1928 BTA LEXIS 3073">*3073 DEPRECIATION. - On the facts, held that petitioner is due an allowance for depreciation on its railroad facilities leased to two operating roads under a lease which only obligates the lessees to make current maintenance repairs, and the rates for such depreciation on the various classes of facilities determined.
13 B.T.A. 1291">*1291 This proceeding results from the determination by respondent of deficiencies in income taxes of $1,429.34 for 1919, and $147.69 for 1920.
Petitioner assigns as error respondent's failure to allow a deduction in each year from income of an allowance for wear and tear including obsolescence of the railroad of petitioner.
FINDINGS OF FACT.
Petitioner, a California corporation, with its principal office at San Francisco, was organized on August 19, 1902, and began shortly thereafter the construction of a railroad extending from Richmond, Calif., northerly about four miles to Point San Pablo, Calif. Subsequently, the railroad was extended south to Winehaven, Calif., was completed in 1905, and is approximately 5.88 miles in total length. 1928 BTA LEXIS 3073">*3074 Petitioner owns no cars, engines or operating equipment. Its property consists principally of its roadway and a wharf with warehouses at Point San Pablo.
On December 14, 1905, petitioner leased its roadway to the Atchison, Topeka & Santa Fe Railroad Co. (hereafter called the Santa Fe), the Southern Pacific Co., and the Southern Pacific Railroad Co. (hereafter together called the Southern Pacific) jointly, with provision that the lessees should operate the roadway in alternate years. Subsequently, the lease was modified to provide for alternate periods of five years' operation by each of the lessees.
The material parts of the lease provided as follows:
* * * the Belt Company will, upon rendition to it of bills therefor, reimburse the Company by which said Belt Railway is operated hereunder for all 13 B.T.A. 1291">*1292 sums expended by the Company operating such railway for extraordinary repairs to or for additions to existing facilities used in connection with said railway during the time such railway shall be operated by the Atchison Company and the Pacific Companies hereunder, it being expressly understood that the term "extraordinary repairs" is intended to include any and all1928 BTA LEXIS 3073">*3075 repairs made necessary by the caving in of embankments, the sinking of fills, or repairs made necessary by other causes incident to the operation of a new line of railway, and against the happening of which said Belt Railway, by reason of its construction or otherwise, is not provided, and the cost of such repairs to be borne by the Belt Company shall include the amount actually expended therefor by the party operating such Belt Railway, and to cover the expense of supervision, use of tools and store department expenses, there shall be charged by the party operating such Belt Railway in addition to the amounts actually expended as aforesaid the sum of seven and one-half per cent (7 1/2%) of all expenditures for labor, and the sum of ten per cent (10%) of all expenditures for material.
* * *
That the party operating said Belt Railway shall keep such Belt Railway and all other tracks within the scope of this agreement in good condition and repair; provided, however, that the cost of additions to existing facilities of the Belt Railway chargeable to capital account and "extraordinary repairs," as defined in paragraph 3 of Article 1 of this agreement, shall be borne by the Belt1928 BTA LEXIS 3073">*3076 Company, and provided, further, that the cost of any and all repairs which are made necessary on account of ordinary use, wear and tear, shall be borne by the Atchison Company and the Pacific Companies in the same proportion as the number of cars handled over said Belt Railway for the Atchison and Pacific Companies, respectively, bears to the total number of cars handled over said railway in such month, and settlement between the parties shall be made for such repairs at the expiration of each month during the term hereof.
That the party operating such Belt Railway shall collect all charges for services thereon from the party from whom such charges are due, and will each month during the term hereof pay to the Belt Company for the use of the premises hereby demised the sum of 40 per cent of the total gross revenue received for switching, hauling or handling cars over the tracks of said Belt Railway during the preceding months;
* * *
* * * That this agreement shall be and remain in force until December 31st, 1906, and thereafter until terminated by either of the parties hereto upon sixty (60) days' notice in writing to the other parties, stating therein the date that such termination1928 BTA LEXIS 3073">*3077 shall take effect, and upon the expiration of the time specified in such notice, all of the rights of the respective parties hereunder shall immediately cease and determine.
During 1919 and 1920, the roadway was operated by the Santa Fe; the operations for all of 1919 and until midnight of February 29, 1920, were as agent of the Director General of Railroads of the United States, and for the remainder of 1920 in its own right under the lease. The wharf and warehouses were operated by petitioner.
Petitioner claimed as deductions from income in its income-tax returns, allowances for wear and tear and obsolescence of its roadway as follows:
| Year | Cost | Rate | Amount |
| Per cent | |||
| 1919 | $357,333.68 | 4 | $14,293.35 |
| 1920 | 357,360.68 | 4 | 14,294.43 |
13 B.T.A. 1291">*1293 Respondent has disallowed these deductions.
The principal traffic over the roadway of petitioner is to and from the wharf and warehouses of petitioner located on deep water at Point San Pablo, on San Francisco Bay. At the southern end of petitioner's roadway was located the plant of the California Wine Association and at Richmond, Calif., was located a refinery operated by the Standard Oil Co. 1928 BTA LEXIS 3073">*3078 , and at this latter point connection was made with the lines of the Santa Fe and the Southern Pacific Systems. In 1919, at Point San Pablo, the Pacific Oil & Lead Works, engaged in the shipment of vegetable oil from the Philippine Islands, had shut down, and the Philippine Refinery Co. was carrying on business in only a very small way; further south a can factory of the Standard Oil Co. had been abandoned, and at Winehaven it was known that the property of the California Wine Association would be compelled to close down. It was subsequently closed down and has remained idle. In 1919 the construction of a turning basin for ships at Richmond was under consideration by the Standard Oil Co., which would allow ships to go directly to the refinery at Richmond.
Under the lease of December 14, 1905, the lessees have borne the cost of normal operating repairs alone, these being in the nature of operating expenses. For expenditures of a capital nature, even though made necessary by wear and tear of operation, the lessees have been reimbursed by petitioner. In the year 1917 renewal of the rails of petitioner's road, due to wear and tear, became necessary and this expense, amounting to1928 BTA LEXIS 3073">*3079 $15,897.70, was borne by petitioner. At various times during the term of the lease, the "riprapping" of the embankment of the road, where it borders San Pablo Bay for several miles, was washed out and was renewed at the expense of petitioner.
The aggregate costs of the several classes of depreciable assets of petitioner as entered on its books were the same for the calendar years 1919 and 1920, and as follows:
| Grading | $197,519.52 |
| Bridges, trestles and culverts | 15,520.36 |
| Ties | 14,455.13 |
| Rails | 38,193.47 |
| Track materials | 13,123.84 |
| Ballast | $15,787.71 |
| Track laying | 20,926.41 |
| Crossings | 263.30 |
| Telephone lines | 275.01 |
| Tools | 5,658.14 |
| 321,722.89 |
13 B.T.A. 1291">*1294 The depreciable assets of petitioners sustained during the taxable years 1919 and 1920 a loss in value from wear and tear, over and above expenditures made, or due under the lease to be made at the expense of the lessees, as follows:
| Per cent | |
| Grading | 3 |
| Bridges, trestles and culverts | 10 |
| Ties | 12 1/2 |
| Rails | 5 |
| Other track materials | 5 |
| Ballast | 4 |
| Track laying and surfacing | 5 |
| Crossings | 5 |
| Telephone lines | 4 |
| Tools and work equipment | 10 |
OPINION.
TRUSSELL: The sole issue1928 BTA LEXIS 3073">*3080 before us is the amount, if any, which is allowable as a deduction from income under the provisions of section 234(a)(7) of the Revenue Act of 1918, as a reasonable allowance for wear and tear, including obsolescence, of the railroad roadway of petitioner. The amounts which petitioner charged off on its books of account and deducted from income in its income-tax returns have been disallowed by respondent in their entirety. The allowances claimed on the wharf and warehouses of petitioner are not involved in this issue.
The roadway has been operated by the lessees since 1905, save for the period during and after the World War when the property was operated under Federal control through the Director General. Under the provisions of the lease the lessees undertake to operate the railway and to maintain the property in good repair and operating condition. The lease is nothing more than an operating agreement, for it may be terminated by any of the parties upon so short a notice as 60 days, and the rental to be paid to the lessor is merely a share of the gross income, if any, from operations. There is no provision for the return of the property to the lessor in the same condition1928 BTA LEXIS 3073">*3081 in which it was when taken over by the lessees.
Respondent insists that under the lease of December 14, 1905, there is an obligation upon the lessees to repair all damage due to wear and tear and, consequently, petitioner, as lessor, suffers no loss in value of its property from that cause and can claim no deprecation except upon a showing that the lessees refuse to make such repairs and replacements and that a judgment against them would not be collectible.
Petitioner admits the solvency of the lessees but insists that the lease in question only obligates them to make the usual and necessary maintenance repairs to keep the road in good operating condition and that in addition to deterioration arrested by such repairs there is a general decrease in value from use which necessitates replacements at 13 B.T.A. 1291">*1295 intervals and that the expense of this is upon it under the lease, and it is this depreciation for which it asks an allowance.
An examination of the lease sustains the contention of petitioner as to its not placing on the lessees the obligation to make good all depreciation. We see only one meaning to attach to the wording of the lease, that being that the lessee will1928 BTA LEXIS 3073">*3082 make the usual maintenance repairs necessary to keep the property in operating condition but the cost of major items of recontruction, renewal or replacement of permanent character are to be borne by petitioner. Not only is this the natural meaning to be gathered from the phraseology of the lease, but the proof shows that such meaning has been given it by the parties and that at various times during the term of the lease petitioner has paid for reconstruction and renewal of facilities exhausted through wear and tear. In 1917 it is shown to have renewed the rails at a cost to it of $15,897.70, and that at various times it has reconstructed the "riprapping" of its embankment which extends for several miles along the margin of San Pablo Bay and is subject to the action of the water.
Under the record it must be concluded that there is depreciation sustained which the lessees are under no obligation by reason of the lease to restore, and the question becomes one of a reasonable rate to apply.
On this question the only testimony is that of James J. Walsh, petitioner's consulting engineer. This witness was an engineer of long experience who qualified satisfactorily as an expert and1928 BTA LEXIS 3073">*3083 also had actual and intimate knowledge of the facilties in question and their length of life as shown by the necessity arising at various times of renewing them.
This witness testified to the length of life of the several classes of depreciable assets, as set out in the findings of fact, and stated that such was the extent of the life of each even when maintained by current repairs, and this testimony appears in all respects to be reasonable and accurate. The rate of 3 per cent depreciation on grading would under ordinary conditions appear to be excessive, but in the present case it was shown that nearly half of petitioner's line of road was built along the waterfront, the embankment "riprapped" and subject to the action of the water which undermined it, calling for periodic renewals of the stone work, and we consider the rate under such conditions as reasonable.
We do not agree with petitioner's insistence that it is entitled to an additional allowance for obsolescence of its road due to the fact that several industries located on it, and from which it formerly received considerable business, are now shut down and idle. The road is still in operation and is the link between1928 BTA LEXIS 3073">*3084 the Santa Fe and Southern Pacific at Richmond, and deep water at Point San Pablo. 13 B.T.A. 1291">*1296 The conditions complained of are ones that have decreased petitioner's earnings, perhaps, although this may be only temporary, but nothing is shown justifying the conclusion that the property is in the process of becoming obsolete.
Petitioner is entitled to a deduction of depreciation on the cost of the several assets involved at the rates found by us, but in computing such allowance these asset accounts should be adjusted by depreciation at those rates from the dates acquired and the allowances for depreciation in respect to each for the taxable years 1919 and 1920 should be limited by the undepreciated balances of cost remaining in those years under such adjustment.
The deficiency should be recomputed in accord with the foregoing findings of fact and opinion.
Reviewed by the Board.
Judgment will be entered under Rule 50.