour.
Rates being substantially equal, the better-paying freight prefers the faster ship. Consequently, the preferential freight went to the new type ships and petitioner could obtain only lower-paying freight.
Except for the completion of the Shipping Board program of cargo ships laid down during the War, no vessels of the Robin type and equipment have been built in the United States since the War, and only seven have been built elsewhere in the world. Out of 7,245 vessels completed throughout the world from 1920 to 1927, but 116 were of the Robin type and of these 109 were completed under wartime contracts.
From time of purchase until 1922 petitioner was engaged in the trade between North America and South America, but in the latter year placed its boats in the intercoastal trade, carrying general cargo from the East coast to the Pacific coast*2514 and carrying lumber back. When petitioner sent its boats to British Columbia for lumber it came into competition with British and other foreign vessels operating with cheaper labor. The wage or labor cost on foreign vessels is at least 20 per cent less than on American-flag vessels.
In 1919 there were 32,900 tons of shipping equipped with Diesel engines afloat. In 1920 this figure increased to 86,900 tons; in 1921 to 306,000 tons; and in 1925 there were built 843,000 tons equipped with Diesel engines. In 1926 Diesel equipped tonnage equalled 76 per cent of the total steam tonnage of the world. Beginning in 1921 the Shipping Board made a survey for evaluation of its tonnage and *844 as a consequence in 1923 fixed a price of $35 per ton dead weight for the best ships in the fleet, with lower prices on other ships. In August, 1921, the Shipping Board had approximately 900 vessels of varying sizes tied up. All of these had previously been in operation. In computing the cost of operation of Government vessels the Shipping Board did not take into account as an element of cost depreciation, obsolescence or amortization of the ships.
Since 1921 there has been no sale of*2515 a vessel of the type of petitioner's ships at a price in excess of $35 per ton. The probable physical life of petitioner's ships is not in excess of 15 years from the date of purchase by petitioner. The probable useful economic life of petitioner's ships is not in excess of 12 years from the date of purchase by petitioner. The salvage or junk value of the ships when retired will not exceed $20,000 each.
In its returns for the various years covered by these proceedings petitioner deducted from gross income as a reasonable allowance for depreciation, exhaustion, wear and tear, including obsolescence, the following sums:
| Sept. 1 to Dec. 31, 1920 (2 ships) | $ 300,000 |
| 1921 (4 ships) | 487,200 |
| 1922 | 487,200 |
| 1923 | $487,200 |
| 1924 | 487,200 |
| 1925 | 243,600 |
| 1926 | 243,600 |
Respondent allowed 5 per cent of cost as depreciation, but allowed nothing for obsolescence.
The gross income of petitioner's ships from September 1, 1920, to December 31, 1926, without deductions, was as follows:
| 1920 | $483,966.77 |
| 1921 | 657,763.00 |
| 1922 | 646,412.27 |
| 1923 | 263,305.88 |
| 1924 | 139,770.94 |
| 1925 | $216,783.11 |
| 1926 | 304,075.90 |
| 2,712,077.87 |
During the years 1920 to*2516 1926 petitioner also chartered and operated other vessels, earning therefrom a gross total income of $919,512.83. Excepting a negligible amount of office equipment, the four steamships were the only capital assets owned by petitioner during the taxable years.
OPINION.
VAN FOSSAN: In these proceedings petitioner contends that a deduction from income in the amount of 10 per cent of the cost of ships purchased and used by it is a reasonable allowance on account of depreciation, exhaustion, wear and tear and obsolescence. Respondent has allowed 5 per cent on account of depreciation, but refuses any allowance on account of obsolescence.
*845 Respondent's allowance of 5 per cent as depreciation is based on an estimated physical life of the ships of 20 years. The evidence shows that a cargo ship built under normal conditions with normal materials and in accordance with the usual practice in the shipbuilding industry may reasonably be expected to last 20 years. The ships in this case, however, were part of the war-time program of the Shipping Board, built in an emergency shipyard under stress of War pressure when materials, labor and the quality of workmanship were notoriously*2517 inferior to normal times. The testimony of well qualified witnesses was that the physical life of the ships would not exceed 15 years. We concur in this conclusion and were we concerned only with depreciation would find respondent's allowance therefor inadequate.
There is, however, the further question of obsolescence. Petitioner contends that shortly after the purchase of these boats, which were of blunt lines equipped with Scotch boilers and a single turbine engine, there appeared on the seas a new type of cargo ship, finer in lines, greater in speed and more economical in operation. This new type of ship was equipped either with water-tube boilers and high-pressure turbine engines or with a Diesel engine which required no boilers. The maximum speed of petitioner's ships was 10 knots. The newer ships could make 12 or 14 knots. The oil consumption of the Scotch boilers on petitioner's ships was 1.3 pounds of oil per horse power per hour. The high-pressure engine with water-tube boilers used 0.8 pound of oil per horse power per hour, while the Diesel engine used only 0.4 pound per horse power per hour. The Diesel engine also effects a considerable saving in space, thereby*2518 increasing the space available for cargo. The new type of ship-propulsion machinery, though somewhat higher in original cost, was less expensive in upkeep and repair.
The effect of this pronounced improvement in the art of ship building and ship installation was positive and far-reaching. Shipping rates being equal, freight prefers the faster ship. Petitioner soon found it impossible to compete for the preferential freight and was obliged to accept less desirable freight. If rates were cut, income was reduced, while the higher operating costs of petitioner's ships increased the disadvantage. When petitioner filed its 1920 tax return these new factors, fundamental in charactr, had already appeared and their future influence on shipping could readily be discerned. Petitioner's claim for obsolescence was not based on a mere expectation that improvements in the art would probably occur. Here, the improvement had already taken place and the obsolescence of its ships was established by most convincing evidences. This distinguishes the present case from such cases as Columbia Malting*846 *2519 , and , cited by respondent.
It was apparent to petitioner in 1921 that the day of the Robin type boat as a successful economic competitor was past. Though the ships were not rendered at once obsolete the forces which bring about economic obsolescence had been set in motion and obsolescence was occurring. The building of the improved type of boats and their infiltration into the channels of trade was a slow but steady process and their relative importance in the trade became progressively greater each year.
Yet other elements added to petitioner's disadvantage. The influx of foreign ships released from war service into American trade, the flooding of the American market with Shipping Board vessels at sacrifice prices, the establishment by the Shipping Board of numerous trade routes, the sharpening of competition, with consequent radical reduction in ocean freight rates and the lessening in some quarters of cargo supply, were all factors that increased petitioner's difficulty. These factors, though intangible and difficult of measurement, were nevertheless real influences that accelerated*2520 the obsolescence of petitioner's ships. In the quickened competition of the postwar years the advantage of the fast, modern-type vessel was cumulative. Its greater speed made it more attractive to shippers, while its lower cost of operation gave a distinct money advantage to the operators.
Though income depends so much on management and various other factors beside physical or general economic life that it is not a safe or accurate standard by which to determine the fact of obsolescence, it may be examined to ascertain whether it tends to support or dispute the practical acuracy of the conclusion that such obsolescence is occurring. Looking at the record of earnings solely for this purpose, it appears that only during the first two and one-half years of the period 1920 to 1926 have petitioner's ships made gross earnings equal to their reasonable physical depreciation computed on a basis of a 15-year life. For the four years from January 1, 1923, to December 31, 1926, the average annual gross earnings, without any deductions, are approximately $230,000. The highest amount earned in any one of these years was $304,000. If an annual depreciation charge of $325,000 be applied*2521 against these average earnings, we find an average annual loss of approximately $95,000, and this without any deduction of overhead and other proper charges.
Accurately appraising the situation in 1922 and realizing the consequence indicated therein, petitioner reasonably concluded that the economically useful life of its boats would be less than their physical life. The evidence sustains this conclusion. Petitioner was justified *847 in the belief that under the law it was entitled to an allowance for obsolescence in addition to normal physical depreciation.
The evidence convinces us that the useful economic life of the ships in question will not exceed 12 years from the date of purchase. Their salvage value will not exceed $20,000. The "reasonable allowance" for exhaustion, wear and tear, including obsolescence, should be computed on this basis.
Judgment will be entered under Rule 50.