*2614 A lessee of chattels that has no capital investment therein, is not entitled to deduct from gross income the amount of an annual depreciation reserve established for the purpose of replacing or renewing such chattels.
*304 This proceeding is for the redetermination of deficiencies in income and profits taxes in the amount of $342.55 for 1916; $4,474.27 for 1917; $21,884.69 for 1918, and $18,991.64 for 1919. The deficiency letter also asserts additional taxes for the years 1913 to 1915, inclusive, but the petitioner admitted at the hearing that the Board has no jurisdiction of such taxes and abandoned the appeal in so far as it relates to those years.
FINDINGS OF FACT.
The petitioner is a corporation organized under the laws of the State of Illinois, with its principal office and place of business at Chicago. It was, during the years 1913 to 1919, inclusive, engaged in operating freight-train-terminal and clearing-yard facilities in Chicago, primarily for the benefit of 12 railway companies which owned all of*2615 its capital stock in equal amounts and which are hereinafter referred to as the tenant companies.
The petitioner did not, during the years mentioned, own the tracks, right of way, rolling stock and other equipment used by it, excepting a few locomotives, but leased its facilities from the Chicago & Western Indiana Railroad for a period of 50 years under a written lease dated November 1, 1912. Under the terms of the lease the petitioner was obligated to pay as money rental for the use of the properties the following amounts:
(a) Five Dollars on the first day of January in every year of said term.
(b) Monthly, on the last day of each month, one-twelfth of $828,000, being the annual interest at the rate of four per cent per annum upon $14,000,000, the valuation placed upon the Belt Division as it existed on May 11, 1911.
(c) Monthly, on the last day of each month, one-twelfth of $39,840, being the annual interest upon $996,000 of the Consolidated Mortgage bonds of the lessor (the Western Indiana Company) which had been issued and used for additions and betterments to the Belt Division made between May 11, 1911, and September 2, 1912.
(d) Monthly, one-twelfth of the annual*2616 interest on all obligations of the lessor issued and outstanding from time to time, the proceeds of which shall *305 have been used after September 2, 1912, for the construction or acquisition of additions or betterments to said leased properties.
The lease also provided:
SEC. 4. The entire cost of the management, operation, maintenance, repair, renewal and insurance of, and all taxes, liens, water rents and assessments on said railroad buildings, equipment and all other property and facilities by this indenture demised to the Lessee and included as aforesaid in the "Belt Railway," and the entire cost of the management, operation, maintenance, repair and renewal of, and all taxes, liens, water rents and assessments on, all enlargements and improvements thereof, and additions thereto, and on and to any other lines of railroad hereafter acquired by the Lessor for the exclusive use of the Lessee, its sub-lessees and assigns, shall be borne and paid by the Lessee. * * *.
SEC. 5. The Lessee, at its own expense, shall and will exercise the rights and privileges hereby granted, as fully as the Lessor, as the owner thereof or otherwise, is now or may be by law required*2617 to do, and at the same time shall and will maintain the Belt Railway in thorough repair, working order and condition, using the best and most suitable materials for renewals of the same, as renewals shall from time to time become necessary, so as to be suitable at all times for the adequate movement over the Belt Railway of the traffic and business to be moved thereover * * *.
SEC. 9. At the expiration of said term, to-wit, September 1, 1962, or at the date thereafter at which the principal and interest of all the bonds and other obligations in this indenture mentioned, secured to any extent by mortgage lien upon the Belt Railway, shall have been fully paid and said mortgages shall have been satisfied and discharged, or at the earlier termination of this lease, the Lessee shall and will redeliver and surrender to the Lessor the several subjects of this lease or such thereof as shall then be subsisting in their place, in as good order and condition as they now are (reasonable use and wear and tear excepted), with such additions, alterations and improvements as shall have been made thereto.
The petitioner, on November 1, 1912, entered into a written agreement with the 12 tenant*2618 companies, which agreement granted to each of such companies, "equal right and privilege of running and operating the freight trains, locomotives and cars of such Railway Company, over and upon, or to use and enjoy, for the purposes of freight traffic, in common with the Belt Railway and with the other Railway Companies, and with such other companies as hereafter may receive from the Belt Railway, grants of similar or other rights of user," all the properties which were leased to the petitioner by the Chicago & Western Indiana Railroad Co. The agreement also provided:
Each of the Railway Companies hereby covenants and agrees to and with each other of the Railway Companies, and to and with the Belt Company, as follows:
SECTION 1. To pay monthly to the Belt Company a proportionate share, to be determined as hereinafter provided, of the Working Expenses of the Belt Company, and the term "Working Expenses" shall include all rentals under said lease of November 1, 1912, and under such additional leases as hereafter may *306 be made to the Belt Company, taxes, cost of maintenance, operation, repairs and renewals, insurance, management expense and all other expenses of the Belt*2619 Company, all expenses of its work trains engaged in maintenance or repair of the Belt Railway, and including such sums as may be necessary to pay dividends at the rate of not less than six per cent per annum upon the capital stock of the Belt Company, and excluding only the expenses of the train service of the Belt Company, the wages of its trainmen and the cost of maintaining and operating its own rolling stock, in its separate operations as defined in Article Four of this agreement. * * *.
Annual expenses, such as taxes, insurance and all other expenses which are not payable in monthly installments shall be estimated by the Auditor of the Belt Company and one-twelfth thereof shall be charged to the Working Expenses for each month. If practicable, any mistaken estimate of such annual expenses or such other expenses shall be adjusted in the accounts for the remaining month or months of the fiscal year to which they apply, but, if the accounts for such fiscal year are closed, such adjustment shall be made in the accounts for the remaining month or months of the fiscal year in which the proper correction of such estimate is ascertained.
On or before the 20th day of each calendar*2620 month during the said term, the Belt Company shall render to each of the Railway Companies, statements showing the results of its accounts of and for the next preceding calendar month, as follows, to wit:
(a) A statement, by sections, of the number of cars and locomotives moved over the tracks of the Belt Railway during said month, specifying how many were handled by the Belt Company and by each of the Railway Companies.
(b) A statement, by sections, of all expenses incurred during such month in the operation, maintenance, repair and renewal of the Belt Railway (after applying to such renewals or repairs any sums which may have been received on account of insurance), including all salaries, wages, materials, supplies, time tables, insurance and rentals, all loss and damage to specific sections, and all other expenses whatsoever applicable to specific sections; also a statement of the Working Expenses incurred by the Belt Company for said month, common to all sections or not applicable to specific sections, which Working Expenses shall be apportioned in such statements among the several sections in the ratio which the aforesaid valuation of each section for such month bears to*2621 the total valuation of such month of all said sections.
(c) A statement of all income or receipts of the Belt Company, from whatever source, for such month.
* * *
All net revenues of the Belt Company from its separate operations mentioned in Article Four of this agreement, and all income of the Belt Company from all sources other than payments on account of Working Expenses, for each month, shall be first applied to the payment of the proportion of Working Expenses chargeable, on the aforesaid locomotive and car basis, to said separate operations of the Belt Company during such month. Any such net revenues and income of the Belt Company then remaining, for any month, shall be applied by the Belt Company to reduce pro-tanto the amounts of Working Expenses payable by each of the Railway Companies for the next succeeding month, in the proportion which the amount of Working Expenses payable by such Railway Company for such succeeding month shall bear to the total amount of the Working Expenses for such succeeding month.
The properties of the petitioner have been operated under the foregoing lease and operating agreement in the following manner. *307 The tenant companies*2622 ran their trains under their own power directly to the clearing yard. The petitioner operated the clearing yard and took over the trains at that point and conducted the transfer of cars between nonowner and owner lines and industries located along the petitioner's tracks. The petitioner then completed the haul from the clearing yard to junction point with the owner and nonowner lines and with industries located on its tracks. The petitioner's properties were divided into 33 "wheelage sections" against which were charged the expenses attributable to each section. Other expenses which were common to the entire road were allocated to the various active sections on the basis of the valuation placed on each section by the parties to the agreement. In addition to entire amount of rentals under the lease and amounts sufficient to pay dividends on the petitioner's stock at the rate of 6 per cent ($172,800) were charged to all sections on the basis of the valuation placed on such sections. By this process all the expenses of every nature, including dividends at the rate of 6 per cent, were charged to the various wheelage sections. The total amounts so charged to the wheelage sections, *2623 less the tariffs and incidental revenue received from other sources, were then allocated between the 12 tenant companies on the basis of the use made of the properties during each month. The amounts so allocated were billed to the tenant companies and were paid by them, the net effect being that all the expenses of the petitioner for each year, except the incidental operations for nonowner lines, were paid by the tenant companies, as well as the amount of $172,800 with which to pay dividends of 6 per cent on its capital stock. As the result of these operations the books of the petitioner were balanced each year and always reflected a total net income of $172,800, which was appropriated as a dividend to the petitioner's stockholders in proportion to their stock holdings.
Immediately after the lease of November 1, 1912, was signed the board of directors of the Chicago & Western Indiana Railroad Co., in order to determine the extent of the petitioner's liability to the replacement of equipment and rolling stock under the provision of the lease providing for the return of the properties in as good condition as when they were taken over, had an appraisal made of the equipment and rolling*2624 stock. This appraisal, which was made as of November 1, 1912, was completed May 1, 1913, and was submitted to and adopted by the board of directors of the petitioner and of the Chicago & Western Indiana Railroad Co. The maximum useful life of the cars used by the petitioner is from 23 to 28 years and of the locomotives from 21 to 30 years.
The petitioner, in each of the years 1916 and 1917, took depreciation on the equipment and rolling stock leased by it from the Chicago & Western Indiana Railroad, computed at the rate of 3 per cent on *308 the appraised valuation as of November 1, 1912, with adjustments for subsequent additions and retirements. This depreciation, which amounted to $28,978.59 for the year 1916 and $27,846.96 for the year 1917, was charged to an expense account denominated "Working Expenses" and was credited to an account denominated "Accrued Depreciation on Equipment of the C. & W.I. Railroad Company." The account "Working Expenses," which included such depreciation, was allocated to and charged against the 12 tenant companies in proportion to their use of the properties, the effect being that the tenant companies paid to the petitioner an amount sufficient*2625 to cover the depreciation taken on the leased equipment, and that the income from this source exactly offset the depreciation taken. The money so collected from the tenant companies to cover such depreciation was held by the petitioner for the express purpose of meeting the obligation for the replacement of the leased equipment and, from time to time as conditions required, was used for that purpose.
In the year 1918 all the properties used by the petitioner were taken over by the United States Government as of January 1 of that year, and were operated by the Director General of Railroads during the period of Federal control, which lasted until February 29, 1920. The Director General, during the years 1918 and 1919, operated the properties in the same manner as the petitioner had previously done, by charging the working expenses, including depreciation, against the wheelage sections and, in turn, against the tenant companies. The results of these operations were reflected on the books maintained by the Director General. During the years 1918 and 1919 the petitioner engaged in no operations but merely maintained its corporate organization, collecting all items of miscellaneous*2626 nonoperating income as well as compensation from the Director General, and disbursing the amounts necessary to meet the incidental charges of the corporate organization, such as salaries, et cetera. The petitioner's books reflected the following gross income and deductions for the years 1918 and 1919:
| 1918 | 1919 | |
| Income: | ||
| Miscellaneous rent income | $12,009.66 | $13,321.60 |
| Income from funded securities | 50,000.00 | 53,333.34 |
| Income from unfunded securities | 8,999.88 | 8,292.53 |
| Compensation from United States Government | 1,538,998.28 | 1,614,609.91 |
| 1,610,007.82 | 1,689,557.38 | |
| Less: | ||
| Railway operating expenses, general | 9,777.23 | 45,699.78 |
| Railway tax accruals | 18,808.00 | 14,769.92 |
| Rent for leased road | 1,408,592.59 | 1,456,022.19 |
| Miscellaneous rents | 30.00 | 30.00 |
| Interest on unfunded debt | 255.49 | |
| 1,437,207.82 | 1,516,757.38 | |
| Net income | 172,800.00 | 172,800.00 |
*309 The Director General assumed the obligations of the petitioner to pay the trustees under the mortgages of the Western Indiana Co. the rental payments provided by the lease agreement of November 1, 1912, for the purpose of meeting the interest charges on bonds of the lessor in a principal*2627 amount equivalent to the value or cost of the leased properties. These rental payments amount to $1,408.592.59 and $1,456,002.19 in the years 1918 and 1919. The payments were made directly to the trustees by the Director General, but were included as offsetting items on both sides of the petitioner's income account as shown above. None of the items set forth in the above statement of the petitioner's income for 1918 and 1919, include any amount for depreciation of its leased equipment.
The petitioner in its returns of income for the years 1916 and 1917 included in gross income the amounts of $28,978.59 and $27,846.96, respectively, entered on its books and collected from the tenant companies for depreciation of its leased equipment and rolling stock, and also deducted those amounts in computing its net income for those years. No deductions were taken for such depreciation on its returns for 1918 and 1919. The petitioner in the year 1917 estimated its income tax for 1916, accrued an aliquot part thereof on its books each month, and included it in the monthly working expenses billed to and collected from the tenant companies. The amount of such estimated tax, or the amount actually*2628 paid in the year 1917, was included in the petitioner's income for 1917. The 1917 and 1918 income and profits taxes were estimated and accrued on the petitioner's books and the amount so estimated, or actually paid for 1917, was included in the petitioner's return of income for 1918, and the amount estimated, or paid in 1918, was included in the petitioner's income for 1919. The respondent, upon audit of the petitioner's returns for 1916, 1917, 1918, and 1919, disallowed the deductions of $28,978.69 and $27,846.96, taken in 1916 and 1917, respectively, on account of depreciation of leased equipment; added to income for 1918 and 1919 the amounts of $33,468.28 and $55,642.34, respectively, as disallowed depreciation on such equipment for those years, and also added $15,049.63 to income for 1917, $44,454.29 to income for 1918, and $37,557.50 to income for 1919, as "income tax accrued," and determined deficiencies as above set forth.
OPINION.
MARQUETTE: The deficiency letter herein asserts additional taxes for the years 1913 to 1919, inclusive, and the petitioner appealed as to all of those years. However, at the hearing counsel for the petitioner conceded that the Board had no*2629 jurisdiction as to the years *310 1913, 1914, and 1915, and abandoned the appeal in so far as it relates thereto.
The first question presented by the record is whether or not the petitioner, in computing its net income for the years 1916 to 1919, inclusive, is entitled to any deduction for depreciation of the rolling stock and equipment which was held under the lease set forth in the findings of fact. The Revenue Acts of 1916 and 1918 each provide that in computing its net income a corporation is entitled to deduct a reasonable amount for the exhaustion, wear and tear of its property, and the petitioner rests its contention as to this issue on these provisions of the statutes.
The record discloses that the petitioner had no invested capital in the property for which the depreciation was taken and the depreciation reserve established. This reserve then, can not be a fund set aside for keeping intact invested capital; it can only be regarded as a fund accumulated from year to year to meet a contingent liability. This contingency - the wearing out and consequent need of replacement of locomotives and cars leased to and used by petitioner - probably would become an actuality*2630 before the termination of the lease. If and when such replacements became necessary, petitioner was obligated by its contract to supply them at its own expense. But until such expenditures become necessary and are actually made by the petitioner, it can not deduct the amounts thereof from its gross income. It can not anticipate a probable expense as to leased property, and in which it has no capital investment, in computing its income tax.
The Board early decided that a taxpayer operating under a lease, who had no capital investment in the chattels under lease, had no basis for an allowance for wear, tear and exhaustion. . In that case, just as in the case before us, the lease expressly bound the lessee taxpayer to maintain the chattels, supplies and equipment under the lease "in as good condition as they now are and in such condition to * * *" redeliver them to the lessor at the end of the term. It was apparent in that case, as in this, that the chattels under lease could not be maintained and returned to the lessor in like good condition, except by renewals and replacements. In that case, as in this, the taxpayer's*2631 books were kept on the accrual basis. The Board said:
In order that an item may be accrued, however, a liability must actually be incurred in the taxable year. . The statute recognized the accrual basis of making returns by providing for the deduction of expenses incurred but not paid. It is apparent that no liability in praesenti was incurred under the terms of the lease in question in the years 1918 and 1919 however well known it might have been that a liability in some amount would be incurred at some time in the future. The liability to restore chattels as good as new or as good as when received when a lease is ultimately *311 canceled or surrendered at some indefinite or indeterminate time in the future is not a present actual liability, and is not the actual incurring of an expense or liability.
* * *
In the case of a lessee of chattels who is required by the terms of the lease to make such renewals or replacements as are necessary to keep the property in as good condition as when received as additional rental or as a condition to the continued use of the property to which he has no title and*2632 is acquiring none, they are deductible, if at all, as expenses paid or incurred in carrying on a trade or business. Reserves for future unincurred expenses are not allowable as deductions under the Revenue Act of 1918.
The same conclusion applies under the Revenue Act of 1916. See also ; 6 Am.Fed. Tax Rep. 6527, to the same effect.
These decisions are directly in point with the case we are now considering. The petitioner had no cost or capital investment in connection with the leased rolling stock. Whatever liability it may have had with respect to such chattels, it was a future, not a present liability. The petitioner's original capital would have remained unimpaired even though this depreciation reserve had not been established. We therefore sustain the Commissioner in his disallowance of the depreciation reserve as a deduction from gross income in the years 1916 and 1917. The record shows, however, that the petitioner did not take any deductions for depreciation of the leased equipment in computing its net income for 1918 and 1919 and the respondent, therefore, erred in adding to its income as reported, *2633 any amount as disallowed depreciation of that equipment for those years.
The only other assignment of error is that the respondent added to the petitioner's income for 1917, 1918, and 1919, inclusive, erroneous amounts as "income tax accrued" in those years. The record as to what actually occurred in this respect is not as clear as might be desired; in fact, it is difficult to tell what the true situation is. However, it appears that the petitioner in the year 1917 estimated the tax that would be due and payable in that year on its return for 1916, accrued such estimated amount on its books and collected it from the tenant companies. In reporting its income for 1917 the petitioner included therein either the amount estimated and accrued for 1916 taxes, or the amount thereof actually paid in 1917. The 1917 and 1918 taxes were handled in a similar manner; that is, they were estimated, accrued and collected, and either the estimated amount, or the actual amount paid, included in income for 1918 and 1919. The respondent has added to incme for 1917, 1918, and 1919, the amounts set forth in the findings of fact which, it is conceded, resulted, to some extent at least, in a duplication*2634 of income. We have heretofore held in , that income and profits taxes of the lessor, paid by the lessee, constituted income *312 in the year in which paid, in the nature of additional rental. Therefore, the petitioner's income tax for each of the years 1916, 1917, and 1918 was a proper accrual in the subsequent year, and since it passed its taxes on to the tenant companies - that is, they reimbursed the petitioner in each year for the taxes on the preceding year's income, there should be included in income for 1917, 1918, and 1919, respectively, the exact amount of taxes due in each of those years on the income for the preceding year.
Reviewed by the Board.
Judgment will be entered on 15 days' notice, under Rule 50.
MORRIS and GREEN did not participate.
STERNHAGEN concurs in the result.
TRUSSELL dissents.