Southern Pacific Transp. Co. v. Commissioner

CONTENTS

Page

Headnote . 499 Opinion (Introduction) . 505 General Findings of Fact . 506

I. Issue (i): Rapid Amortization of Freight Cars Findings of Fact Opinion . 1Í5 ^ H H CO LO lO lO

II. Issues (hh) and (9): Recovery Upon Merger of Previously Deducted Amounts . 548 Findings of Fact . 549 Opinion . 557

Issue (kk): Deduction of Timber Expenses Findings of Fact . Opinion . ÜI ÜI OI Oi 0$ HH HH HH

Page

IV. Issues (w) and (x): Deductions Involving Houston Depot . 586 Findings of Fact . 587 Opinion . 594

V. Issue (rr): Deductions Incident to Relocation Projects . 605 Findings of Fact . 605 Opinion . 612

VI.Issue (bbb): Deduction of Estimated Payroll Taxes on Earned Vacation Pay . 624 Findings of Fact . 625 Opinion . 632

VII.Issue (zz): Deduction of Penalties for Violations of Federal Statutes . 643 Findings of Fact . 643 Opinion . 646

VIII. Issue (¿i): Freight Car Useful Life Findings of Fact . Opinion . Si Oi <rn

IX. Issue (yy): Deduction of Embankment Expenditures ... 672 Findings of Fact . 672 Opinion . 680

X. Issm (mm): Diesel Locomotive Useful Life . 687 Findings of Fact . 688 Opinion . 702

XI. Issue (g): Welded Rail . 709 Findings of Fact . 709 Opinion . 717

XII. Issues (l) and (ccc): Relay Rail . 726 Findings of Fact . 726 Opinion . 732

XIII. Issue (aaa): Depreciation of Replacement Facilities. 746 Findings of Fact . 746 Opinion . 757

XIV. Issue (pp): Grading and Tunnel Bore Useful Life . 769 Findings of Fact . 769 Opinion . 788

XV. Issues (pp) and (qq): Historical Costs as Tax Basis .... 807 Findings of Fact . 808 Opinion . 826

XVI.Issue (p): Adjustment for Interest and Taxes During Construction . 843 Findings of Fact . 843 Opinion . 845

Conclusion . 850

In the statutory notice in this case, respondent determined income tax deficiencies as follows:

Deficiency TYE Dec. 31—

$4,411,069.04 1959

5,986,337.91 1960

9,994,970.22 1961

In its petition, petitioner placed all of the asserted deficiencies in controversy. Petitioner also alleged overpayments of income taxes in each of the years at issue. The petition has been amended three times, and in the most recent amendment, dated February 9, 1979, petitioner alleges that, during the indicated years, it made overpayments of income taxes in not less than the following amounts:

TYE Dec. 31— Overpayment

$15,252,000 1959

14,438,000 1960

15,531,000 1961

Most of the issues raised by the pleadings have been conceded or otherwise settled by the parties. Various issues were presented for the Court’s consideration in five extended trial sessions which took place over a 3-year period. For the most part, the contested issues were tried and briefed separately, although in some instances, related questions were tried and briefed together. As a result, the Court has been called upon to write 16 generally lengthy opinions to resolve the outstanding disputes. The legal questions involved in each opinion are stated just prior to the specific findings of fact relating to each opinion.

GENERAL FINDINGS OF FACT

The record in connection with most of the issues in this case consists of extensive testimony and voluminous documentary evidence.1 Given the scope of this record, we have found it necessary, in making the findings of fact relating to many of the issues, to summarize much of the material received in evidence and to state our conclusions as to the facts which this material tends to prove. While it was impossible to include in our findings the specific details as to all pertinent factual matters, we have taken all such information into consideration in deciding each issue.

Some of the general facts have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

Petitioner Southern Pacific Transportation Co. is a corporation which was organized under the laws of the State of Delaware on February 20, 1969. Its principal offices are at One Market Plaza, San Francisco, Calif.

The present case was initiated by the filing of a petition in 1969 by the Southern Pacific Co., a corporation organized under the laws of the State of Delaware on March 21,1947, hereinafter referred to as the former Southern Pacific Co., with its principal offices during the years at issue at 65 Market Street (now called One Market Plaza), San Francisco, Calif.

By order dated December 23, 1969, the Southern Pacific Transportation Co. was substituted as petitioner in this matter in lieu of the former Southern Pacific Co.2

The former Southern Pacific Co., as the common parent company of an affiliated group of companies, timely filed consolidated Federal income tax returns covering itself and all subsidiaries eligible to be included for the taxable years ended December 31, 1959, December 31, 1960, and December 31, 1961, with the District Director of Internal Revenue, San Francisco, Calif., on September 14, 1960, September 15,1961, and September 17,1962, respectively. (Extensions for filing the final returns had been granted.)

The former Southern Pacific Co. paid total amounts of $27,461,132.41, $19,140,819.54, and $34,184,088.78 in Federal income tax for the taxable years ended December 31,1959,1960, and 1961, respectively, on behalf of the consolidated group. None of the Federal income tax paid has been refunded by respondent.

Consents on Form 872, extending the statutory period for asserting deficiencies and making assessments ultimately to April 30, 1969, were timely and duly executed on behalf of the former Southern Pacific Co. and respondent for the taxable years ended December 31,1959,1960, and 1961.

The former Southern Pacific Co. was a successor to a Southern Pacific Co. organized under the laws of the State of Kentucky on March 17, 1884, hereinafter referred to as the predecessor Southern Pacific Co. On September 30, 1947, the former Southern Pacific Co. received, pursuant to a “tax-free” plan of reincorporation, all of the assets of the predecessor Southern Pacific Co.

Among the assets of the predecessor Southern Pacific Co. received by the former Southern Pacific Co. in 1947 was the entire outstanding stock of, inter alia, the Central Pacific Railway Co., the Texas & New Orleans Railroad Co., the Pacific Electric Railway Co., the San Diego & Arizona Eastern Railway Co., the Northwestern Pacific Railroad Co., the El Paso & Southwestern Railroad Co. of Texas, the Holton Inter-Urban Railway Co., and the Visalia Electric Railroad Co., which thereupon became wholly owned subsidiaries of the former Southern Pacific Co.3 The Northwestern Pacific Railroad Co. owned the entire outstanding stock of the Petaluma & Santa Rosa Railroad Co. The El Paso & Southwestern Railroad Co. of Texas owned the entire outstanding stock of the El Paso Southern Railway Co. Also among the assets of the predecessor Southern Pacific Co. received by the former Southern Pacific Co. in 1947 was a controlling interest in the outstanding stock of the St. Louis Southwestern Railway Co., which thereupon became controlled by the former Southern Pacific Co. The St. Louis Southwestern Railway Co. owned all the outstanding stock of the St. Louis Southwestern Railway Co. of Texas and the Dallas Terminal Railway & Union Depot Co.

In 1959, the Central Pacific Railway Co. was merged into the former Southern Pacific Co. In 1961, the Texas & New Orleans Railroad Co. was merged into the former Southern Pacific Co. as were the El Paso & Southwestern Railroad Co. of Texas and the El Paso Southern Railway Co.4

The former Southern Pacific Co. and all of the other above-named companies were engaged in operations as common carriers by railroad and were subject to the jurisdiction of the Interstate Commerce Commission. For the most part, during the years at issue all of the railroad lines of these companies, except the lines of the St. Louis Southwestern Railway Co. and its subsidiaries, served as parts of a unified railroad system under common ownership and were known, collectively, as the Southern Pacific Lines.5

The railroad lines which now comprise the Southern Pacific Lines were constructed and placed in service at various times, some as early as the year 1853. Most of the construction dates from and after 1863, at which time construction began on the original Central Pacific railroad line from Sacramento across the Sierras to its meeting with the Union Pacific Railroad at Promotory in Utah. By 1870, this line and another line from Sacramento to the San Francisco Bay Area had been completed. In the early 1870’s, construction was begun on the so-called Sunset Route, southward from San Francisco, into Los Angeles, then to Yuma in Arizona, across Arizona, New Mexico, and Texas, and into Louisiana to New Orleans. The original line over this route was completed and service commenced between San Francisco and New Orleans in 1883. In 1887, the line from the San Francisco Bay Area to Portland, Oreg., was completed and placed in service. The so-called Golden State Route, with its line from El Paso to Tucumcari in New Mexico, was not completed and placed in service until after 1900. The line of the San Diego & Arizona Eastern Railroad, from the Imperial Valley in southern California, continuing ultimately into San Diego, Calif., was also completed and placed in service after 1900. Other new railroad lines were added around 1900, including lines of the Central Pacific (or of railroad companies whose assets were acquired by Central Pacific) in Oregon, California, and Nevada, and lines of the Arizona Eastern Railroad Co. and the El Paso & Southwestern Railroad Co. in Arizona and New Mexico.

An examination of petitioner’s corporate history prior to the 1947 reorganization shows that numerous predecessors were involved in the creation of petitioner’s present-day rail system. In summary form, a portion of that history is hereinafter set forth.

The Central Pacific Railroad Co. was originally organized under the laws of the State of California in 1861. The Central Pacific railroad lines ultimately included those of the Western Pacific Railroad Co. and the California & Oregon Railroad Co., both organized under the laws of California in the 1860’s. The latter two companies, along with other railroad companies, were consolidated with the Central Pacific Railroad Co. during the 1870’s. Until 1885, the Central Pacific, in addition to operating its own lines, operated certain lines leased from other railroad companies.

The Southern Pacific Railroad Co. was originally organized under the laws of California in 1865. The Southern Pacific Railroad Co. ultimately included among its railroad lines those of the San Francisco & San Jose Railroad Co., the California Pacific Rail Road Co., and the Northern Railway Co., all organized under the laws of California prior to 1872. The latter three companies were consolidated with the Southern Pacific Railroad Co. in 1870, 1898, and 1898, respectively. Additional railroad companies were involved in these and in other consolidations. A Southern Pacific Railroad Co. organized under the laws of the Territory of Arizona in 1878, and another organized under the laws of the Territory of New Mexico in 1879, were merged into the Southern Pacific Railroad Co. in 1902. Most of the Southern Pacific Railroad Co. railroad lines were leased to and operated by the Central Pacific Railroad Co. until 1885. The remainder were operated by the Southern Pacific Railroad Co., itself. The Southern Pacific Railroad Co. also operated some lines leased to it by other railroad companies.

The Galveston, Harrisburg & San Antonio Railway Co. was organized under the laws of Texas in 1870. The Texas & New Orleans Railroad Co. was organized under the laws of Texas in 1875. Both of these railroad companies were organized in order to acquire the assets of earlier railroad companies in financial distress; however, they added their own railroad lines. Morgan’s Louisiana & Texas Railroad & Steamship Co. was organized under the laws of Louisiana in 1877 to incorporate what had been a sole proprietorship. The Louisiana Western Railroad Co. was organized under the laws of Louisiana in 1878. During 1881-83, the Central Pacific Railroad Co. leased the portion of the line of the Galveston, Harrisburg & San Antonio Railway Co. east of El Paso. Except for that lease, these railroad companies operated their own lines until 1885, but as part of the same system as the lines operated by the Central Pacific.

The Oregon & California Railroad Co. was organized under the laws of Oregon in 1870, and was independently operated until 1887 when the predecessor Southern Pacific Co. leased and operated the lines of this railroad company.

The predecessor Southern Pacific Co., organized under the laws of Kentucky in 1884, would ultimately control the stock, directly or indirectly, at various times beginning in 1885, of all the railroad companies referred to above whose railroad lines were to become part of the Southern Pacific Lines. It at first became the operating railroad as to most of the lines by leasing the lines of the railroad companies which were or would become its affiliates. The predecessor Southern Pacific Co. did not directly own any railroad lines until 1907.6

In 1884, the San Antonio & Aransas Pass Railway Company was organized under the laws of Texas, as were the Houston & Texas Central Railroad Co. in 1889, the Texas Midland Railroad in 1892, and the Houston East & West Texas Railway Co. in 1892. The Iberia & Vermillion Railroad Co. and the Lake Charles & Northern Railroad Co. were organized under the laws of Louisiana in 1891 and 1906, respectively. The San Antonio & Aransas Pass Railway Co. and the Texas Midland Railroad were orginally independent, but the other named railroad companies were operated as part of the rail system described above.

There were additional early consolidations of railroad companies which would become parts of the Southern Pacific Lines. The South Pacific Coast Railway Co., organized under the laws of California in 1876, had consolidated with it a number of railroad companies in 1887. The Arizona & New Mexico Railway Co., organized originally in 1883, had another railroad company consolidated with it in 1911. The South Pacific Coast Railway Co. became part of the Southern Pacific system in 1887. The Arizona & New Mexico Railway Co. was originally independent. Its line came to be operated as part of the petitioner’s rail system in 1924, when it became part of the El Paso & Southwestern system.

The El Paso & Southwestern Railroad Co. was organized under the laws of Arizona in 1900. The El Paso & Rock Island Railway Co. was organized under the laws of New Mexico in 1900. These two railroad companies were initially independent and remained so until 1924.

The Arizona Eastern Railroad Co. was organized under the laws of both New Mexico and Arizona in 1904. In 1910, several other railroad companies were consolidated with it. The Arizona Eastern Railroad Co. remained independent until 1910.

The San Diego & Arizona Eastern Railroad Co., organized under the laws of Nevada in 1931, is successor to the San Diego & Arizona Railway Co., organized under the laws of California in 1906. The San Diego & Arizona Railway Co.’s lines became a separately operated part of the petitioner’s rail system upon completion of construction of its lines in 1919.

The Beaverton & Willsburg Railroad Co., organized in 1906, the Coast Line Railway Co., organized in 1905, and the Hanford & Summit Lake Railway Co., organized in 1910, operated their lines in connection with the lines of petitioner’s rail system. The Beaverton & Willsburg Railroad Co. sold its assets to the predecessor Southern Pacific Co. in 1916. The Coast Line Railway Co. and the Hanford & Summit Lake Railway Co. sold their assets to the Southern Pacific Railroad Co. in 1916.

The Dawson Railway Co., organized in 1901, the El Paso & Southwestern Railroad Co. of Texas, organized in 1902, the El Paso & Northeastern Railroad Co., organized in 1896, the El Paso & Northeastern Railway Co., organized in 1897, the Alamagordo & Sacramento Mountain Railway Co., organized in 1898, and the Burro Mountain Railroad Co., organized in 1909, all were originally independent and, together with the Arizona & New Mexico Railway Co., El Paso & Southwestern Railroad Co., and El Paso & Rock Island Railway Co., became part of petitioner’s rail system in 1924.

The Phoenix & Eastern Railroad Co. was organized in 1901 and was originally independent. Stock control was acquired by the predecessor Southern Pacific Co. in 1907.

The Porterville Northeastern Railway Co., organized in 1910, and the Southern Pacific Terminal Co., organized in 1901, were affiliates from their inception.

The New Mexico & Arizona Railroad Co., organized in 1882, and originally independent, leased its lines to the predecessor Southern Pacific Co. in 1899, and became controlled by the latter company in 1912.

The Inter-California Railway Co. was organized in 1904, and the Tucson & Nogales Railroad Co. was organized in 1909, both as affiliates from their inception. The Dayton-Goose Creek Railway Co. was organized in 1917, as an affiliate. The Franklin & Abbeville Railway Co. was organized March 16, 1903, as an affiliate, but it operated separate from the predecessor Southern Pacific Co. until 1925. The Houston & Shreveport Railroad Co. was organized in 1891, and remained independent until 1899.

In 1925, the Oregon & California Railroad Co. was merged into the predecessor Southern Pacific Co.

In 1934, the Dayton-Goose Creek Railway Co., the Franklin & Abbeville Railway Co., the Galveston, Harrisburg & San Antonio Railway Co., the Houston East & West Texas Railway Co., the Houston & Shreveport Railroad Co., the Houston & Texas Central Railroad Co., the Iberia & Vermillion Railroad Co., the Lake Charles & Northern Railroad Co., the Louisiana Western Railroad Co., the Morgan’s Louisiana & Texas Railroad & Steamship Co., the San Antonio & Aransas Pass Railway Co., and the Texas Midland Railroad were merged into the Texas & New Orleans Railroad Co.

Also in 1934, the New Mexico & Arizona Railroad Co. and the Tucson & Nogales Railroad Co. were merged into the Southern Pacific Railroad Co. and the Phoenix & Eastern Railroad Co. and the Porterville Northeastern Railway Co. were merged into the predecessor Southern Pacific Co.

In 1935, the Inter-California Railway Co. sold its railroad assets located in the United States to the predecessor Southern Pacific Co. Also in 1935, the Arizona & New Mexico Railway Co. was merged into the El Paso & Southwestern Railroad Co.

In 1937, the South Pacific Coast Railway Co. was merged into the predecessor Southern Pacific Co. Also in 1937, the Alamagor-do & Sacramento Mountain Railway Co. and the El Paso & Northeastern Railroad Co. were merged into the El Paso & Southwestern Railroad Co. Additionally, the El Paso & Northeastern Railroad Co. was merged into the El Paso & Southwestern Railroad Co. of Texas.

At the time of the 1947 reincorporation, the former Southern Pacific Co. received physical assets, including railroad properties of the above-named companies held by the predecessor Southern Pacific Co. Some of those assets had been purchased by the predecessor company. The former Southern Pacific Co. also received all of the outstanding stock in the above-named companies (and other companies) then held by the predecessor Southern Pacific Co.

In 1955, the El Paso & Southwestern Railroad Co., the El Paso & Rock Island Railway Co., and the Arizona Eastern Railroad Co. were merged into the Southern Pacific Railroad Co. Thereafter in 1955, the Southern Pacific Railroad Co. and the Dawson Railway Co. were merged into the former Southern Pacific Co.

All of the remaining railroad companies were ultimately merged into the former Southern Pacific Co., with the exception of the San Diego & Arizona Eastern Railway Co.

With one exception, the issues are hereinafter dealt with in the order in which they were tried. Unless otherwise indicated, all section references throughout this opinion are to the Internal Revenue Code of 1954, as in effect during the years at issue.

I. Rapid Amortization of Freight Cars7

This issue presents the following question for our consideration:

Whether the provisions of section 168 (in effect during the years 1959,1960, and 1961), providing for the rapid amortization of facilities for which a certificate of necessity has been issued, apply to 4,550 freight cars certified in 1956, but not delivered to petitioner until after February 20,1958.

FINDINGS OF FACT

Isstie (i)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

This issue involves freight cars of the former Southern Pacific Co., the Texas & New Orleans Railroad Co., and the Northwestern Pacific Railroad Co., hereinafter sometimes referred to collectively as petitioner.

Among the assets of the predecessor Southern Pacific Co. acquired by the former Southern Pacific Co. in the 1947 reincorporation was all of the stock of Southern Pacific Equipment Co. (SPEC). SPEC had been formed in 1920 for valid business reasons, and its officers and directors were different from petitioner’s officers and directors. SPEC was organized primarily to construct, purchase, or otherwise acquire railroad rolling stock and equipment, including locomotives and freight cars, for petitioner. From 1920 on, petitioner (and its predecessor corporation) placed equipment orders for freight cars and locomotives with SPEC, and SPEC either built itself, or purchased from other manufacturers, the ordered equipment. It was customary for SPEC to sublet to outside car builders the construction of freight cars that it was not itself equipped economically to construct.

SPEC built freight cars at shops in Sacramento, Calif., owned by petitioner under contractual arrangements whereby SPEC utilized petitioner’s shops and employees and was charged for the use of the petitioner’s facilities and labor. SPEC had no separate physical equipment or operating personnel. Petitioner charged the wages of shop employees engaged in work for SPEC against SPEC. SPEC reported no income or loss on its books and records, and it had no retained earnings.

In the period following World War II, the .railroad industry, through the Association of American Railroads (AAR), became actively engaged in self-help efforts to increase the nation’s freight car capacity in order to satisfy both commercial and defense requirements.

In 1950, Congress added section 124A to the 1939 Code, the predecessor of section 168 of the 1954 Code (discussed later). This legislation provided for the rapid amortization (extending over a 5-year period) of certain facilities which were “certified as necessary in the interest of national defense,” and it stimulated the acquisition of freight cars by the railroads. The enactment of section 124A led the AAR to establish a freight car expansion goal. This goal served as an incentive to railroads and other car owners to buy cars, with their own or borrowed funds, to augment the carrying capacity of the fleet. The availability of the amortization benefits furthered the industry program by generating additional cash flow.8

By executive order, the President designated the Defense Production Administration (DPA), later the Office of Defense Mobilization (ODM), as the certifying authority for purposes of section 124A of the 1939 Code and section 168 of the 1954 Code.9 The DPA and later the ODM delegated certain responsibilities with respect to domestic transportation facilities (including freight cars) to the Defense Transport Administration, until it ceased to exist June 30, 1955, after which the Interstate Commerce Commission (ICC) became the delegate agency administering the Defense Mobilization program with respect to domestic transportation facilities.

On April 15,1952, the DPA announced a freight car expansion goal (Number 68) to provide 436,000 freight cars by July 1,1954. This goal was designed to meet 1954 traffic forecasts under conditions of partial mobilization. While defense requirements for additional cars were given a great deal of emphasis, consideration was also given to civilian requirements. All freight cars became part of a national pool10 which served the civilian economy and, in turn, fulfilled the needs of the mobilization programs. However, to allow for the fact that some cars would have a use beyond the defense mobilization requirements, the certifying authorities often granted necessity certificates for only a portion of the cost of the new cars (85 percent in 1954). The establishment of the expansion goal by DPA permitted completion of action on applications for certificates of necessity allowing for rapid tax amortization. Certification, however, was only granted to cars whose construction began before the specified closing date.

The expansion goal was not achieved by July 1, 1954. In revision 1 (issued March 24, 1954), revision 2 (issued July 29, 1954), and revision 3 (issued January 14, 1955), the ODM extended the expansion goal for railroad freight cars to make eligible cars on which construction would begin on or before December 31,1954, then June 30,1955, and finally December 31, 1955.

Freight car orders placed with both carbuilders’ shops and with railroad and private-line shops were at a low level in 1954 because railroad freight revenues were down, and there were indications that the shortage would become even more acute in the months ahead. The Interstate Commerce Commission was urging the railroads and car users to be more efficient in the use of existing equipment and to obtain more cars and had solicited and received the aid of the railroad associations in its efforts.

By June 1, 1955, the backlog of freight car orders was only 16,886 cars. In view of complaints about car shortages, a special meeting of the Association of American Railroads was held on June 24, 1955, in Chicago, to consider plans for increasing the railroad car fleet and improving its utilization.

In July 1955, a subcommittee of the Committee on Government Operations of the House of Representatives held hearings on the tax amortization program and the freight car shortage. The U.S. Senate’s Interstate and Foreign Commerce Committee held similar hearings. Financial factors and an unfavorable allocation of steel to car builders were pointed to as a cause for the failure of the railroads to meet the 436,000-car expansion goal. It was also pointed out that the elimination of the rapid amortization tax incentive could result in a substantial reduction of new car orders.

On August 11,1955, the ODM suspended issuing certificates of necessity for freight cars, while reviewing the freight car goal to determine whether adequate productive capacity existed to meet defense mobilization needs. The certification program was reinstated in late 1955, which helped induce the railroads to increase their orders for freight cars substantially. There was roughly a tripling of the number of cars on order. Many of the carbuilders were not prepared for these increased orders.

The certifying authorities considered carbuilders, both in-house and independent, to have a capacity to produce approximately 100,000 freight cars per year. This estimate assumed ideal or optimum conditions. However, it was understood by ODM that while the carbuilding industry could be said to have a capacity of 100,000 cars per year in terms of past actual production, the capability for any given year depended on many factors. For example, the product mix, i.e., the type or types of cars to be built, affected a builder’s capability to produce. Some builders turned out only certain types of cars and might not be able to produce other types. The availability of car wheel sets, and components, generally, could have an effect on the ability to complete construction of cars. Some plants were not set up for freight car production, and some employees, although available, were not adequately trained. Strikes by employees of the builders or by employees of suppliers of components and materials (such as steel strikes in 1956 and 1959) could end production after it had begun. These factors could and, in varying degrees, did affect the production capabilities of the carbuilders during this period.

The lead time from commencement of work on order to delivery of a freight car could be as much as 27 months in the case of new types of cars. The new car types would involve some lead time first for research and development and engineering and design work, and after that, there would be additional lead time necessary for procurement and production.

On September 29, 1955, the ODM announced the resumption of certification of railroad freight cars within the expansion goal (Number 68), and in revision 4, issued on the same date, modified that goal to include “cars for which firm orders have been placed, or, in the case of company built cars, for which construction has been authorized on or before December 31, 1955.” On the same date, the ODM issued Defense Mobilization Order III — 1, “Policy For The Establishment Of Expansion Goals For Tax Amortization,” the first paragraph of which read:

1. Expansion goals are for the purpose of establishing a quantitative limit of expansion which may be covered by certificates of necessity.

On October 4, 1955, Commissioner Owen Clarke of the Interstate Commerce Commission wrote to the Association of American Railroads requesting that organization to assist in advising the railroad industry about the effect of the December 31, 1955, termination date on the issuance of certificates of necessity for freight car acquisitions. His letter stated the following regarding the requirements for issuing certificates of necessity:

Applications must be filed on or before December 31, 1955. Where the applicant is purchasing from a freight car builder, a firm order must be placed prior to December 31, 1955. This order must provide for the earliest possible delivery. Certificates will not be issued for freight cars where the applicant’s order calls for delayed delivery. The Appendix “A” must bear the following notation or its equivalent:

“Firm order for the delivery of these_was placed on (Number of cases) _with the builder, providing for delivery at the earliest (Date of firm order) possible date”

Where the applicant is constructing freight cars in its own shops, the Board of Directors must have authorized, prior to December 31,1955, the construction of the freight cars covered by the application, such construction to begin at the earliest possible date and to proceed without delay. In this case, the Appendix “A” will bear the following notation, or its equivalent:

“The Board of Directors authorized construction of-(Number of cars) covered by the application on_, such construction to proceed without (Date) delay.”

The roads [sic] should be advised that delays of delivery or construction, in and of themselves, will not invalidate a certificate but if such delays are the result of the applicant’s action, which could have been avoided, such action wall invalidate the certificate.

As of November 1955, the industry program to acquire freight cars, assisted by the Government’s certification program, resulted in a backlog of orders for freight cars worth over $1 billion, the largest such backlog in the history of the railroad industry. Because of the obstacles to getting the cars on order manufactured and delivered, particularly the tremendous difficulty of obtaining steel at that time, it was expected by the Association of American Railroads that delivery of the cars could not be expected until 1957 at the earliest and might take longer.

As of December 31, 1955, there were 147,320 freight cars on order, and pending applications from railroads for necessity certificates covered 59,305 cars in excess of the 436,000 freight car expansion goal. On the recommendation of the Interstate Commerce Commission, the numerical limit of the ODM’s freight car goal was increased to cover the 59,305 cars (which were, on December 31, 1955, either on firm order or authorized for construction). The goal was increased by ODM to 495,000 cars on April 27,1956. At this time, both the carbuilders and ICC felt that even under optimum conditions, with construction proceeding smoothly without interruption because of material shortages and strikes, it would take approximately 2 years to produce the certified cars. If there were subsequent delaying events over which a railroad or the builders had no control, both the builders and the ICC believed completion of the freight car production program would take longer.

In the latter part of 1955, petitioner was advised by the Association of American Railroads that it should place firm orders for new freight cars by the end of the year if it wished to have the benefits of rapid amortization. Petitioner was advised of the number of freight cars that AAR studies indicated it should acquire (over and above what petitioner then owned or had on order). The “seriousness of the existing and prospective shortage of freight cars” was emphasized. Petitioner was advised that further extension of the rapid amortization program for new freight car acquisitions was doubtful.

In October 1955, petitioner completed its own study of its freight car needs, which differed somewhat with the recommendations of the AAR but gave petitioner its own figures for freight car shortages.

On November 17, 1955, petitioner’s board of directors approved acquisition of 10,700 new freight cars (6,600 boxcars, 1,050 flatcars, 1,550 gondolas, 500 covered hoppers, and 1,000 open hoppers) at a total cost originally estimated at $90,197,500, subject to escalator clauses to cover increases or decreases in costs of labor and materials. The board approved the president’s proposal to place a firm order immediately with Southern Pacific Equipment Co. for acquisition of these 10,700 cars. The availability of rapid tax amortization served as an inducement to petitioner in the placement of these orders.

By purchase orders dated November 17, 1955, petitioner ordered the aforesaid 10,700 freight cars from SPEC. The purchase orders did not specify costs or delivery dates but did specify: “Cars to be delivered at the earliest possible date.”

On November 18) 1955, the board of directors of SPEC accepted the orders from, petitioner for the construction of 10,700 freight cars, and authorized and empowered the officers of SPEC to place orders for all necessary materials and supplies required for and entering into the construction of the cars to be constructed by SPEC. Orders were “to be placed with the company or companies presenting the bid most favorable to this Company, considering the lowest price or prices for the material and supplies and the ability and reliability of the bidder or bidders, financially or otherwise, to deliver the property.”

On November 21, 1955, petitioner submitted to the Office of Defense Mobilization its application No. 97 for a necessity certificate, dated November 18,1955, with respect to the above-described 10,700 freight cars. Among other things, the application stated:

The facilities described in Appendix A, consisting of 10,700 freight cars, are necessary to enable applicant more adequately to meet the present and prospective transportation requirements of the Armed Forces and national defense production, and the essential needs of the civilian economy as well. It is estimated these cars will cost approximately $90,197,500. Without adequate railroad facilities, the industrial economy of the nation, upon which its security so vitally depends, would be seriously curtailed, and the ability of the Armed Forces to move men and material to strategic areas and points of need with promptness and efficiency would be seriously impeded.

The Board of Directors of applicant authorized construction of the 10,700 freight cars covered by the within application on November 17, 1955, such construction to proceed without delay, and on November 18, 1955, firm order for the delivery of these 10,700 freight cars was placed with Southern Pacific Equipment Company, the builder, providing for deliveries at the earliest possible dates.

*******

* * * The facilities described in Appendix A are all needed to enable applicant to meet the demands for railroad transportation incident to the national defense program and to place its transportation plant in a state of readiness for any eventuality, including full mobilization.

*******

The facilities described in Appendix A are not replacements in any proper sense of the term. Under normal, peacetime conditions, and in the absence of the increased demands for transportation due to the defense effort and the necessity of maintaining the large Armed Forces required by today’s unsettled international situation, such facilities would not be essential to enable applicant to meet all reasonable demands for transportation.

On December 30, 1955, petitioner, by letter, amended its application to increase the total estimated cost for the 10,700 cars to $91,435,000.

In practice, the certifying authorities did not deny timely applications for certificates of necessity on freight cars when the acquisitions were consistent with the mobilization goal, although its practice was not to certify cars ordered primarily for normal replacement purposes. In investigating an application for a certificate, the ODM, after a review of the application, referred it to the delegate agency with the requisite expertise for a report and recommendation. If it appeared that the applicant was carrying out the purposes for which the expansion goal had been established, the ODM certified the application. The ODM regarded the application and its attachments as an integral part of a certificate of necessity.

On February 24,1956, the ODM issued Certificate of Necessity TA-NC-30812 to petitioner. This certificate read in part:

Pursuant to Section 168 of the Internal Revenue Code * * * and in response to application No. TA-30812 filed on November 21,1955,

It Is Hereby Certified that subject to the conditions herein below set forth the facilities (excluding land) described in the attached Appendix A* * * are necessary in the interest of national defense during the emergency period, and that 85% of the cost of construction, reconstruction, erection, installation or acquisition thereof after December 31, 1949, is attributable to defense purposes.

Attached to the certificate of necessity was “Appendix A,” which was identical to a similarly designated appendix to petitioner’s application of November 21,1955, with the exception of certain handwritten cost figures. However, the following language printed on the face of the certificate, which was a standard form used before the middle of 1955, was crossed off:

As to the described facilities which are to be constructed, reconstructed, erected, or installed, this certificate shall be valid only with respect to those facilities the construction, reconstruction, erection, or installation of which is begun before the expiration of 6 months after the date of this certificate; and as to the described facilities which are to be acquired, or which are to be acquired and installed, this certificate shall be valid only with respect to those facilities acquired or contracted for before the expiration of 6 months after the date of this certificate.

In its place, the following paragraph was typed in:

As to the described facilities which are to be constructed by the taxpayer, this certificate shall be valid only with respect to those facilities the construction of which has been authorized on or before December 31,1955; and as to the described facilities which are to be acquired, this certificate shall be valid only with respect to those facilities acquired or for which firm orders are placed on or before December 31,1955.

The ODM had eliminated the 6-month time condition in certificates of necessity issued petitioner and other railroads for administrative convenience because due to shortages of material, work stoppages, and the like, production could not be started within 6 months, and there had been numerous requests for extensions of time. As a result of this action by the ODM, there was no definite time limit specified in the certificates of necessity within which cars had to be acquired. In place of the old 6-month rule, ODM expected that cars would be produced as quickly as reasonably possible under the prevailing circumstances.

The certifying officer who issued certificate TA-NC-30812 expected petitioner to receive the 10,700 certified cars in accordance with the normal industry practices for carbuilding and delivery. The ODM would not have issued the necessity certificate to petitioner if its application specifically called for delayed delivery since delayed deliveries were merely for the convenience of an individual applicant and the ODM sought to avoid unequal treatment within a given industry.

While it was not intended to penalize a railroad for delays over which it had no control, neither the ODM nor any delegate agency ever published any rules as to which delays in taking delivery would be regarded as ones which could have been avoided. Nor were any communications ever addressed to any applicants, individually or as a class, giving advice as to what conduct would be considered reasonable under the prescribed general rules.

In the beginning, petitioner estimated it could take 5 years to construct and acquire the 10,700 cars described in certificate TA-NC-30812 in view of the existing backlog and the prevailing conditions. There was no requirement that petitioner apprise the ODM of this estimate, and in its application of November 21, 1955, petitioner did not do so.

As of December 31, 1955, SPEC had a backlog of 13,937 freight cars on order from petitioner (the 10,700 cars ordered November 17, 1955, plus 3,237 freight cars previously ordered). The 3,237 freight cars, previously ordered by petitioner from SPEC, also were, or became, covered by necessity certificates.

The orders for 10,700 freight cars represented about 3 to 3y2 times the normal acquisitions by petitioner in an average year. The 10,700 freight cars were ordered because petitioner was asked by the AAR and the ICC to help increase the nation’s freight car fleet, and it was to petitioner’s advantage to comply with this request while the certification program was operational. Were it not for this request, some of these freight cars might never have been acquired since they differed to some extent from the types of cars required by petitioner’s customers.

The orders to SPEC for 10,700 cars also called for a much greater number of cars at one time than was customary in ordering freight cars. Ordinarily, petitioner placed freight car orders with outside builders in 200-, 300-, or 400-car lots.

As of the end of 1955, it was expected to take SPEC about a year to complete the backlog of 3,237 cars which were already on order before the placement of the orders for the 10,700 cars covered by certificate TA-NC-30812. Upon completion of the back order, it was anticipated that SPEC would proceed with construction of all of the 10,700 cars except for those cars not suitable for construction at SPEC’s Sacramento shops. Whether or not more rapid deliveries could be obtained by spreading petitioner’s orders among several carbuilders was dependent upon their backlog of orders from other railroads and the availability of labor and materials. At the end of 1955, the total order national backlog was 147,320 cars.

The procedures followed in the placing of orders by petitioner with SPEC were, when the process was completed, essentially similar to the procedures followed in placing orders with outside manufacturers. The orders placed by petitioner with SPEC for the 10,700 certified cars did not contain certain provisions that are standard in freight car orders placed with independent carbuilders (e.g., provisions regarding procedures for determining price, regarding car specifications, or regarding delivery dates). No bids were obtained before these orders were placed, and costs were based on estimates furnished by petitioner’s purchasing department. However, the equipment orders placed by petitioner with SPEC in November 1955 were in accordance with petitioner’s established practices. Under petitioner’s procedures, SPEC would follow petitioner’s specifications when it was building the car itself; and in those instances when SPEC was subcontracting construction, it was SPEC which obtained bids and placed detailed orders with the outside car manufacturers. It was anticipated at the time the orders were placed that SPEC would build those cars which it was physically set up to build (e.g., boxcars) and subcontract the building of other cars.

On March 2, 1956, in a letter supporting his recommendation to increase the goal, Commissioner Clarke advised the ODM that the railroads had been responding to the “dire need for cars” and had filed applications for certifications covering car construction which exceeded the ODM goal by 59,305 cars. He pointed out that the shortage of steelplate was having an adverse effect on freight car production, although he anticipated greater allocations to the builders. Assuming the requisite steel to be available, Commissioner Clarke believed “the backlog of orders could be liquidated within 18 months.” He stated he was convinced that, unless certification (and rapid tax amortization) were granted to the 59,305 cars exceeding the goal, freight car production would “materially decrease.” Commissioner Clarke’s estimate of production time assumed optimum conditions.

On March 28, 1956, Senator Richard L. Neuberger of Oregon wrote the ODM, asking for data regarding the “actual increase in capacity which will result from the purchase of the cars for which the Southern Pacific Company was granted its certificate.” The ODM’s reply to Senator Neuberger, dated May 18, 1956, stated petitioner had reported “that on January 1,1956 it owned 75,749 cars * * * . By the end of 1957, when 10,511 new cars will have been received, the Southern Pacific Co.’s fleet will have increased to 82,346 cars after the retirement and reclassification of 3814 cars. This will represent a gain of 6597 cars, or nearly 9 percent, in the two years of acquisition.”

On April 27, 1956, the ODM increased the freight car goal to 495,000 cars. This increase permitted the ODM to certify as eligible for amortization all pending applications covering the purchase of freight cars for which firm orders were placed or construction authorized by December 31, 1955. No further applications would be accepted, and the ODM closed this goal on April 27,1956.

On May 7, 1956, Victor E. Cooley, Deputy Director of the ODM, testified before the Senate Interstate and Foreign Commerce Committee that, in view of the fact that the applications for certification had exceeded the previous 436,000-car goal by nearly 60,000, the ODM had adopted a new goal of 495,000 cars to include all of the applications. He pointed out that there were 147,000 cars on order with the builders, “but it will be at least a year and a half before all can be completed.” He predicted “a net figure of about 2,100,000 available cars toward the end of 1957.” Deputy Director Cooley’s estimate of production time assumed ideal conditions.

During 1956, a total of 3,068 freight cars were acquired by petitioner, all of them covered by certificates of necessity. Of that number, 180 were part of the 10,700 cars covered by certificate TA-NC-30812; the remaining cars were part of the existing backlog when the 10,700 cars were ordered and were covered by other necessity certificates. Because of the backlog of previously ordered cars and because of disruptions to production such as that caused by a steel strike in 1956, SPEC and the outside builders, to which SPEC had sublet some of its work, were not able to start the construction of any significant quantity of the 10,700 freight cars until 1957.

In 1957, petitioner took delivery of 4,990 freight cars from SPEC, most of them constructed by that company; 4,491 of those 4,990 freight cars were part of the 10,700 cars, and almost all of the rest were covered by previously issued certificates of necessity.

Petitioner’s board of directors held a meeting on February 20, 1958. For the information of the directors, a memorandum was prepared which referred to “the substantial falling off in traffic volume” and suggested discontinuing or deferring certain activities. The memorandum recommended that petitioner defer the acquisition of 4,550 of the freight cars covered by certificate TA-NC-30812. The recommendations contained in this informational document did not receive the approval of the directors.11 Shortly after the meeting, petitioner engaged in activities directly contrary to the courses of action proposed in the memorandum. The directors made no decision to delay construction of the 4,550 freight cars,12 and petitioner continued to acquire the certified cars.

Petitioner’s executive department, in reviewing proposals for acquisition of freight cars, had to consider them in the light of all capital programs. As of 1955, for example, petitioner had to consider other very costly programs already undertaken such as the dieselization of the railroad (acquisition of diesel locomotives to replace the old steam locomotives) and the construction of the Great Salt Lake fill (a certified roadway project). And there were various other projects, or planned projects, to improve the roadway properties. Specific programs for capital expenditures, such as the program to acquire the 10,700 freight cars, were presented to the directors for approval only if the executive department had concluded that funds would be available.

Petitioner had to finance most of its equipment acquisitions and other capital expenditures because as a railroad it had a very slow capital turnover. It generated cash slowly and did not have enough cash to cover the capital expenditures. Debt was maturing each year and had to be paid in cash. Cash had to be paid annually into sinking funds of mortgage bonds. And roughly $10 million cash was required per year to make the downpayments in financing equipment acquisitions. Finally, cash was needed each year to pay dividends.13

Before any freight cars could be delivered, petitioner had to complete its financial arrangements so that payment could be made to the carbuilder. Generally, about 80 percent of the purchase price was financed; at least 20 percent of the cost had to be paid at once with cash funds of the company to make equipment trust certificates legal for certain types of investors.

The purchase of freight cars by petitioner from SPEC entailed customary financing through both equipment trusts and conditional sales, as in the case of purchases from outsiders. There was no effort by petitioner to arrange financing for all of the 10,700 certified cars at the beginning of the program, since it was not feasible to arrange financing for deliveries to occur several years later.

During the period 1956 to 1962, petitioner was advised by investment bankers that, generally, petitioner should not try to finance more than about $10 million of equipment acquisitions quarterly (about $40 million per year) because a great number of equipment trust obligations were being sold by other railroads and there was limited demand for them. On those occasions when petitioner financed more than $40 million of equipment acquisitions in a given year, the additional financing was managed principally by the use of conditional sales agreements. Petitioner’s inability to arrange financing at one time for all of the freight cars on order had the effect of spreading out the construction of all cars on order.

In 1956, Moody’s Investors Service lowered its rating for petitioner’s equipment trust certificates from Aa to A. In the financial community and among investors, such a reduction is regarded as a warning signal about petitioner’s credit and a cause of concern to potential investors, as to the security of petitioner’s certificates. It thus became necessary for petitioner to avoid overcommitment and to strengthen its financial position.

In 1957, petitioner’s treasurer, John B. Reid, conducted a study of petitioner’s financial condition. He was concerned that petitioner’s certificates might be removed from various States’ lists of lawful investments for institutional lenders. He was also concerned that the credit rating reduction was causing an increase in interest rates, adding to petitioner’s costs of borrowing. Further, the credit rating was believed to have an adverse effect on the popularity of petitioner’s stock, and the resultant decrease in equity was viewed as indirectly affecting petitioner’s ability to finance projects.

From 1946 through 1957, petitioner’s debt (including fixed charges), particularly petitioner’s debt for new equipment acquisitions, had increased substantially. Reid concluded that petitioner’s credit problems could be solved by reducing fixed charges on these debts and that the only practical way to accomplish such a reduction was to keep new borrowing to a minimum until earnings increased in response to the capital improvements that had already been made.

From 1956-58, petitioner’s annual freight revenues dropped by about $25 million, an adverse financial development which had not been anticipated in 1955 when petitioner approved the ordering of the 10,700 cars. Restricted financial capacity and shipper demands for other types of freight cars14 led petitioner to give a higher priority to some noncertified cars, although petitioner continued to acquire freight cars covered by certificate TA-NC-30812. It was essential for the successful operation of petitioner’s business that it respond to the demands of its shippers for the new types of freight cars being developed. Although petitioner’s freight revenues did not begin to improve until late 1958, petitioner continued to increase its ownership of freight cars and honor its commitment to help increase the industry’s freight car fleet. Petitioner never canceled, deferred, or in any manner modified the orders it had placed with SPEC.

Petitioner’s earnings remained at a low level for several years, and there was no significant upward trend discernible until 1962. Indebtedness in relation to earnings remained on the high side, as evidenced by the fact that the reduced rating on petitioner’s equipment trust certificates was continued until, in late 1962, it was increased to Aa. Petitioner had borrowed as much as it could on its low level of earnings without further weakening the company’s position. During the period 1956 through 1963, petitioner spent approximately $375 million for equipment acquisitions, of which about $285 million (approximately 75 percent of the total cost) was financed. The balance was paid for in cash. In view of the level of earnings during 1956 through 1961, petitioner could not prudently have financed the acquisition of more equipment of all types than it did during those years. Petitioner’s cash flow would have been adequate to finance the acquisition during 1956 and 1957 of 4,550 freight cars acquired after February 20,1958, but the use of the cash for that purpose would have prevented expenditures for other significant purposes. Because of the credit situation, it would not have been financially prudent for petitioner to have arranged for the acquisition at an earlier date of the 4,550 cars. While petitioner also acquired noncertified cars during the period 1956 through 1961, all such cars were ordered by petitioner from outside manufacturers, with no interruption of the production of those of the 10,700 cars being constructed by SPEC.

From 1956 through 1963, petitioner acquired 21,206 certified and noncertified cars at a total cost of $262,140,360. The yearly acquisitions were as follows:

Disallowed1 Cars for which amortization: Total cars Year acquired Total certified Total cars cars Certificate TA-NC-30812 a,

1956 3,068 3,068 180 O

1957 4,990 4,840 4,491 rH

50 1958 2,349 1,529 1,529 05 t-T

1,300 1959 1,500 1,300 1,300

1,100 1960 1,965 1,100 1,100

1,100 1961 1,607 1,100 1,100

1962 2,146

1,000 1963 3,581 1,000 1,000

21,206 13,937 10,700 6,150 24,550

During 1957 and 1958 there were indications that, because of increased labor and operating costs at the Sacramento plant, and the fact that outside carbuilders were beginning to solicit business at decreased prices, SPEC was becoming noncompetitive with the outside carbuilders. Because the estimates showed costs of manufacturing at the Sacramento shops of the remainder of the 10,700 cars would be greater than the cost of acquiring the cars from outside builders, SPEC decided to subcontract the remainder to the independent carbuilders. The first such subcontracting occurred in May 1958. SPEC stopped constructing the certified freight cars at the Sacramento shops in May 1958. SPEC, itself, built 3,850 of the 10,700 freight cars at the Sacramento shops. The remaining 6,850 were manufactured by other carbuilders.

All of the 4,550 cars here in issue were built by outside carbuilders under subcontracts made by SPEC after February 20, 1958. Details of the transactions involving these 4,550 cars that were a part of the 10,700 certificated cars are as follows:

Month subcontracting authorized No. of and/or Dates Order No. cars ratified delivered Builder

1958

P-3117-A 50 5/58 7/58-7/58-9/58 Texas & New Orleans RR Co.

Total 1958 50

1959

P-3110 100 11/58 2/59- 3/59 General American Transportation Co.

P-3113-B 500 1/59 5/59-9/59 Pacific Car & Foundry

P-3119 700 1/59 9/59-12/59 Pacific Car & Foundry

Total 1959 1,300

1960

P-3119-A 100 1/59 1/60 Pacific Car & Foundry

P-3119-B 500 4/59 2/60- 4/60 Pacific Car & Foundry

P-3119-C 500 4/59 8/60-10/60 Pacific Car & Foundry

Total 1960 1,100

1961

P-3119-D 600 7/60 1/61- 3/61 Pacific Car & Foundry

P-3105 500 7/60 4/61-12/61 Pacific Car & Foundry

Total 1961 1,100

1968

P-3117 400 10/62-2/63 3/63- 8/63 Gunderson Bros.

P-3117-20 350 7/63-8/63 8/63-11/63 Gunderson Bros.

P-3115-21 250 2/63-3/63 11/63-12/63 Bethlehem Steel Co.

Total 1963 1,000

On April 8, 1959, petitioner forwarded to the Office of Defense Mobilization a suggested scope amendment of necessity certificate TA-NC-30812 covering the 10,700 freight cars at issue. Petitioner desired to amend the certificate to reflect (1) an increase in estimated expenditures due to increased labor and materials costs and (2) some mechanical changes to some cars, such as the addition of hydra-cushion underframes, the deletion of auto loaders, and changes in length of cars. The scope amendment was approved by the ODM on June 16,1959.15

On January 30, 1963, petitioner forwarded to the Office of Emergency Planning, successor to the Office of Defense Mobilization, a further suggested scope amendment of necessity certificate TA-NC-30812 covering the 10,700 cars. Petitioner desired to amend the certificate to substitute 250 drop-door hopper cars for 250 drop-bottom gondola cars. The major differences between the two types of cars were the dimensions (length and height) and the weight-carrying capacity. Weight-carrying capacity had to be “increased due to requirements of shippers for cars capable of carrying heavier loads.” This scope amendment was approved by the Office of Emergency Planning on August 12,1963.

In approving the above scope amendments, the Office of Defense Mobilization and Office of Emergency Planning issued letters to respondent each of which included a paragraph which said the amendment was “not to be construed as extending the time within which construction is to be begun or acquisition effected beyond the time limit set forth in the original certificate.” This paragraph was standard language that was included in all cases where an extension of time was not the subject of the scope amendment.

Petitioner, not having received any indication from any source as to a specific time limit on the construction of the cars at issue, viewed the granting of the scope amendments as evidencing that the certifying authorities believed reasonable progress had been made by petitioner to the dates of the amendments.

On its returns for 1959-61 and later years, petitioner claimed deductions for amortization of emergency facilities, based on 85 percent of the cost of 10,700 freight cars described in Certificate of Necessity TA-NC-30812, as amended. In the statutory notice of deficiency, respondent disallowed these deductions, in part. The explanation for this adjustment read:

It is determined that 5,250 freight cars out of a total of 10,700 cars purchased by you do not qualify for emergency amortization under Certificate of Necessity (ODM-78) No. TA-N-C-30812, because firm orders were not placed for their acquisition prior to December 31, 1955, as required by the Certificate, and your Board of Directors deferred acquisition of a substantial portion of the cars in contravention of the intent of the Certificate and the directives of the Office of Defense Mobilization.

In his pretrial statement, respondent conceded this adjustment with respect to 700 cars. As a result, respondent now contests the amortization of only 4,550 freight cars, representing those of the 10,700 certified cars the delivery of which, respondent claims, was deferred by petitioner “to and beyond February 20,1958. ”16

OPINION

Issue (i)

In its consolidated income tax returns for the years 1959,1960, and 1961, petitioner claimed deductions for amortization of emergency facilities under section 168, which, during the years at issue, provided in pertinent part:

Every person, at his election, shall be entitled to a deduction with respect to the amortization of the adjusted basis * * * of any emergency facility (as defined in subsection (d)), based on a period of 60 months. * * * The amortization deduction above provided with respect to any month shall, except to the extent provided in subsection (f), be in lieu of the depreciation deduction with respect to such facility for such month provided by section 167. * * *

Section 168(d)(1) defined “emergency facility” as “any facility, land, building, machinery, or equipment, or any part thereof, the construction, reconstruction, erection, installation, or acquisition of which was completed after December 31,1949, and with respect to which a certificate under subsection (e) has been made.”

Section 168(e)(1) provided:

In the case of a certificate made on or before August 22,1957, there shall be included only so much of the amount of the adjusted basis of such facility * * * as is properly attributable to such construction, reconstruction, erection, installation, or acquisition after December 31,1949, as the certifying authority, designated by the President by Executive Order has certified as necessary in the interest of national defense during the emergency period, and only such portion of such amount as such authority has certified as attributable to defense purposes. Such certification shall be under such regulations as may be prescribed from time to time by such certifying authority with the approval of the President. * * *

In 1955, petitioner had applied to the certifying authority, in this instance the Office of Defense Mobilization (ODM), for a certificate of necessity for the acquisition of 10,700 freight cars. This certificate was issued by the ODM in 1956 (certificate TA-NC-30812), and the 10,700 freight cars were constructed and delivered to petitioner during the period 1956-63. Petitioner claims that the rapid amortization provisions of section 168 (in effect during the years at issue) apply to each of the 10,700 cars. Respondent contends that those provisions do not apply to 4,550 freight cars (out of the certified 10,700) which were constructed and delivered after February 20, 1958.17 According to respondent, the acquisition of cars after December 31, 1957, did not comply with the terms of the certification, and hence, the 4,550 cars were not covered thereby.18

Neither section 168 nor the congressional committee reports19 which accompanied its enactment deal with the question of how promptly a certified facility must be acquired.20 The same may be said of the immediate predecessor of section 168 under the 1939 Code, section 124A, and the committee reports relating to that provision.21 And this pattern also holds true for section 124, I.R.C. 1939, a provision similar to section 124A.22

The parties are in accord that in order to qualify for a section 168 deduction, a taxpayer must receive a determination from a certifying authority that the facility is necessary in the interest of national defense. See sec. 168(e)(1); cf. United States v. Allen-Bradley Co., 352 U.S. 306 (1957).23 The parties agree that only the certifying authority has discretion to determine whether a facility is necessary in the interest of national defense and, therefore, is eligible for certification; neither the Commissioner of Internal Revenue nor this Court has the jurisdiction to make such a determination. See Gray v. Commissioner, 16 T.C. 262, 267(1951).24

The parties are further in agreement that, in ascertaining whether the provisions of section 168 are to be applied in a given instance, respondent must determine whether the taxpayer has complied with the terms of the certification. Respondent’s determination of compliance relates to such matters as the identity of the facilities, the cost of the facilities, and (if regarded as a relevant factor by the certifying authority) the dates of construction and acquisition.25

The parties agree that, in exercising his jurisdiction, respondent is bound by all conditions imposed by the certifying authority in the certificate, including any time limitations. See 4 J. Mertens, Law of Federal Income Taxation, sec. 23.132 (1973 rev.); cf. H. Reiling, “Income Tax Problems in National Defense,” 29 Taxes 1044 (1951). Additionally, the parties concur that the intent of the certifying authority when it issued a given certificate can be significant for purposes of interpreting the certificate. Respondent has acknowledged his lack of authority to “revise, supplement, or enlarge the scope of” a certificate. Rev. Rui. 54-214, 1954-1 C.B. 298, 299.26

What is in dispute here is whether petitioner acquired the freight cars covered by certificate TA-NC-30812 within the time limit imposed by the certifying authority when it granted the certification. It is clear that the certificate, itself, contains no stated time limitation. In fact, the certifying authority expressly removed a standard provision calling for acquiring or contracting for the freight cars “before the expiration of 6 months after the date of this certificate.” However, respondent argues that, when the ODM issued certificate TA-NC-30812, it expected petitioner to acquire all of the certified cars within a reasonable time — at least by the end of 1957.27 Respondent also argues that petitioner deliberately deferred delivery of 4,550 cars beyond a reasonable time,28 and, in so doing, was not in compliance with the implicit requirements of the certificate of necessity. As a result, respondent contends petitioner may not avail itself of the benefits of section 168.29

Relative to the intent of the ODM in issuing this certificate, respondent argues that, when the ODM issued certificate TA-NC-30812, the ODM intended “to impose a time limit or condition” on petitioner for obtaining the certified cars. According to respondent, the ODM wanted petitioner to acquire the cars in 18 to 24 months, or no later than December 31,1957. We have carefully scrutinized the record, and we find no support for an acquisition deadline of December 31,1957.

Respondent claims that the ODM’s intent in this regard is manifested in various official statements and documents, some of which are discussed in our findings of fact. He points to statements made to Congress in 1956 by an ODM official in which it was estimated that, under optimum conditions, it would take “at least a year and a half” to complete construction of the approximately 147,000 cars then on order. He refers to correspondence in 1956 between the ODM and the Interstate Commerce Commission in which it was estimated that, in the best of circumstances, it would take from 18 months to 2 years to complete construction of the backlog of certified freight cars. Respondent also makes reference to a March 28, 1956, letter from the ODM to Senator Richard L. Neuberger in which the ODM reported petitioner’s statement that it would receive 10,511 new freight cars by the end of 1957.

These estimates were optimistic predictions, based on the assumption that there would be no factors beyond the control of the railroads which would serve to inhibit prompt acquisition of the cars. As can be seen from our findings and the discussion below, the conditions which developed did not favor the acquisition of the certified cars in as rapid a manner as had been predicted. The prevailing circumstances were less than optimum, and factors over which petitioner had little, if any, control caused it to depart from its early estimates.

Respondent also points to the testimony of the ODM official who issued petitioner’s certificate as supporting respondent’s conclusion that the ODM intended petitioner to acquire the 10,700 certified cars by December 31,1957. However, while that ODM official testified that he expected petitioner to acquire the 10,700 cars in accordance with the normal industry practices for carbuilding and delivery and that he would not have issued a certificate where an application called for delayed delivery, he did not elaborate on what he would consider to be normal industry practices. It is also clear from the record in this case that the ODM would not hold an individual railroad responsible for delaying factors which affected an entire industry. The certifying agency did not wish to penalize a railroad for delays occasioned by prevailing conditions over which the railroad had no control, such as those due to shortages of steel, labor strikes, economic changes, and subsequent financing problems.

Respondent further contends that the language of certificate TA-NC-30812, itself, shows that the ODM intended petitioner to acquire the cars by December 31, 1957. He refers to language indicating that production would proceed “without delay” and that car orders would provide for deliveries “at the earliest possible dates.” This language is certainly not specific, and furthermore, it is taken from an attachment to the certificate which contains portions of petitioner’s own application.

We agree that the language of the necessity certificate is significant in any inquiry regarding the manifested intent of the ODM. And, in this regard, it must be noted that the standard time-limitation language was deliberately removed from petitioner’s certificate. That provision was replaced with language which required only that construction should be authorized and firm orders should be placed on or before December 31, 1955, terms with which petitioner complied. Nothing in the certificate implies the existence of a deadline for obtaining the cars. The removal of the standard language from the certificate effectively eliminated any definite time limit. In place of the old 6-month rule, there was substituted a rule of reason in the expectation that freight cars would be acquired as quickly as possible under the prevailing circumstances.30

Another factor which militates against an intent on the part of the ODM that all of the certified cars be acquired by December 31, 1957, is the financial factor involved, which we will discuss more in detail later. We do not believe that either the ODM or the ICC was oblivious to the fact that for petitioner to add 10,700 additional cars to its existing fleet in such a short period would have required it to commit all of its cash and funds available for additions and improvements to this program at the expense of its normal operating needs and to the detriment of its customers. The necessity for petitioner to remain financially sound and to meet the needs of its users was certainly as important to the national defense as the addition of a specified number of cars to the freight car fleet. We believe the ODM took this factor into consideration in not fixing a specific deadline for delivery of the cars. Its purpose in issuing the certificate under the prevailing circumstances was to encourage the railroads to increase the number of freight cars available within a reasonable time, unless changing circumstances mandated a crash program.31 As stated by the ODM in its policy statement issued September 29, 1955 (DMO-III-1, see findings of fact), the expansion goals were for the purpose of establishing a quantitative limit of expansion that may be covered by the certificates.

If the ODM in fact intended petitioner to acquire the cars by the end of 1957, it seems unlikely to us that the agency would have granted petitioner’s scope amendment in 1959. Petitioner asked the ODM in 1959 to amend certificate TA-NC-30812 to reflect additional costs and some mechanical changes relating to the certified cars. In approving these amendments, the ODM made no mention of the timing of petitioner’s acquisitions under the certificate.32

It is true that the ODM did not have procedures for verifying acquisition dates and that it left such verification to the Internal Revenue Service. Nevertheless, it would not have required verification, as such, for the ODM to take note of the date of the necessity certificate and the date of the application for the scope amendment and to call to petitioner’s attention any obvious anomalies in the progress of its acquisitions.33

From time to time in the performance of its duties, the certifying authority was called upon to determine whether a railroad’s proposed acquisition schedule was compatible with the mobilization goal. Since such matters were within its purview, the failure of the agency to give any indication of disapproval to petitioner’s progress could fairly be viewed as tacit approval. In any event, we do not find the ODM’s action in granting the amendment consistent with respondent’s assertions regarding that agency’s intent.

None of the items of record to which respondent has directed our attention show that the ODM ever manifested an intent that petitioner was required to have the certified cars delivered by the end of 1957. If the ODM in fact intended to impose a time limit of any sort on petitioner (a point not established by the record herein), such intent was never disclosed. Respondent is relying on the general rule that an administrative agency’s interpretation of its own regulation or other directive is controlling unless plainly erroneous or inconsistent with the directive. Bowles v. Seminole Rock Co., 325 U.S. 410, 414 (1945); see generally 73 C.J.S., Public Administrative Bodies and Procedure, secs. 69, 105, and 106 (1951). However, neither the ODM nor any delegate agency ever published any rules specifically indicating what it expected in the way of promptness or indicating what delaying factors would be considered acceptable. Nor were any communications ever addressed to any applicant advising as to what conduct would be considered reasonable under the prescribed general rules.

We believe it is a necessary corollary to the general rule stated above that, in order for an agency’s interpretation to be binding in a given situation, it must be clearly made a matter of public record such that all affected parties are aware of it. See Udall v. Tallman, 380 U.S. 1, 16-18 (1965). On the facts of record in this case, we are unable to conclude that the ODM adequately manifested any intent to have petitioner acquire the certified cars by a specific date.34

Furthermore, we do not agree with respondent that petitioner acted unreasonably or delayed unnecessarily in acquiring the certified cars through the years at issue.35

Initially, some industry-wide problems stood in the way of rapid acquisition of the cars. There was a rather serious shortage of steel, and the Defense Production Administration allocated only a small amount of steel to the freight car builders. This shortage was compounded by steel strikes, particularly one in 1956. The inability of the car builders to obtain adequate amounts of steel, combined with the limited supply of component parts, had an obvious negative impact on the production capacity of the builders.

While some estimates were made that the railroad car building industry had an annual production capacity of 100,000 cars, these estimates assumed ideal conditions; various factors, in addition to those mentioned above, could act to limit actual production of certified freight cars. The reinstatement of the certification program in 1955 caused a tripling of the number of cars on order, producing the largest backlog in history. Many builders were not prepared for the increased orders. Some builders were set up to produce only certain types of railroad cars, and their facilities were inadequate (and their employees insufficiently trained) for the freight car construction occasioned by the certification program. Leadtime on new types of cars, involving research, development, engineering, and design work, plus additional leadtime for procurement and production could be as much as 27 months. Furthermore, carbuilders could be affected by strikes, accidents, and other contingencies beyond their control. In short, at the beginning of 1956, the builders were operating at considerably less than full capacity, and it could be expected that it would take 2 years and more to complete manufacture of the cars on order.

When petitioner placed its order for 10,700 cars in 1955, it caused SPEC to have a backlog of 13,937 cars.36 The rather large order for the 10,700 cars was about 3 times the number of cars petitioner customarily ordered in a year and was many times greater than the number of cars petitioner customarily ordered at one time. Given the size of the order and the industry-wide problems discussed above, SPEC was not able to start construction of a significant quantity of the 10,700 cars until 1957. Subsequently, when the cost of producing the cars at SPEC’s Sacramento shops proved prohibitive, it became necessary to find other builders for the certified cars.

As mentioned before, financial factors played a significant role in the timing of freight car acquisitions. Petitioner and other railroads generated cash very slowly. Petitioner’s cash flow was generally completely absorbed for such things as the payment of maturing debts (which had to be paid in cash) and was available only to a limited extent for capital projects like freight car acquisitions. At the same time that petitioner was committed to acquiring the 10,700 certified cars, petitioner had other demands on the funds it had available for capital programs. One such project was the Great Salt Lake fill (a certified roadway project). Other programs involved the acquisition of diesel locomotives and the improvement of various roadway properties. Petitioner could approve specific capital expenditures only when the funds were available.37

Because of the limited availability of cash, petitioner customarily obtained the requisite funds for freight car acquisitions through financing arrangements. These arrangements had to be completed before any cars could be delivered. For the most part, petitioner financed the cars by means of equipment trusts. To a much more limited degree, conditional sales agreements were used. It was clearly not feasible for petitioner to arrange for acquisition of the 10,700 cars all at once. Petitioner was advised that it could not, consistent with sound financial practice, finance more than approximately $40 million of its annual equipment acquisitions through equipment trusts.

In 1956, petitioner’s credit rating was reduced. To strengthen its financial position, petitioner found it necessary to avoid overcommitment. Petitioner had to keep its borrowing to a minimum until its earnings increased in response to the capital improvements that had already been made.

This restricted financial capacity and shipper demands for other types of freight cars led petitioner to give priority to some cars that were not certified. Some customers were requesting that petitioner acquire freight cars of a rather specialized nature. These cars were not within the scope of the 1956 certification. In view of petitioner’s need for an improvement in earnings, it was essential to respond to the demands of the shippers for these noncertified cars. Even during this economically difficult period, however, deliveries of the certified cars continued.

There was no discernible upward trend in petitioner’s earnings until 1962. In that year, petitioner’s credit rating improved. In view of the level of petitioner’s earnings during the period here involved, petitioner could not prudently have financed the acquisition of more equipment of all types than it did through the years at issue. While petitioner’s cash flow theoretically could have financed the 10,700 certified cars at issue before December 31, 1957 (assuming they could all be built by then), it seems fairly certain that the acquisition of those cars would have prevented expenditures for other significant purposes and would have had a detrimental effect on petitioner’s economic position.

From our examination of the record, we have concluded, in view of the prevailing conditions, that petitioner did not delay acquisition of the certified cars during the years here in issue for reasons that could have been reasonably avoided. Rather, in extending the acquisition of the cars over a period which continued through the years at issue, petitioner was responding to developments beyond its control in a reasonable manner and was following a financially prudent course of action.38 We do not believe petitioner was compelled under the terms of the necessity certificate to react any differently to the existing conditions. We therefore reject any suggestion that the extended period of acquisition was, in itself, incompatible with the certification or otherwise precluded petitioner from obtaining the benefits of section 168 for its freight car acquisitions through the years at issue.39

Here, we have a situation where the Government offered a tax incentive to taxpayers producing certified facilities and in practice never denied a timely application that was consistent with the mobilization goal. In such a circumstance, we do not see how the Government can justify withdrawing the promised tax benefit because of a taxpayer’s failure to comply with an unspecified time limitation. The denial of the benefit seems to us to be particularly inappropriate where, as here, the evidence shows that the facilities were acquired in a reasonable period of time and that the acquisition of the cars was consistent with prudent fiscal management. There is no evidence relating to the years at issue which shows deliberate delays in obtaining the certified cars for the sole purpose of meeting expenses of a less critical nature or of serving petitioner’s administrative convenience. We find nothing in the record which establishes that petitioner, through the year 1961, conducted its affairs in such a manner that it must be precluded from enjoying the tax benefit that was promised to it in 1956.

We recognize that, in enacting section 168, Congress did not intend the period for acquisitions of certified facilities to be open-ended and without limitation. However, in a case where no time limit is specified, the determination of whether given facilities were acquired within a proper time frame under the statute must depend on an analysis of whether the acquisitions were reasonably prompt under the prevailing conditions.

In accordance with the preceding discussion, we hold that petitioner is entitled to rapid amortization of the 3,550 freight cars (out of the 4,550 in dispute) which were acquired by petitioner through 1961, the last of the tax years at issue herein.

The remaining 1,000 of the cars certified under certificate TA-NC-30812 were acquired after 1961 and are technically not at issue in this case.40 They are at issue, however, in other docketed cases since the question discussed herein arises as well in petitioner’s taxable years 1962 through 1968, which years are also the subject of petitions filed with the Court. See note 16 supra. Each of these petitions places at issue the availability of section 168 amortization for freight cars under certificate TA-NC-30812 acquired between 1958 and 1963. The applicability of section 168 to the 1,000 cars delivered in 1963 must necessarily be resolved in the cases dealing with the later docketed years, and we have no intention of deciding that issue here. However, our conclusion herein regarding 3,550 of the 4,550 cars in dispute should be dispositive, to that extent, of the section 168 question arising in the docketed cases for these later years. See Commissioner v. Sunnen, 333 U.S. 591 (1948); Lea, Inc. v. Commissioner, 69 T.C. 762 (1978).

Nevertheless, on brief, both parties have suggested that we express our views with respect to the 1,000 cars acquired by petitioner in 1963 in the belief that it might dispose of this issue for the later years without further trial. At the trial of this issue, the parties presented evidence pertinent to all docketed years, covering circumstances arising before and after the years at issue herein. Both parties have argued this case on brief as though the eligibility for amortization of the 1,000 cars delivered in 1963 was at issue herein.

In the hope that it may promote settlement of this issue for subsequent years,41 we express the following views.

We have examined the evidence relating to all 4,550 disputed cars. We are not convinced that the 1,000 cars delivered in 1963, in contrast to the 3,550 cars delivered through 1961, were acquired as quickly as possible under the prevailing circumstances, as required by the ODM. The delay in obtaining the 1,000 freight cars was such that, in our view, the 1963 acquisitions were incompatible with the intent of the certifying authority when it issued the necessity certificate.

Of particular significance is the fact that petitioner did not acquire any certified freight cars during the year 1962; nor did SPEC subcontract for construction of any of these cars in 1961 or until October of 1962. Petitioner’s failure to do so was inconsistent with a pattern that it had established over the previous 12 years. Petitioner did acquire 2,146 cars during 1962, but not one of them was covered by a necessity certificate. Moreover, by the year 1962, some of the conditions which had inhibited acquisitions in the prior years appear to have become much less of a problem. The scarcity of steel and components, the huge backlogs of car orders, the inadequately trained employees — none of these factors appear from the evidence to have had the negative impact on car construction in 1962 that they had in the earlier years. While economic matters continued to be a consideration throughout this period, petitioner’s financial problems lessened in their severity during 1962. Nothing in the record suggests that the postponement of deliveries was occasioned by factors affecting the entire railroad industry, and we are of the impression that petitioner delayed acquisitions of certified cars for a year for reasons of its own administrative convenience.42 If this is so, we do not believe petitioner would be entitled to rapid amortization under section 168 for the 1,000 certified freight cars it received in 1963.

We decide this issue in favor of petitioner for the years here involved.

II. Recovery Upon Merger of Previously Deducted Amounts43

This issue presents the following question for our consideration:

Whether, to the extent certain amounts deducted by petitioner’s predecessor during 1916 to 1924 were recovered when the Texas & New Orleans Railroad Co. was merged into petitioner in 1961, the tax benefit rule applies to include the previously deducted amounts in petitioner’s gross income under section 61.

FINDING OF FACT

Issues (hh) and (9)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

Upon the organization of the predecessor Southern Pacific Co. in 1884, the company proceeded to acquire the outstanding stock of a number of railroad companies, including that of the Texas & New Orleans Railroad Co. and the Galveston, Harrisburg & San Antonio Railroad Co. By the end of 1885, the predecessor Southern Pacific Co. (PSP) had acquired over 90 percent of the outstanding stock of said companies and subsequently acquired all of the outstanding stock.

PSP, as common parent company of an affiliated group of companies, as defined by the various Revenue Acts prior to 1939 and by the Internal Revenue Code of 1939, filed consolidated Federal tax returns, covering itself and all subsidiaries eligible to be included, for all years that Federal tax returns were required to be filed, through the period ended September 30, 1947, when its existence ceased upon consummation of a plan of reincorporation, discussed below.

The San Antonio & Aransas Pass Railroad Co. (SA & AP) was incorporated in 1884 under the laws of the State of Texas. In 1890, SA & AP defaulted in the payment of certain liabilities, and its properties were taken over and its operations continued by court-appointed receivers.

In 1892, a plan of reorganization was adopted, and the properties of SA & AP were released from receivership by court order. The plan provided for issuance of $21,600,000 par value first mortgage 4-percent, 50-year gold bonds of $1,000 denomination each, carrying interest from January 1,1893. Some of the bonds were issued in exchange for the entire outstanding capital stock and previously outstanding bonds of SA & AP. For reasons not important here, all of the new bonds were guaranteed as to payment of both principal and interest by PSP. In 1899, PSP became the beneficial owner of all the stock of SA & AP.

As a result of action taken by the State of Texas in 1903, PSP was forced to divest itself of ownership and control of SA & AP. This action is described in a report44 of the Interstate Commerce Commission (ICC) as follows:

Prior to 1903 the Southern [PSP] owned all of the stock of the Aransas [SA & AP], and had guaranteed payment of the principal and interest of $17,544,000 of its 50-year 4% bonds, dated January 1,1893. By force of a decree of the District Court of Travis County, Tex., rendered December 14,1903, the Southern was enjoined from owning or controlling any of the stock of the Aransas so long as it owned or controlled any of the stock of Galveston, and accordingly, the Southern disposed of its interest in the Aransas, but its liability as guarantor of the principal and interest on the bonds has continued.

During the years 1915 to 1924, it became necessary for PSP to honor its guarantee and pay interest on the SA & AP bonds.

On March 26, 1919, PSP sent a letter to the Commissioner of Internal Revenue, which read as follows:

Dear Sir:

The Southern Pacific Company has guaranteed both the principal and interest of the outstanding bonds of the San Antonio & Aransas Pass Railway Company (hereinafter called the Railway Company), aggregating $17,544,000 par value. At the time that this guaranty was made the Southern Pacific Company controlled the Railway Company through ownership of the latter’s capital stock. Subsequently, the Southern Pacific Company was forced by the State of Texas to sell this stock for the reason that the San Antonio & Aransas Pass Railway was a line competitive with the railroads controlled by the Southern Pacific Company.

During the calendar year 1918 the Southern Pacific Company paid for the account of the Railway Company interest coupons aggregating $645,090., which amount the Southern Pacific Company, for reasons stated below, proposed to charge to Profit and Loss in its accounts for the calendar year 1918.

The property of the Railway Company, as shown in the 26th Annual Report of the Railroad Commission of Texas for the year 1917, was valued as follows, viz:

Valuation by Railroad Commission of Texas $13,970,335.05

Valuation for State and County tax assessments 13,327,709.00

According to the former valuation, which is the higher of the two, the property is worth $3,573,664.95 less than the par value of the outstanding mortgage bonds, which aggregate $17,544,000.

In 1905 the Southern Pacific Company received from the Railway Company income bonds to the amount of $3,898,000 par value, in the discharge of the indebtedness then existing from the latter to the former company. In 1910, as there was no prospect of the collection of any part of the debt evidenced by these income bonds, the Southern Pacific Company wrote down their book value to the sum of $194,900., which represented 5% of their face value. The reason for not writing off the entire amount was that it was desired to carry them at nominal value for the purpose of record.

The advances made by the Southern Pacific Company to the Railway Company from the date of settlement in 1905 to December 31,1917, together with interest thereon aggregated $4,993,593.98.

The May 1918 balance sheet, which is the latest in our files of the Railway Company, shows that current and deferred assets practically offset current and deferred liabilities, the former amounting to $1,557,356.81 and the latter to $1,613,334.39. The indebtedness of the Southern Pacific Company is not carried as current or deferred liabilities, but as long term debt, and therefore not included in the liabilities mentioned, of $1,613,334.39.

The financial condition of the Railway Company clearly indicates that worthlessness of its indebtedness for current advance. In other words, the guaranty hereinbefore referred to has resulted in the Southern Pacific Company now having to pay all the coupon interest on the bonds of the Railway Company, with no possibility of ever being reimbursed for such advances.

Please advise, under the circumstances outlined above, whether Southern Pacific Company can deal with the amount of these advances made to the Railway Company in 1918, which it proposes to charge to profit and loss, as a deduction in its return of annual net income, and oblige.

On April 5,1920, PSP received the following reply to its letter of March 26,1919:

Reference is made to your letter of March 26,1919, from which it appears that the Southern Pacific Company guaranteed both the principal and interest of the outstanding bonds of the San Antonio & Aransas Pass Railway Company aggregating $17,544,000 par value. At the time the guaranty was made the Southern Pacific Company controlled the Railway Company through ownership of its capital stock. Subsequently, the Southern Pacific Company was forced by the State of Texas to sell this stock for the reason that the San Antonio & Aransas Pass Railway was a line competitive with the railroads controlled by the Southern Pacific Company.

During the calendar year 1918, the Southern Pacific Company paid for the account of the Railway Company interest coupons aggregating $645,090, which amount the Southern Pacific Company “proposes to charge to profit and loss in its accounts for the calendar year 1918.”

In 1905, the Southern Pacific Company received from the Railway Company income bonds to the amount of $3,898,000 par value, in the discharge of the indebtedness then existing from the latter to the former company. In 1910, as there was no prospect of the collection of any part of the debt evidenced by these income bonds, the Southern Pacific Company wrote down their book value to the sum of $194,900, which represented five per cent of their face value. The reason for not writing off the entire amount was that it was desired to carry them at a nominal value for the purpose of record. The advances made by the Southern Pacific Company to the Railway Company from the date of settlement in 1905 to December 31, 1917, together with interest thereon, aggregated $4,995,593.98.

The Railroad Commission of Texas for the year 1917 has valued the property of the Railway Company at $3,573,664.95 less than the par value of the outstanding mortgage bonds, which aggregate $17,544,000. It appears that not only is there no present prospect that the Railway Company will be able to pay these bonds at maturity, but also there is no prospect that the advances made by the Southern Pacific Company to the Railway Company and carried by the Southern Pacific Company in its books of account as a “long term debt” will ever be paid. Therefore, the company for the year 1918 proposes to charge to profit and loss the amount of the interest which it was compelled to pay during 1918 upon bonds of the San Antonio & Aransas Pass Railway Company.

From the facts stated, it is obvious that the payment made by the Southern Pacific Company in 1918 was not a voluntary expenditure but was made in the discharge of an obligation. Since the Southern Pacific Company had guaranteed the payment of the interest upon the bonds of the Railway Company, the payment by the Southern Pacific Company of such interest is deductible from gross income in the return of the Southern Pacific Company, provided the amount were shown as a payment by the Southern Pacific Company. It appears, however, that the company prefers to charge it as a loss to the profit and loss account. There does not appear to be any reason why the company should not so treat the item and deduct it from gross income as a loss sustained during the taxable year.

It is, therefore, held that the payment under the guaranty of interest of the insolvent principal is a legal deduction from gross income of the corporation making the payment, either as an operating expense or as interest, or as a bad debt, provided it is charged off the books of account of the guarantor.

Respectfully,

Commissioner.

Consistent with this ruling, PSP claimed and was allowed the following income tax deductions for payments made under its guarantee agreement:

Period ended Deduction allowed

June 30, 1915 . $696,627.67

June 30, 1916 . 493,966.20

Dec. 31, 1916 . 344,109.60

Dec. 31, 1917 . 339,090.40

Dec. 31, 1918 . 641,446.00

Dec. 31, 1919 . 697,338.00

Dec. 31, 1920 . 425,164.00

Dec. 31, 1921 . 48,664.00

Dec. 31, 1922 . $195,759.00

Dec. 31, 1923 . 204,380.00

Dec. 31, 1924 . 72,080.00

Total . 4,158,624.87

While the payments made pursuant to the guarantee were eliminated from PSP’s open account of amounts due from SA & AP, both PSP and SA & AP, subsequent to the years of payment, recognized SA & AP’s continuing obligation to reimburse PSP.

SA & AP filed separate income and excess profits tax returns for the years 1913 to March 31,1925. The consolidated return of PSP and its affiliates for 1925 included SA & AP for the period April 1 to December 31,1925, and for all subsequent years until SA & AP ceased to exist in 1934.

In 1924, SA & AP directors approved a lease of all SA & AP properties to the Galveston, Harrisburg & San Antonio Railway Co. (GH & SA) pursuant to which the GH & SA would take over all SA & AP assets and assume SA & AP liabilities, amounts owed to PSP excepted. GH & SA would operate SA & AP and pay SA & AP an annual rent. Also in 1924, PSP sought to purchase SA & AP capital stock in an attempt to reacquire control of SA & AP.

In 1925, the ICC approved both the GH & SA lease and the PSP reacquisition, stating:

That the acquisition by the Southern Pacific Company of control of the San Antonio and Aransas Pass Railway Company by purchase of the capital stock of that company, as set forth in the application and report aforesaid, be, and the same is hereby, approved and authorized.

That the Galveston, Harrisburg & San Antonio Railway Company be, and it is hereby, authorized to acquire control of the railroad of the San Antonio and Aransas Pass Railway Company in accordance with the terms of the lease described in the application and report aforesaid.

PSP formally reacquired control of SA & AP in 1925. PSP anticipated increased profitability for SA & AP and the ability of SA & AP to meet its interest obligations.

In 1926, the SA & AP stockholders approved an assignment of the GH & SA lease to the Texas & New Orleans Railroad Co. (T & NO), subject to the approval and authorization of the ICC. The T & NO lease would include provisions identical to those in the GH & SA lease. The assignment of the lease to T & NO was subsequently approved by the ICC.45

Upon reacquisition of control of SA & AP by PSP, the two companies decided generally to discontinue all intercompany interest on open accounts between PSP and its solely controlled and separately operated affiliated companies, and to cancel and write out of the books of account all unearned intercompany interest on open accounts, and also on notes and bonds which the creditor companies were carrying in “Transit in suspense.” It was intended that all unpaid interest on SA & AP income bonds accrued to January 29, 1926, were to be written out of the accounts. As a result, all SA & AP notes payable to PSP were transferred to open account.

In 1932, the SA & AP stockholders (and the stockholders of other companies controlled by PSP) authorized and approved the conveyance of all SA & AP properties to T & NO upon the terms and conditions contained in a certain “Plan of Consolidation of Texas and Louisiana Companies,” subject to approval and authorization by the ICC. Under the plan, T & NO agreed to pay the total indebtedness of the companies to PSP (which totaled $40,299,797.91 at December 31, 1931) and PSP also received 596,464 shares of stock of T & NO in exchange for its stock in the merged companies. The ICC subsequently approved the merger, noting the T & NO would assume SA & AP’s indebtedness and that SA & AP’s accounts would “be carried without change into the books of [T & NO.]”46 The plan of consolidation was carried out during 1934.

In the 1934 consolidation, 13 PSP affiliates, including SA & AP, merged with T & NO and ceased to exist. As constituted after the consolidation, T & NO was a solvent corporation. The 1934 post-consolidated book balance sheet of T & NO included balances in the book accounts of SA & AP at the time of the consolidation for open account amounts payable to PSP, including the amounts owing as a result of PSP’s payments of interest during the years 1915-24 pursuant to its guarantee.

After the 1934 merger, the intercompany open accounts between PSP and T & NO showed that T & NO’s account payable to PSP exceeded PSP’s account receivable from T & NO by $10,738,931.42. Included in this amount was the $4,158,624.87 debt which SA & AP owed to PSP and which T & NO assumed. Through 1942, this $10,738,931.42 remained on the T & NO books as the net debt owed by T & NO to PSP.

As of December 31, 1943, the balance of indebtedness shifted from T & NO to PSP. As of that date, T & NO books reflected an account receivable from PSP of $1,131,797.29, and the PSP books reflected an account payable to T & NO in the amount of $11,870,728.71, or a difference of $10,738,931.42. Beginning in 1943 and continuing until the 1961 merger discussed below, this $10,738,931.42 amount appeared on the PSP and T & NO books as a net debt owed by PSP to T & NO. Officials of PSP recognized and considered equalizing these accounts from time to time but for various reasons relating to excess profits and capital stock taxes took no action. The $10,738,931.42 difference remained on the books up to the time of the 1961 merger.

In 1947, the former Southern Pacific Co. (FSP) was organized under the laws of Delaware.47 On September 30,1947, pursuant to a plan of reincorporation, FSP received all of the assets of PSP, including the T & NO stock owned by PSP.

Upon consummation of the 1947 plan of reincorporation, FSP became the common parent company of the same affiliated group of companies of which PSP had been the common parent company, as that term was then defined in section 141(d), I.R.C. 1939, and, commencing with the period beginning October 1, 1947, continued to file consolidated Federal tax returns.48

In 1960, the stockholders of FSP and T & NO authorized a plan of merger, subject to ICC approval, pursuant to which FSP would acquire all the assets and assume all the obligations of T & NO. By decision dated September 12,196149 the merger of the properties and franchises of the T & NO into FSP for ownership, management, and operations was approved and authorized, the ICC stating, in part:

The plan of merger is governed by an agreement dated August 22, 1960, between Southern Pacific and the three named subsidiaries. The agreement has been submitted to and approved by stockholders of all of the applicant companies, subject to this Commission’s approval. Under the plan, Southern Pacific will acquire all the assets and assume all the obligations of the three subsidiary companies. Upon cancellation of the outstanding capital stock of each, all of the properties of the three merging subsidiaries will be vested in Southern Pacific. * * * The agreement further provides that on and after such date all obligations between Southern Pacific and the other merging companies, or between the merging companies-, shall be deemed to be cancelled and discharged, other than those bonds which were issued by Texas and New Orleans and upon the effective date of the merger are owned by Southern Pacific.

Since the transaction involves no change in the scope of the Southern Pacific transportation enterprise, applicants propose that the accounts of the merging subsidiaries be carried over intact into the consolidated accounts of the surviving parent, Southern Pacific, as shown in the constructed balance sheet submitted. The accounting for the transaction will not be approved at this time, but will be reserved for consideration upon submission of appropriate journal entries as required by our order herein.

The merger of T & NO into FSP was consummated on October 31, 1961. At that time, the $10,738,931.42 open account balance remaining on the books was eliminated in the postmerger book balance sheet of FSP by a debit entry to the intercompany open account. FSP Co. in its postmerger book balance sheet also reflected an addition of $15,721,458.22 ($15,853,323 in the constructed balance sheet) by credit to its book retained income.50 Included in the amount thus credited was the $4,158,624.87 amount reflecting the SA & AP debt.

For tax purposes, the 1961 merger of the T & NO into the former SP Co. has been treated as a “tax-free” reorganization by both petitioner and respondent. The above-described book credit to retained earnings was covered by Schedule M of the consolidated return for the year 1961, wherein $9,738,931.42 (including the $4,158,624.87 amount) was shown as recorded in book account 798, retained income — unappropriated, for “Open account indebtedness of S.A. & A.P. Ry. Co. assumed by T & NO RR Co. written off by SP Co. but not forgiven,” and $862,000 was shown as recorded in book account 796, other capital surplus, as “Difference between book value of Texas Midland stock and advances on SP Co. books,” both as elements in an overall increase of $242,756,093.24 in total FSP book capital surplus and retained income from December 31, 1960, to December 31, 1961, for purposes of reconciling book and tax accounting.

In his statutory notice of deficiency, respondent stated as to this issue (in part):

Southern Pacific Company realized ordinary income in the amount of $6,897,831.00 upon satisfaction of indebtedness due it from Texas and New Orleans Railroad Company at the time of the merger of Texas and New Orleans into Southern Pacific Company under the provisions of sections 11 and 332 of the Internal Revenue Code and the regulations thereunder and Regulations 1.1502-41(b).

The adjustment consists of the following amounts: Advances to San Antonio and Aransas Pass Railway Company from 1913 to 1924 and assumed by Texas and New Orleans upon merger into it of San Antonio and Aransas Pass. Written off by Southern Pacific, but not forgiven.$5,303,293.00

Other questions raised by this issue have been conceded by respondent. Further, owing to respondent’s concessions, only $4,185,624.87 is now involved in the above-described adjustment.

In his “Third Amendment to Answer,” filed June 28, 1973, respondent claims that petitioner is estopped “from denying that the original bad debt deductions claimed by petitioner and allowed by respondent were erroneous deductions in the years taken.”

OPINION

Issues (hh) and (9)

During the years 1915-24, PSP had to make good on its guarantee of interest payments on SA & AP bonds. Consistent with a 1920 ruling obtained from the Commissioner of Internal Revenue, PSP deducted on its tax returns for those years the total amount of $4,158,624.87, reflecting amounts it had expended in connection with the guarantee of SA & AP bond interest. At the end of the 1915-24 period, the $4,158,624.87 remained as an outstanding debt which SA & AP owed to PSP.

Respondent argues that since T & NO was a solvent corporation in 1961 and had sufficient retained earnings to pay the $4,158,624.87 obligation, when T & NO was merged into FSP in 1961 this outstanding SA & AP indebtedness to PSP was satisfied. Accordingly, since PSP had previously deducted the $4,158,624.87 amount in its 1915-24 income tax returns, respondent views FSP as realizing ordinary income to that extent in 1961.

Respondent relies upon the tax benefit rule, which provides that, where an amount which was deducted from gross income in a prior year is recovered in a later year, the amount is includable in gross income in the year of recovery if a tax benefit was realized from the deduction. Unvert v. Commissioner, 72 T.C. 807 (1979), on appeal (9th Cir., Nov. 5, 1979); Merchants Nat. Bank v. Commissioner, 199 F.2d 657, 659 (5th Cir. 1952), affg. 14 T.C. 1375 (1950); Mayfair Minerals, Inc. v. Commissioner, 56 T.C. 82, 86 (1971), affd. 456 F.2d 622 (5th Cir. 1972); Alice Phelan Sullivan Corp. v. United States, 180 Ct. Cl. 659 (1967); 381 F.2d 399, 401-402 (1967).51 See also Rosen v. Commissioner, 71 T.C. 226 (1978), affd. 611 F.2d 942 (1st Cir. 1980), wherein we stated (p. 229):

It has long been established that the receipt of money or property which might not otherwise be regarded as income may nevertheless constitute income within the meaning of the statute (section 61, I.R.C. 1954, and corresponding provisions of prior law) if it represents the repayment, restoration, or return of an item which the taxpayer had deducted in an earlier year. The general concept has often been referred to as the “tax benefit rule.” [Fn. ref. omitted.]

In Mayfair Minerals, Inc. v. Commissioner, supra, we pointed out the rationale for the tax benefit rule (p. 86):

The reason for this rule is clear. “When recovery or some other event which is inconsistent with what has been done in the past occurs, adjustment must be made in reporting income for the year in which the change occurs. No other system would be practical in view of the statute of limitations, the obvious administrative difficulties involved, and the lack of finality in income tax liability, which would result.” Estate of William H. Block, 39 B.T.A. 338, 341 (1939), affirmed sub nom. Union Trust Co. v. Commissioner, 111 F. 2d 60 (C.A. 7, 1940), certiorari denied 311 U.S. 658 (1940).

Petitioner argues that the tax benefit rule cannot apply in this case because the deduction by PSP of the $4,158,624.87 at issue during the years 1915-24 was erroneous as a matter of law.

It is well settled, as both parties acknowledge, that the tax benefit rule can be applied only where the prior deduction was legally proper. In those instances where the prior deduction was not properly allowable under the applicable law, the Commissioner may not make an adjustment to the taxpayer’s gross income for the year in which the deducted amount is recovered. Streckfus Steamers, Inc. v. Commissioner, 19 T.C. 1, 8 (1952); Canelo v. Commissioner, 53 T.C. 217, 226-227 (1969), affd. on another issue 447 F.2d 484 (9th Cir. 1971). See also Kingsbury v. Commissioner, 65 T.C. 1068, 1087-1088 (1976); Twitchco, Inc. v. United States, 348 F. Supp. 330, 335 (M.D. Ala. 1972).52 This exception to the rule is premised on the notion that—

the statute of limitations requires eventual repose. The “tax benefit” rule disturbs that repose only if respondent had no cause to question the initial deduction, that is, if the deduction was proper at the time it was taken. * * * [Canelo v. Commissioner, supra at 226-227.]

In an attempt to prevent petitioner from avoiding the application of the tax benefit rule under the theory of the above-cited cases, respondent raises, by an amendment to his answer, the defense of “duty of consistency” or “quasi-estoppel.” By means of this defense, respondent seeks to preclude petitioner from contending herein that the prior deductions were improperly taken.

The “duty of consistency” doctrine operates to negate the exception to the tax benefit rule enunciated in the Streckfus Steamers and Canelo cases “where the taxpayer, either deliberately or unintentionally, misleads the Commissioner through erroneous representations of fact in his returns, and the Commissioner, consequently, allows the statute of limitations to run on adjustments of taxable income on the misleading returns.” Mayfair Minerals, Inc. v. Commissioner, supra at 91. In such a case, the taxpayer “is estopped to contend that the recovery * * * does not constitute taxable income because of the fact that the deduction may have been erroneously claimed and allowed in [the prior year].” Faidley v. Commissioner, 8 T.C. 1170, 1173 (1947). As a result, “In situations where the duty of consistency or quasi-estoppel applies, a taxpayer is required to follow the tax-benefit rule even though the original deduction was erroneous.” Mayfair Minerals, Inc. v. Commissioner, supra at 89.

We believe that respondent’s reliance on this doctrine is misplaced in the present circumstances and that petitioner is not precluded from attempting to establish the legal impropriety of the prior deductions. The doctrine of “duty of consistency” or “quasi-estoppel” does not apply where all pertinent facts are known to both the Commissioner and the taxpayer. “It is said that when both parties know the facts, there is no reason to estop the taxpayer from changing his position with respect to the transaction.” Bartel v. Commissioner, 54 T.C. 25, 32-33 (1970). This would seem to be particularly true where the crucial facts are known to both parties and the erroneous deductions are due to a mutual mistake of law. Cf. Mayfair Minerals, Inc. v. Commissioner, supra at 93; Sugar Creek Coal & Mining Co. v. Commissioner, 31 B.T.A. 344, 347-348 (1934).53 See Crosley Corp. v. United States, 229 F.2d 376, 381 (6th Cir. 1956).

As can be seen from our findings, PSP’s deduction of the amount at issue during the period 1915-24 was consistent with a 1920 ruling by the Commissioner that, under the applicable law, the payments by PSP during the year 1918 on behalf of SA & AP were properly deductible. Petitioner is not now claiming that any of the pertinent facts which PSP represented to be true at the time of the deductions or any of the facts which the Commissioner relied upon at that time do not accurately reflect the events bearing on the question of deductibility.54 Petitioner’s position herein is merely that, given those facts, the deductions were legally impermissible during the years 1915-24. Thus, the question to be resolved is simply whether PSP made a legal error in taking the deductions and respondent made a legal error in allowing the deductions.

Accordingly, under the authority discussed above, we are not presented here with a situation which calls for an estoppel. Petitioner is not precluded from asserting that the deductions were not allowable and contending that, as a result, the tax benefit rule is not applicable herein.

Unvert v. Commissioner, supra, and other cases which have applied quasi-estoppel on the theory of “duty of consistency” are distinguishable. In those cases, either the Commissioner was not apprised of the actual facts at the time of the deduction or the taxpayer in the year of recovery attempted to change the controlling facts and shift his position. Here, both PSP and the Commissioner were aware of the controlling facts when the deductions were taken, and petitioner has not attempted to change the controlling facts.55

We therefore turn to the question of whether PSP correctly took the deductions on its 1915-24 returns under the then-applicable law.56

In 1892, PSP guaranteed the payment of principal and interest on certain SA & AP bonds. During the years 1915-24, PSP had to make good on its guarantee of the interest payments, and PSP deducted on its income tax returns the amounts it expended in that regard. The record is not clear as to the specific nature of the deductions claimed by PSP on its returns during the 1915-24 period. The Commissioner’s ruling letter appears, at the end, to give PSP three alternative theories for deducting the payments.57 When taken as a whole, however, the tenor of the ruling letter seems to suggest, as petitioner notes, that the Commissioner viewed the payments as interest deductions. Our examination of the record leads us to conclude that PSP deducted the amounts at issue either as interest or as a business expense.

We do not believe PSP took the deductions as worthless debts in view of the evidence of record that both SA & AP and PSP, subsequent to the years of the deductions, recognized the continuing obligation of SA & AP (and later T & NO) to reimburse the amounts advanced. Since PSP continued to look to SA & AP to pay the debt and since SA & AP in fact continued to operate, it seems unlikely to us that PSP would have chosen to base its deductions on a worthlessness theory.

Our conclusion in this respect is bolstered by our view that under the prevailing legal principles, the propriety of deducting the amounts in question as worthless debts, given the factual circumstances outlined above, was at best questionable.

First, it would appear to be at least arguable that PSP would not have been regarded as “charging off” the debt during the taxable year of the deduction, as required by the applicable statutes.58

To effect a “charge off,” a taxpayer was required to take some affirmative action to show that the debt was no longer considered an asset. Merely writing off the amount of the debt from the relevant account was insufficient if the taxpayer’s treatment of the outstanding obligation was otherwise incompatible with the ascertainment of worthlessness. For example, a taxpayer would not be regarded as having satisfied the “charge off” requirement where the debt had not been completely eliminated from all asset accounts. Fairless v. Commissioner, 67 F.2d 475 (6th Cir. 1933), affg. 19 B.T.A. 304 (1930); O. S. Stapely Co. v. Commissioner, 13 B.T.A. 557 (1928); Stifel v. Commissioner, 7 B.T.A. 1060 (1927); Milling Moore Mercantile Co. v. Commissioner, 5 B.T.A. 1060 (1927); Mason Machine Works Co. v. Commissioner, 3 B.T.A. 745 (1926); Lasater v. Commissioner, 1 B.T.A. 956 (1925). See 5 J. Mertens, Law of Federal Income Taxation, sec. 30.18 (1975 rev.).

We believe it is doubtful, in light of the mutual recognition of the continuing obligation for reimbursement, that PSP “charged off” the SA & AP debt in the manner contemplated by the cited authority. See also Ames v. Commissioner, 1 B.T.A. 63, 68 (1924). In this regard, we note that while respondent does not specifically address this question,59 he does, in developing other arguments, repeatedly state on brief that the $4,158,624.87 debt owed by SA & AP to PSP continued to be carried on PSP’s (and later FSP’s) books as an account receivable through the year 1961. Respondent thereby lends credence to the view that the debts were not properly “charged off.”

Second, even assuming PSP “charged off” the SA & AP debts during the pertinent taxable years, it is highly unlikely that PSP would have been entitled to base its deductions on a worthlessness theory. In Portland Railway, Light & Power Co. v. Commissioner, 1 B.T.A. 1150 (1925), the taxpayer sought to deduct as worthless, debts owed to it as a result of advances it had made to a corporation, pursuant to a guarantee, during the years 1915 to 1924. In denying the deduction, the Board stated (p. 1153):

The taxpayer in this appeal alleges that the [debtor] railway company was insolvent; that [the taxpayer] was forced to advance the sums of money in question to pay the interest and sinking-fund requirements of the bonds which it had guaranteed, and is, therefore, entitled to deduct such payments. The Board decided, however, in the Appeal of Winthrop Ames, 1 B.T.A. 63, that advances for operating expenses or advances otherwise made to a corporation and carried as a charge against that corporation without any attempt to liquidate the debtor corporation or otherwise terminate the transaction, may not be charged off as worthless debts or as advances so long as the corporation to which such advances are made continues as an active corporate entity, is not actually adjudged bankrupt, and no effort is made to close or liquidate the account. To the same effect is the Appeal of Steele Cotton Mill Co., 1 B.T.A. 299. [In Ames, the debtor corporation was “a going business unable to meet its current liabilities from liquid assets and indeed not expected to do so.” 1 B.T.A. at 71.]

In our view, PSP would have been precluded, pursuant to the rationale of the Portland Railway case, from deducting its payments on SA & AP’s behalf as worthless debts. And this result would have obtained even accepting the assertions made by PSP in its ruling request concerning PSP’s expectation that it would not secure repayment. Portland Railway, Light & Power Co. v. Commissioner, supra; Ames v. Commissioner, supra; Peabody Coal Co. v. Commissioner, 18 B.T.A. 1081 (1930), affd. 55 F.2d 7 (7th Cir. 1931).60

For these reasons, we have concluded when PSP took the deductions on its tax returns, it did so on the basis that the amounts were allowable either as interest or as operating expenses of PSP’s business.

Since 1913, the Federal income tax statutes have contained provisions allowing for the deduction of interest.61 These similarly worded provisions have consistently been construed from the outset as permitting a taxpayer to deduct only his own interest payments and not interest paid on behalf of another person or entity. See, e.g., Griffin v. Commissioner, 7 B.T.A. 1094 (1927); Colston v. Commissioner, 21 B.T.A. 396, 399 (1930), affd. sub nom. Colston v. Burnet, 59 F.2d 867, 869-870 (D.C. Cir. 1932).

Deductions for interest have been denied even in those cases where the payment was required by virtue of the taxpayer’s status as a guarantor; despite the guarantee arrangement, the taxpayer has not been viewed as paying his own obligation. See Simon v. Commissioner, 36 B.T.A. 184 (1937); Eskimo Pie Corp. v. Commissioner, 4 T.C. 669, 675-676 (1945), affd. per curiam 153 F.2d 301 (3d Cir. 1946); Nelson v. Commissioner, 281 F.2d 1, 4-5 (5th Cir. 1960), affg. T.C. Memo. 1958-179;62 Rushing v. Commissioner, 58 T.C. 996, 999-1000 (1972) (Court-reviewed).63

In the present case, it is stipulated that PSP’s payments of the interest on the SA & AP bonds were not made on PSP’s own obligations; PSP was complying with the requirements of the guarantee arrangement it had with SA & AP. In accordance with the above-cited authority, we conclude that the payments at issue were not properly deductible by PSP as interest.

Nor do we believe the payments made by PSP would have been deductible as operating expenses of PSP’s business. The advances were made with the understanding that SA & AP would be obligated to reimburse PSP. PSP was therefore making nondeductible loans to SA & AP. Glendinning, McLeish & Co. v. Commissioner, 24 B.T.A. 518, 523 (1931), affd. 61 F.2d 950 (2d Cir. 1932); Cochrane v. Commissioner, 23 B.T.A. 202, 207-208 (1931); McMillan v. Commissioner, 14 B.T.A. 1367, 1370-1371 (1929).64

In sum, we conclude PSP was not legally justified in deducting the $4,158,624.87 amount at issue. Therefore, in accordance with the principles set forth in Streckfus Steamers, Inc. v. Commissioner, supra, and Canelo v. Commissioner, supra, the present case does not present a proper instance for the application of the tax benefit rule.65

We decide this issue for petitioner.

III. Deduction of Timber Expenses66

This issue presents the following question for our consideration:

Whether timber expenses incurred by petitioner are expenses of management deductible as ordinary and necessary business expenses under section 162 or whether they are expenses directly related to cutting contracts under section 631(b); and, if the latter, whether such expenses are applied as a reduction of capital gain under the contracts (as reported by petitioner) or as a reduction of petitioner’s ordinary income.

FINDINGS OF FACT

Isstoe (kk)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

Among the assets of the predecessor Southern Pacific Co. received by the former Southern Pacific Co. in the 1947 reincorporation was all of the outstanding stock of the Southern Pacific Land Co. (SPLC).

SPLC had been incorporated under the laws of the State of California on February 1, 1912. In 1912 and in 1930, various predecessors67 of petitioner transferred real property to SPLC. This real property consisted principally of what the companies called “outlying” acreage, i.e., alternate sections of land adjacent to railroad rights-of-way. Much of the land was located in the timber country of northern California and bore timber. During the years at issue (1959, 1960, and 1961), all of the real property held by SPLC was located within the State of California.

From the outset (and continuing through the years at issue), the SPLC lands were managed by the land department of the predecessor Southern Pacific Co. and, subsequently, by the land department of the former Southern Pacific Co.

Between the years 1916 and 1949, the land department was actively engaged in a program of trying to dispose of the acreage owned by SPLC and other land-grant properties under the jurisdiction of the department, including timberlands. During this period, the land department did not permit any timber cutting on the lands under its jurisdiction, and between 1916 and 1949, no cutting leases were executed. Even buyers were not permitted to enter upon the land to cut timber until the contracts were paid in full.

During the period 1912 to 1949, SPLC transferred substantial outlying timberland acreage to outsiders. In 1949, SPLC withdrew from the practice of actively selling its timber holdings, and thereafter, except for isolated accommodation transactions, transfers of outlying timber acreage were made by SPLC only to governmental authorities (Federal, State, or local) or to utilities, under threat of condemnation.

The decision by the land department to withdraw the SPLC properties from sale (and also certain lands of the former Southern Pacific Co.) was made to permit a study of whether such sales should continue or whether a land management program should be commenced.

A preliminary study in 1949 determined that the SPLC timber holdings would benefit by a management program. In 1951, SPLC adopted such a program with respect to its timberlands in Northern California which called for limited cutting of timber on a sustained yield basis. Under this method, old and mature trees are permitted to be cut on a given section of land, but only to the extent they will be replaced by new trees.

The 1951 management program was undertaken to conserve timber, to increase the productivity of the land, to generate income for SPLC from timber sales, and, indirectly, to generate freight revenues for the former Southern Pacific Co. In order to implement this program, the land department employed photo-grammetrists to conduct a timber survey and hired additional graduate foresters and experienced woodsmen.

During 1952, a further study was undertaken to determine the volume of timber on the SPLC lands and to estimate. the allowable annual cut on a sustained yield basis. The study determined that it would take 30 years to achieve removal of all of the old and mature trees, and it was estimated that 64 million board feet could be cut each year (and would be replaced each year).

SPLC adopted this program of cutting timber on a sustained yield basis, and continued it through 1959,1960, and 1961.

Annual timber sales were negotiated for the disposition of the allowable cut (i.e., 64 million board feet per year). These sales resulted in an annual harvesting program which was designed to average the calculated sustained production of the forest properties. The only reasons for exceeding allowable cut were fire damage, storm damage, insect damage, and other miscellaneous causes.

During the years at issue, SPLC held approximately 1,900,000 acres of outlying land in California. Of this land, over 700,000 acres were in the timber country of northern California. This timber acreage had been held essentially intact since 1949. Over half of the acreage was considered to contain merchantable timber of excellent to marginal quality.

During the years at issue, SPLC was operating in its first 30-year cutting cycle, in which overmature trees and trees in danger of death from insects and disease were to be cut. This 30-year period was established because the U.S. Forest Service was operating under a 30-year development program. Because of the checkerboard ownership pattern,68 it was essential for road-planning purposes that SPLC cooperate with the Forest Service.

While the primary purpose of the timber program was the production of income, there were several long-term benefits that accrued from the annual harvesting activity. The harvesting served to regenerate the forest by stimulating growth in the remaining timber stand and it improved the general health of the stand by eliminating trees that were overmature, dying, and subject to insect attack. Fire hazard was reduced by the removal of dead trees.

During 1959,1960, and 1961, a timber sale was commenced in the following manner: Discussions would be held between the chief forester and the district foresters regarding the most appropriate places to have a sale of timber. Relying on the district foresters’ field knowledge of the property and information available from SPLC files, certain locations for timber sales were designated. Thereafter, formal “assignment” letters were sent out to the district directors designating the areas within their districts where cutting contracts should be obtained.

Typically, in a year prior to entering into a contract of sale with a purchaser, SPLC’s headquarters offices in San Francisco would have sent one or more “assignment” letters to its pertinent district, asking the district personnel to cruise and appraise timber on acreage described in the letter according to section, township, and range. This involved reconnaissance, line running, marking, cruising, and appraising, and the results of this activity were rendered in written reports referred to as “timber sale offerings.” These written reports served as the basis for offering specific timber in specific areas and specific prices to customers.69

The field reconnaissance conducted by the district personnel was rather extensive. They would go through an area for the purpose of gaining a general impression of the character of the timber, the topography, the roads, the stand conditions, the status of the section corners, and the accessibility of the timber. Aside from its primary purpose of providing information relative to a sale, a reconnaissance also gave the district forester a knowledge of conditions in the area that would affect its future management. Following the field reconnaissance was line running, involving the surveying of boundary lines. No contracts entered into during the years in issue involved a requirement that the purchaser survey the boundaries of the sales area.

SPLC maintained maps for each township showing land ownership and survey information from SPLC sources and from outside sources like the U.S. Forest Service. Other maps showed what areas had been logged and remained to be logged. As a survey was made in preparation for timber sales, the year of the survey and the points determined by the survey were marked on the township maps.

The timber sale contracts described the land on which timber was to be cut by subdivision, section, township, and range. If property lines were not readily ascertainable from prior surveys, it was necessary at times for SPLC employees to perform extensive surveying to delineate the property boundaries involved in the contracts in order to avoid cutting timber upon adjacent lands. This involved locating the corner points of the original survey on the ground and either running lines between the corners or, where a sale involved an area well within a section, flagging a temporary cutting line. In addition to their use in a sales context, line-running surveys were also useful in preventing trespass upon SPLC lands, in the granting of easements, and in the establishment of the number of productive acres available for purposes of management.

After the survey, the district forester and his assistant would go into the area in which the timber was to be offered for sale and mark with a paint stripe each tree that was to be cut. This marking was a time-consuming process, and it was limited only to those areas where there was a sale in the immediate offing. SPLC chose to be specific about the individual trees it would allow to be cut in order to prevent indiscriminate cutting by purchasers and to assure that the trees left after the cutting would be suitable for future sales of timber. Marking also gave the foresters control over the forest stand that would remain after logging, for management purposes.

Thereafter, an employee would perform a timber cruise (i.e., an onsite examination of timberland) to determine the quantity and quality of the timber to be sold. From an examination of the number, size, species, and quality of the trees to be cut, he estimated the volume of timber on the tract to be cut. The information obtained from a timber cruise was included in a written report.

The report of the timber cruiser generally included data on the volume of trees by species and on the volume of trees anticipated to remain after the sale. It included a map showing existing and proposed roads, and it contained a description of the condition of the boundary references. Also generally contained in the report was information regarding (1) the quality and character of the timber by species, including defects and breakage, (2) the average number of logs per tree, including average diameters, (3) the fire damage to the timber, (4) the status of reproduction in the area, (5) the status of site and soil improvements, (6) the potential inclusion of other SPLC lands in the logging unit, (7) the nature of occupancy on the land, (8) the status of water and minerals, and (9) the potential of the area for recreational use.

On most occasions, a cruise was conducted primarily to gain data pertinent to a sale of timber, although the acquisition of this data produced information which was useful in managing the land. On some occasions, cruises were conducted solely for the purpose of reporting on everything within a given section of land. Such cruises, unrelated to timber sales, produced data that was used primarily for management purposes, and the cost of such cruises is not included in the amounts in issue.

Appraising the timber to be cut was the final step of a district forester in response to the “assignment” letter. He calculated the sales prices by grade, using the Forest Service printed statement of price recovery and overrun percentages. The appraisal was very similar to that which the Forest Service used.70

The district forester forwarded the foregoing information (including the report of the timber cruiser) with his letter of transmittal outlining his plan for the sale to the headquarters office. This information was used to prepare a sales offering.

While appraisals were prepared primarily as part of the contract process, they had incidental uses outside of a sales context. They were used to establish the value of timber at the time of a discovered trespass in collecting from the trespasser. They were used in connection with land condemnation cases. They were used in property tax matters.

Following the cruise and appraisal, the headquarters office would make a proposal to a purchaser. If the proposal was accepted, the contract would be prepared and would be submitted to the purchaser for signature. It would then be submitted to the SPLC board of directors and to the executive committee of the former Southern Pacific Co. for approval. A copy of the contract was then forwarded to the district forester. He had the responsibility to see that its terms were complied with.

During the years at issue, employees of the land department and SPLC tried to negotiate the cutting contracts for a 1-year term but very often made them for a 2-year term (but never more than 2 years). Under extraordinary circumstances, a contract would be extended for another logging season. The usual purchasers of timber were operators who had established mills along the railroad and who, in prior years, had been customers for the purchase of timberland.

After the contract had been executed and the purchaser began cutting timber, employees scaled (i.e., measured the quantity of) the cut timber, determined the volume cut, and transmitted the log-scale books and log-scale journal sheets to the headquarters office. The hours spent scaling were reported when it was necessary to make a computation to determine if the purchaser was to pay the cost of the scaling.

Scaling records have value apart from their principal use in billing the purchaser. They are used in adjusting property tax records, in updating inventories, in checking on the efficiency and the quality of the cruise, and in checking on the efficiency of personnel.

The foresters exercised a great deal of control over the felling of timber by purchasers in order to prevent damage to the remaining stand in both the felling and yarding operations. Yarding is the process of moving fallen logs to the roadside. To control damage caused by yarding, the foresters would locate the skid trails of the hauling machinery and determine whether there was damage to the reserve stand, to young growth, or to the soil. If such damage existed, discussions would be held with the operator of the logging operation for the purpose of minimizing the damage.

After felling and yarding were completed, the purchaser was required to cut water bars or ditches across the skid trails to prevent erosion. In addition, slash disposal by the purchaser (i.e., the cutting of damaged young trees) was required in order to prevent insect buildup and to reduce the fire hazard.

During the years at issue, the forestry activities of reconnaissance line running, marking, cruising, appraising, scaling, and inspection were engaged in primarily because of timber sales arising under the cutting contracts in question. While to some extent a portion of these activities served long-term management goals in addition to their immediate sales-related purpose, the forestry work, to a very substantial degree, would not have been required were it not for an actual or potential contract for sale of timber. The fulfillment of management goals was frequently fortuitous, an incidental benefit which flowed from activities that were necessary for preparing or carrying out specific sales contracts. Essentially, the above-described forestry activities were occasioned by and necessitated by the timber sales, and most of the forestry work at issue fulfilled only sales-related goals. Only a small portion of these activities was totally unrelated to the cutting contracts and served solely a management purpose.

It is stipulated that the SPLC timber sale contracts are predominantly cutting contracts to which section 631(b), I.R.C. 1954, applies. (This section is discussed in our opinion, infra.) The issue presently under discussion involves only such stumpage sale cutting contracts.71

In the consolidated income tax returns filed by the former Southern Pacific Co. and its affiliates for 1959, 1960, and 1961, SPLC reported the following amounts as timber “expenses of sale”:

Year Amount

1959 . $133,487.89

1960 . 261,888.24

1961 . 68,524.61

The foregoing amounts include both (1) expenses incident to sales under cutting contracts to which section 631(b) applies, and (2) expenses not within the scope of section 631(b) (e.g., amounts paid to contractors to log timber for SPLC’s own account, and costs of Christmas tree sales). The latter expenses are stipulated by the parties to be within the purview of section 631(a) and to be deductible as ordinary and necessary business expenses. The present issue involves a controversy only as to the expenses attributable to timber sales qualifying for treatment under section 631(b). The expenses attributed to section 631(a) and section 631(b) during the years-at issue are as follows:

Expenditures Amounts in controversy attributable to attributable to

Year sec. 631(a) sales sec. 631(b) sales

1959 . $67,969.47 $65,518.42

1960 . 237,231.96 24,656.28

1961 . 35,066.84 33,457.77

The gains from the sales under the cutting contracts at issue were reported as section 631(b) capital gains on the tax returns, and the expenses incident to such sales were offset against these gains.72

In the consolidated returns for the years at issue, SPLC reported the following as (1) total quantity of timber sold, expressed in thousands of board feet, (2) gross receipts from total timber sales, and (3) total quantity of timber sold under contracts qualifying for section 631(b) treatment, expressed in thousands of board feet:

Total quantity Gross receipts Sec. 631(b) quantity

1959 90,683 $1,878,720.06 89,000.50

1960 51,181 877,217.16 47,181.18

1961 66,636 1,313,448.61 66,191.00

The amounts set out above under the heading “Expenditures in Controversy Attributable to Sec. 631(b) Sales” are stipulated by the parties to be the amounts at issue herein. To compute these amounts, the total quantity of timber (expressed in thousands of board feet) sold during 1959,1960, and 1961 under section 631(b) contracts was multiplied by a figure representing average cost (per thousand board feet of timber) during each year. The average cost figures which were used for the years at issue are as follows:

Year Average cost per thousand board feet

1959 . $0.71

1960 0.50

1961 0.50

The average cost for 1959 ($0.71 per thousand board feet of timber) was derived by totaling the daily salaries of the employees engaged in activities relating to the section 631(b) timber sales and by multiplying that figure by the estimated total days these employees spent engaged in the activities of cruising, appraising, marking, scaling, and inspection. The figure thus obtained was divided by the total quantity of board feet of timber scaled during 1959. In this manner, a cost of $0.71 per thousand board feet cut was calculated for that year.73

The average cost for 1960 and 1961 ($0.50 per thousand board feet of timber) was derived from the 1959 computation above, except that work days relating to the inspection function were eliminated from the calculation.74

The petition filed in this case claims, inter alia, an overpayment of tax due to “Commissioner’s failure to allow claims for deduction of costs of cruising, marking, and other expenses in connection with timber.” In this regard, the petition states:

(1) For each of the taxable years ended December 31,1959,1960 and 1961, Southern Pacific Land Company incurred expenses in cruising and marking timber and other activity pertaining to its standing timber.

(2) In the consolidated returns for the taxable years ended December 31, 1959,1960 and 1961, Southern Pacific Land Company inadvertently treated the foregoing as expenses incident to sale of timber pursuant to cutting contracts and offset them against section 631(b) capital gains.

(3) On audit certain adjustments were made, but the Commissioner’s agents erroneously continued to treat amounts of $65,518.42, $24,656.28, and $33,457.77 as such sales expenses to be offset against section 631(b) capital gains for the taxable years ended December 31, 1959, 1960 and 1961, respectively.

(4) The Commissioner has failed to allow claims by Southern Pacific Land Company for deduction of the foregoing amounts as ordinary and necessary business expenses for the taxable years ended December 31, 1959, 1960 and 1961.

OPINION

Issue (kk)

During the years 1959, 1960, and 1961, petitioner75 received proceeds of sales under cutting contracts falling within the purview of section 631(b). That section, in the circumstances therein specified, provides for capital gains treatment of the proceeds from the disposal of timber of certain cutting contracts with a retained economic interest.76 See sec. 1.631-2(a)(2), Income Tax Regs. Also during 1959, 1960, and 1961, petitioner incurred expenses in the form of salaries for forestry work performed by its employees.

As a general rule, “ordinary and necessary expenses” of a taxpayer’s business are deductible under section 162. However, even if related to a business, such expenses are treated as capital expenditures when they are incurred in the acquisition or disposition of a capital asset. Capital expenditures “are added to the basis of the capital asset with respect to which they are incurred, and are taken into account for tax purposes either through depreciation or by reducing the capital gain (or increasing the loss) when the asset is sold.” Woodward v. Commissioner, 397 U.S. 572, 574-575 (1970).

Thus, if the forestry expenses at issue in the present case were incurred in connection with a timber transaction described in section 631(b),77 the provisions of section 162 will not apply. Instead, the expenses will be viewed either as additions to basis78 or as selling expenses applied in reduction of the amount realized on the sale.79 Clearly, the expenses will not be currently deductible. Woodward v. Commissioner, supra.80

Petitioner’s position is that the forestry activities were not directly related to the sales of timber but were primarily directed at carrying out its timber management program, even though some of the activities may have had some incidental connection with the sales of timber. Accordingly, petitioner contends that the full amount of the salaries paid for forestry work is deductible against ordinary income as a section 162 business expense. Respondent’s position is that the allocated expenses here involved are directly related to the sales of timber under section 631(b) and must be offset against the price received for the timber, thus reducing the capital gain realized on the disposal of the timber.

Respondent’s position, herein, follows the one taken by him in Rev. Rul. 71-334,1971-2 C.B. 248, dealing with expenses directly related to timber disposals under section 631(b), and in Rev. Rul. 58-266, 1958-1 C.B. 520, dealing with expenses directly related to disposals under the predecessor of section 631(b), section 117(k)(2) of the 1939 Code. Both of these rulings conclude that direct expenditures are to be applied as offsets to the capital gains from such disposals.

Rev. Rul. 71-334 provides in part:

In connection with a disposal of timber, so as to produce the maximum income therefrom, the taxpayer expended certain amounts directly attributable to the disposal for:

(1) advertising the timber for disposal;

(2) cruising to determine the quantity and quality of timber to be disposed of;

(3) marking or otherwise designating the timber for cutting;

(4) marking seed trees to be retained;

(5) scaling, measuring, or otherwise determining the quantity of timber cut;

(6) fees paid to consulting foresters, selling agents, and others for services directly related to the timber disposal;

(7) supervising or checking performance under the contract; and

(8) other expenses directly attributable to the disposal.

*******

It has been the consistent position of the Internal Revenue Service, in connection with transactions qualifying for capital gain or loss treatment, that selling expenses are treated as an offset to the selling price. [Citations omitted.] Since the selling expenses in a sale of a capital asset are considered in arriving at income subject to a capital gain tax, it is reasonable to give like consideration to direct expenses in connection with income from leases. * * * *******

* * * it is held that expenditures directly attributable to a disposal of timber subject to the provisions of section 631(b) of the Codé are reductions of the “amount received” for the purpose of computing gain or loss from such disposal.

On the question of whether or not an expenditure is directly-related to a timber cutting contract, Rev. Rui. 71-334 provides:

Whether any expenditure is directly attributable to a disposal of timber is to be determined largely on the strength or persuasiveness of the facts of each particular case and how closely related are the activities in connection with which the expenditure is incurred to the disposal of the timber.

Respondent argues the evidence establishes that a substantial portion of forestry activity was directly attributable to the disposal of timber under the cutting contracts. While respondent seems to admit that some portion of the salaries at issue were paid for work that was management oriented, he contends that petitioner expended not less than the stipulated amounts ($65,518.42 in 1959, $24,656.28 in 1960, and $33,457.77 in 1961) on activities that were directly related to the section 631(b) contracts. Accordingly, respondent concludes that no portion of these amounts is deductible as a management expense.

Petitioner views the evidence as showing the forestry activities to be primarily management oriented and only incidentally related to sales. In this regard, petitioner believes the instant case is similar to Union Bag-Camp Paper Corp. v. United States, 163 Ct. Cl. 525, 325 F.2d 730 (1963).81 There the Government argued that, to the extent of 5 percent of the total cutting contract receipts in that case, the taxpayer’s expenses were to be applied to offset capital gains from the disposition of timber. In refusing to accept the Government’s allocation, the court stated (163 Ct. Cl. at 545, 325 F.2d at 741):

The record shows that during 1949 plaintiff’s [taxpayer’s] employees did spend a small part of their time negotiating sales prices for cutting contracts, designating areas to be cut, marking certain trees to be left standing, making casual checks as to quantities of timber cut, and occasionally inspecting the areas involved after cutting had been completed. * * * The record further shows, however, that the foregoing activities were only incidental to overall forest management activities, and that, even the complete elimination of the contract activities would have affected total management expenses in nominal amounts. * * *

In Union Bag-Camp Paper Corp v. United States, supra, the facts were quite different from those we have found here. In that case, the taxpayer had acquired timberlands solely for the purpose of assuring itself of a constant source of its raw material, woodpulp. The expenses of negotiating and supervising cutting contracts were only a nominal portion of its overall forest management expenses which were in issue, and the sale of timber under cutting contracts was only incidental to the primary purpose for acquiring and managing timberlands. In this case, SPLC had been in the business of selling its timber-lands outright until it realized that it would be more efficient and profitable to sell the timber through cutting contracts. Selling timber at a profit was SPLC’s principal objective. As can be seen from our extensive findings relating to the reconnaissance, line-running, marking, cruising, appraising, scaling, and inspection activities, the evidence of record demonstrates that basically these forestry activities resulted from and were in furtherance of the disposal of timber under section 631(b) cutting contracts. While to some extent a portion of these activities served long-term management goals in addition to their immediate sales-related purpose, the forestry work, to a very substantial degree, would not have been required were it not for an actual or potential contract for the sale of timber. In this respect, the instant case is distinguishable, as well, from Wilmington Trust Co. v. United, States, 221 Ct. Cl._, 610 F.2d 703 (1979), a more recent opinion of the Court of Claims touching upon this question.

In contrast to the Union Bag and Wilmington Trust cases, the forestry activities at issue in the case at bar were engaged in primarily because of the timber sales, and in most instances, the fulfillment of management goals was merely an incidental benefit of such activities. Here, as our findings indicate, the major portion of the forestry salaries was paid for work that had an immediate connection with, and bore a close, casual, and proximate relationship to, the section 631(b) timber disposals. We therefore view such expenditures as directly related to the timber sales and as coming within the purview of Rev. Rui. 71-334.

Further, we agree with respondent that petitioner expended not less than the stipulated amounts for this purpose. The amounts stipulated to be at issue for the years 1959, 1960, and 1961, are, respectively, $65,518.42, $24,656.28, and $33,457.77. These figures were calculated by multiplying the total quantity of timber SPLC sold in each year under section 631(b) contracts by an average cost. As shown by our findings, the average cost figure in each year was based on the total number of days SPLC’s forestry employees engaged, during 1959, in the specific activities of cruising, appraising, marking, and scaling. The 1959 average cost figure also took into account the days spent in the inspection function. The evidence does not establish that time spent in other activities relating to the section 631(b) contracts, i.e., reconnaissance and line running (and in 1960 and 1961, inspection), entered into the computation of average cost.

The record does not apprise us with precision of the extent to which, under section 631(b), all forestry functions served a sales purpose and the extent to which they did not.82 Nevertheless, it is clear that these functions served such a sales purpose to a very substantial degree. For this reason and for the reason that time spent by employees in significant activity related to the cutting contracts was not considered in computing the dollar amounts set out above, we are of the opinion, based on all the evidence before us, that these stipulated figures reflect no less than the minimum amount spent by petitioner on salaries for work occasioned by the section 631(b) timber sales.

Petitioner adopted the formula discussed herein for the purpose of attributing portions of the total forestry salaries to activities directly related to the section 631(b) contracts and, by necessary implication, to attribute the remainder of the salaries to activities not so related. In using this formula (regardless of where it originated), petitioner has adopted a method of allocation which petitioner cannot now repudiate without establishing it to be unreasonable and erroneous. The evidence of record does not do so, and we must hold petitioner to the allocation method it employed.

Under Rev. Rui. 71-334, the stipulated amounts, reflecting those forestry salaries directly attributable to disposals of timber under section 631(b), are properly offset against the gain from such disposals.

Petitioner makes the additional argument that the timber sales, themselves, were a management tool and, therefore, that even sales-related expenditures should be deductible under section 162. We cannot agree. It seems clear to us that the timber sales were conducted for the sales revenue they produced for SPLC and indirectly for the freight revenues produced for the former Southern Pacific Co. All sales-related activity was directed at consummating sales of timber and not at achieving some obscure management goal. The fact that some portion of petitioner’s forestry activities was incidently related to management does not convert the timber sales into a management activity.

In support of its position, petitioner cites Alabama Mineral Land Co. v. Commissioner, 28 B.T.A. 586 (1933). That case involved the deduction of cruising expenses as ordinary and necessary business expenses by a trader in timber and timber-lands. We regard that case as having limited precedential value because it predates the statute at issue and does not involve sales which are related to cutting contracts, as does the case at bar. Petitioner also regards the Union Bag opinion as supportive of its position, but for the reasons given above (and for the reasons given subsequently in this opinion), we find that case not to be controlling. Other authority and evidence cited by petitioner are not adequate to convince us that the sales at issue herein were primarily a management tool and that expenses attributable to such sales are thereby deductible under section 162.

Petitioner would have us conclude that Rev. Rul. 713-334 and Rev. Rul. 58-266 are not accurate reflections of' the law. Petitioner makes reference to congressional committee reports associated with the Revenue Act of 1954 and argues that these reports are in conflict with the position adopted by the respondent in his rulings. Petitioner asserts that these reports support its view that, even where expenditures are directly attributable to the disposal of timber under the provisions of section 631(b), they are deductible against ordinary income and are not in any way to be applied as a reduction of the capital gains from such disposal.

We have carefully considered the pertinent legislative history. See H. Rept. 1337, 83d Cong., 2d Sess. 59, A67 (1954); S. Rept. 1622, 83d Cong., 2d Sess. 229, 337 (1954); H. Rept. 2543, 83d Cong., 2d Sess. 33 (1954). While language can be found in those reports which would tend to support petitioner’s argument, the legislation which was being considered did not deal directly with the deductibility of the expenses associated with timber contracts as “ordinary and necessary expenses” under section 162. As a result, the reports have little significance in the present circumstances and clearly do not stand as authority for the proposition petitioner advances.

More importantly, the reports seem to be concerned with expenses which differ, for the most part, from the forestry expenses at issue herein. The reports discuss property taxes, insurance costs, costs of administering timber leases, costs of timber measurement, and interest on loans attributable to timber. The reports do not seem to be dealing with expenses, such as we are concerned with here, which are directly related to and occasioned by the specific disposals of timber to which the statute is directed. Many of the expenses discussed in the committee reports are of the type that usually are deductible from ordinary income by any taxpayer regardless of the context in which incurred (such as interest and property taxes). Other expenses dealt with in the reports which might have a sales connotation (such as the costs of timber measurement) are of the type that usually would have been deductible from ordinary income prior to the enactment of section 117(k)(2) because the gains from timber disposals had previously been taxed at ordinary rates. We believe the committee reports are concerned with preserving for the owners of timberlands the right to deduct as ordinary expenses such expenses as are not directly related to the timber disposals covered by the statute. We do not read the reports as suggestive of an intent to preserve as deductions from ordinary income those expenses which are directly related to the specific transactions being accorded capital gains treatment under the Code.

We do not agree with petitioner that the committee reports are supportive of its position, and we do not believe an extended law review article discussion of our reasoning is either necessary or justified in this lengthy opinion.

We conclude that, under the relevant case authority, petitioner is required to treat its forestry expenses as a reduction of its gains under the cutting contracts and not as a reduction of its ordinary income. This conclusion finds support in a decision of the Court of Appeals for the Ninth Circuit (to which an appeal in this case would normally lie). See United States v. Regan, 410 F.2d 744 (9th Cir. 1969), cert. denied 396 U.S. 834 (1969), a case involving section 631(b). There, the court held that expenses “directly related to the acquisition and disposal of timber” pursuant to a contract to which section 631(b) applies are required by the Code to be added to basis.

The pertinent statutory language found in section 631(b) is as follows:

the difference between the amount realized from the disposal of such timber and the adjusted depletion basis thereof, shall be considered as though it were a gain or loss, as the case may be, on the sale of such timber. [Emphasis added.]

As to the meaning of “adjusted depletion basis,” section 612 provides:

the basis on which depletion is to be allowed in respect of any property shall be the adjusted basis provided in section 1011 * * *

In section 1011, the following language appears:

The adjusted basis for determining the gain or loss from the sale or other disposition of property, whenever acquired, shall be the basis (determined under section 1012 * * * ), adjusted as provided in section 1016.

Section 1016, entitled “Adjustments to Basis,” states:

Proper adjustment in respect of the property shall in all cases be made * * * for expenditures * * * properly chargeable to capital account * * *

After reviewing these provisions of the Code, the Court of Appeals in United States v. Regan, supra, concluded that “when all of the pieces are pasted together, we can see that section 631(b) contains a direction to include capital expenses as an addition to the cost of the timber to reach ‘adjusted depletion basis.’ ” 410 F.2d at 746. To a similar effect, regarding the term “adjusted depletion basis” in section 631(c), see our recent opinion in Davis v. Commissioner, 74 T.C. 881 (1980) (Court-reviewed).83

Other cases, decided before Regan, ostensibly support petitioner’s position. None of these cases, however, gives any consideration to the term “adjusted depletion basis” appearing in section 631(b) (and in its predecessor section under the 1939 Code). See, e.g., Union Bag-Camp Paper Corp. v. United States, 163 Ct. Cl. 525, 325 F.2d 730 (1963); Drey v. United States, an unreported opinion (E.D. Mo. 1960, 7 AFTR 2d 333, 61-1 USTC par. 9116); Ransburg v. United States, 281 F. Supp. 324 (S.D. Ind. 1967). In Regan, the Court of Appeals expressly took issue with the Court of Claims’ conclusion in the Union Bag case that section 631(b) did not require the offsetting of related expenses. Regan called this conclusion “dicta,” and stated that it was “not persuaded, as was the Court of Claims, that Congress intended to give timber cutters a tax bonanza instead of a capital gains benefit.” 410 F.2d at 746. In a later case, Casey v. United States, 198 Ct. Cl. 232, 459 F.2d 495 (1972), the Court of Claims agreed with the approach adopted by the Ninth Circuit, in a case which presented the same facts as Regan.84

We agree with the view expressed in the Regan opinion that the Union Bag case incorrectly concluded that expenses directly related to a section 631(b) transaction are deductible under section 162. Cf. Davis v. Commissioner, supra. We note that recently the Court of Claims turned down an opportunity to reaffirm that position. See Wilmington Trust Co. v. United States, supra.85

Accordingly, we hold that an offset against capital gains is necessary here. It is not critical for our present purposes to determine whether the expenses at issue should be viewed as additions to basis (like the expenses in Regan and Davis) or as selling expenses to be applied in reduction of the proceeds of the section 631(b) cutting contracts (like the expenses in Rev. Rul. 71-334).86 On the facts of this case, the result would be the same. What is significant is that there is clearly no justification for applying these expenses in reduction of petitioner’s ordinary income.

Consistent with the foregoing discussion, we conclude and hold that petitioner must apply the respective amounts of $65,518.42, $24,656.28, and $33,457.77, during the years 1959, 1960, and 1961, to offset its capital gains under the section 631(b) cutting contracts.

We decide this issue for respondent.

IV. Deductions Involving Houston Depot87

This issue presents the following questions for our consideration:

Whether, as a result of a transaction involving the sale of certain property to the United States in 1959:

(a) Petitioner may deduct the adjusted basis of its Houston depot under section 165 or section 167; or

(b) Petitioner may deduct the fair market value of its Houston depot as a charitable contribution under section 170.

FINDINGS OF FACT

Issues (w) and (x)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

In March 1958, the Texas & New Orleans Railroad Co. (T & NO)88 owned a contiguous parcel of land in Houston, Tex., consisting of 31.701 acres. A railroad passenger station and related facilities known as the Grand Central Passenger Station had been constructed on the 31.701-acre parcel and opened for use on September 1, 1934. The multistory station building also contained office space used by the T & NO. (The said station building and related facilities are hereinafter sometimes referred to as the “Houston depot” or as the “improvements.”)

In March of 1958, at the request of the U.S. Post Office Department (hereinafter sometimes referred to as Post Office), negotiations commenced between officials of the Post Office and officers of the T & NO with respect to possible acquisition by the Post Office of a portion of the 31.701 acres.

The Post Office Department was considering the construction of new mail-handling facilities in Houston. It had already purchased large parcels of property in the vicinity of the Houston depot and had constructed a two-story masonry structure adjacent to it for handling parcel post.

In March of 1958 at a meeting in the offices of the Houston postmaster, T & NO officials were advised that the Post Office was considering the construction of additional mail-handling facilities in the area of the Houston depot. The T & NO officials indicated that the depot site might be available. Railroad passenger traffic had declined since the passenger station was opened in 1934, and the depot building was larger in size than was needed for passenger traffic in 1958.89 While some of the property on the depot site was vital to railroad operations, the T & NO officials believed the depot and the underlying land could be sold if a satisfactory price and other terms could be arranged and if substitute facilities were provided.

The Post Office Department initially expressed interest in purchasing from the T & NO a 14.58-acre parcel of this property, including the passenger station and related facilities situated thereon. The Post Office Department had no use for these facilities and it was its intention to demolish them in order to build a postal facility. The representatives of the T & NO were made aware of this fact.

After preliminary investigation, including the obtaining of appraisals by both parties, the representatives of the T & NO and the Post Office began negotiations relating to the sale of the 14.58-acre parcel by the T & NO to the Post Office. While the appraisers differed somewhat in their approaches to the problem and the appraised values varied to some extent, the appraisers of both parties suggested a value for the 14.58-acre parcel and the improvements thereon of somewhere in the vicinity of $3 million.

In preliminary negotiations, the T & NO quoted to the Post Office a price of approximately $3 million for the 14.58-acre parcel, including the improvements. In light of this price, the Post Office reassessed its needs and determined that its requirements might be reduced from 14.58 acres to 10.66 acres.

At a meeting held between T & NO and Post Office representatives on August 6, 1958, the Post Office representatives informed the T & NO that they were interested in only 10.66 acres of the T & NO property and that the improvements then on the property were without value to the Post Office. At this meeting, the representatives of the T & NO were informed that the Post Office would be willing to spend something over a million dollars for the 10.66-acre tract, as well as provide new passenger and division office facilities for the T & NO and severance damages on the remaining property, but that the Post Office would not pay anything for the depot building. The Post Office was willing, however, to take the depot with the property on the assumption that the salvage would offset the cost of wrecking, or to give the T & NO the option of demolishing the building and delivering to the Post Office the cleared property.

Upon deliberation, the T & NO reassessed its position and determined to make a counteroffer to the Post Office in the amount of $2,122,000. This counteroffer was presented to the Post Office representatives by the representatives of the T & NO at a meeting in Washington on November 4, 1958. At that meeting, the Government officials advised that, while the appraisals of both parties were close, the Post Office could not spend $2,122,000 for a Houston site and had only $1,600,000 for that purpose. The parties understood that the Post Office did not want, and would pay nothing for, the depot. T & NO was informed that the Post Office would also not be able to provide a replacement railroad station. The T & NO officials were asked to consider this new proposal. Although disappointed, the T & NO officials decided on the next day to advise the Post Office Department of their willingness to accept the $1,600,000.90

Also on the following day, the Post Office Department wrote to the T & NO that “unless you are willing to negotiate further within the next three weeks and to agree on a price commensurate with fair market value for the sale of [the 10.66 acres at the depot site] to the Government, it will be necessary for this Department to institute condemnation against your property for the purpose of acquisition.” The reason for the writing of this letter is not clear, although it apparently was not written at T & NO’s request.

On November 14, 1958, T & NO, “in recognition of the Post Office Department’s right of eminent domain as referred to in [the] letter of November 5,” advised the Post Office by letter that T & NO would enter into a sales contract with the Post Office Department under which the 10.66-acre tract of land in question would be conveyed to the Post Office in consideration of payment by the Post Office of $1,115,000 for the land being taken, and of $485,000 for severance damages to the adjacent land. The sales contract would have to contain a number of provisions, including:

1. Land (passenger station and division office building to be abandoned by Railroad in place and with no value recognized by Post Office Department) to be conveyed * * * . Railroad reserves the right to demolish the passenger station and division office building and recover the salvage if it elects to do so.

At that time, T & NO officials anticipated that there would be no taxable gain as a result of the sale and expected that they would be entitled to a deduction for an abandonment loss. In their inter sese communications regarding the negotiations, they used a figure of approximately $236,000 as the tax benefit from a deduction of the $455,000 depreciated value of the building as an abandonment loss.

The Post Office Department, in a letter dated November 24, 1958, stated it would prepare formal contracts embodying the terms of sale in T & NO’s November 14, 1958, letter. The Post Office Department subsequently submitted a proposed agreement, and the parties negotiated certain modifications. One change involved the deletion of a provision calling for the sale of “buildings and improvements.”

On May 14,1959, the T & NO and the Post Office Department, in the name of the United States of America, entered into an agreement of sale, which, among other things, at paragraph 9 provided:

9. This sale does not cover any of the buildings or other improvements upon the property described in section 1 hereof, and Seller reserves the right, subject to the conditions hereinafter specified, to demolish or remove all or any part of said buildings and other improvements. Seller shall remove from the premises on or before November 30, 1959, all railroad trackage, umbrella-type train sheds, concourse enclosures, auxiliary buildings, and furniture and air-conditioning equipment in the passenger station and division office building now located on the premises to be conveyed. Seller will lose the right to remove or demolish all other buildings and improvements, or parts thereof, upon the aforesaid premises if it does not notify the Government on or before August 1, 1959 which buildings, improvements, or parts thereof, it intends to demolish or remove, and if it does not thereafter complete the removal and demolition of said buildings, improvements, or parts thereof, included within the notice, plus the resulting debris, from the site on or before the possession date of November 30, 1959. * * * Any buildings or improvements on the property which seller does not elect to remove and the removal of which is not completed within the time specified above, shall automatically revert to the Government and shall be the absolute property of the Government, and the Government shall be free to remove said buildings or improvements, at its own expense, or otherwise use or dipose of them as it deems fit.

The agreement further provided in part:

2. The price is one million six hundred thousand dollars ($1,600,000), covering both the land conveyed and damages to the remaining land of Seller, * * *

T & NO had not contemplated replacement of the Houston depot until the Post Office opened negotiations for the purchase of the property under discussion. A passenger facility of some sort was essential to T & NO’s business in Houston during the period here in question. T & NO gave consideration to joining other railroads in using the Union Depot in Houston but could not make satisfactory arrangements. T & NO thereupon began construction of a new railroad station to replace the Houston depot. The substitute station was built one block west of the Houston depot at an overall cost of $241,389.31 and was a single-story structure containing 2,950 square feet of space as compared with the Houston depot’s 63,775 square feet.91

On July 23,1959,92 T & NO wrote the Post Office Department, as follows:

Under provisions of Article 9 of Agreement of Sale covering acquisition by Post Office Department of portion of Southern Pacific’s passenger station property at Houston, it is required that notice be given to the Department on or before August 1,1959, with respect to any buildings, improvements, or parts thereof now existing within the limits of the property to be acquired by the Department which Southern Pacific wishes to remove for its account prior to possession date of November 30,1959.

After full consideration, determination has been made that Southern Pacific does not desire to remove for its account any buildings or other improvements on the site beyond those items specifically enumerated in Article 9; namely, all railroad trackage, umbrella type train sheds, concourse enclosures, auxiliary buildings (of which there are none), and furniture and air-conditioning equipment in the main passenger station building. * * *

The T & NO did not remove the improvements on the property other than those above enumerated because the cost of demolition would have exceeded the salvage value of the improvements.

By deed dated September 28,1959, the Texas & New Orleans Railroad Co. conveyed the 10.66 acres to the United States of America for and on behalf of the Post Office Department.93 The deed included among its recitals a provision similar to paragraph 9 of the agreement of sale quoted above.

In accordance with the requirements of the agreement of sale and the deed, the Post Office Department, in 1959, paid to the Texas & New Orleans Railroad Co. $1,600,000. Payment was made in the following manner: $160,000 on May 26, 1959, and $1,440,000 at the closing on September 30,1959. Of this amount, $485,000 was treated by the T & NO as severance damages to its remaining acreage.94 T & NO treated the remaining $1,115,000 as received for the sale of land only, reporting no gain or loss.95 T & NO incurred selling expenses of $7,794.65.

The sale transaction under discussion herein was negotiated by the parties at arm’s length. The officials of the Post Office Department and of the T & NO agreed to a sale of the 10.66 acres for a price which both parties agreed was fair for the underlying land alone. The Post Office acquired this parcel in order to have postal facilities constructed thereon. It had no use for the existing improvements (the Houston depot). The United States Government paid for neither the improvements on the 10.66 acres nor the substitute passenger station.

As of the date of the sale of the 10.66 acres to the United States in 1959, only 25 years had expired of the estimated 60-year useful life of the Houston depot.

Shortly after the surrender of possession of the property by the T & NO on or about November 30, 1959, the Post Office caused the remaining improvements (the Houston depot) to be entirely removed by demolition in order to permit construction of the postal facilities.96

The Texas & New Orleans Railroad Co. claimed an ordinary deduction of $389,246.13 in the consolidated return filed by the former Southern Pacific Co. affiliated group for the year 1959, which amount was at that time thought, on the basis of preliminary data, to be the adjusted basis of the improvements on the 10.66 acres which remained when possession was given to the Post Office. This deduction was claimed on a schedule headed “Texas and New Orleans Railroad Company — Special Obsolescence Losses Year 1959 of Depreciable Property Included in Depreciation Reserve for Accounting Purposes,” and was specifically identified as “Retire passenger depot and appurtenances. Depot site sold to U.S. Post Office Department.” Because for book purposes all retirements of roadway properties are charged to the depreciation reserve, this deduction was also shown in the Schedule M reconciliation of tax accounting with book accounting as “unusual road property retirement.”

For the purposes of this issue, the parties have stipulated that the cost of construction of the portion of the Houston depot facilities which remained on the 10.66-acre parcel conveyed to the U.S. Government when possession was given to the Post Office Department was $661,715.51 and that the adjusted basis of those facilities is $481,497.88. The adjusted basis of those improvements which were removed prior to the transfer of possession of the 10.66 acres to the Post Office is not included in the $481,497.88 figure.97

In his statutory notice, respondent denied the claimed retirement deduction. It is the respondent’s position herein that the Texas & New Orleans Railroad Co. was entitled to a loss under section 1231 of the Internal Revenue Code of 1954 of $200,560.75, computed as follows:

Consideration received by T & NO . $1,115,000.00

Less: Expenses of sale . 7,794.65

Net consideration received . 1,107,205.35

Basis of land .$826,268.22

Adjusted basis of improvements . 481,497.88 1,307,766.10

Loss . (200,560.75)

OPINION

Issues (w) and (x)

In 1958, petitioner98 was approached by the Post Office Department which was looking for land on which to build a mail-handling facility in the area of petitioner’s Houston depot. Petitioner expressed a willingness to sell the needed property, and extensive negotiations followed. Petitioner was willing to give up the Houston depot property, including the depot facility, itself, since petitioner’s diminishing passenger business at that time obviated the need for a large passenger station. The Post Office, however, did not want to acquire the depot and declined to pay for it or for a substitute passenger facility. Ultimately, as detailed in our findings, the parties entered into an arm’s-length sales transaction, and petitioner moved its passenger operations from the Houston depot to a new passenger station which it had constructed. The land was sold to the Post Office with the depot still on it; the Post Office immediately demolished the building.

Petitioner claims that, as a result of this transaction, it retired the Houston depot and is therefore entitled to a deduction under the provisions'of section 1.167(a)-8, Income Tax Regs.99

There can be no doubt that petitioner did retire the depot in the sense that there was a “permanent withdrawal of deprecia-ble property from use in the trade or business.” Sec. 1.167(a)-8(a). The question before us relates to the tax consequences which flow from that retirement. The resolution of this question turns on the manner in which the retirement was effected. Under section 1.167(a)-8, an asset can be retired by selling it (sec. 1.167(a)-8(a)(l)), exchanging it (sec. 1.167(a)-8(a)(2)), or abandoning it (sec. 1.167(a)-8(a)(4)).100

Petitioner seeks herein to obtain an ordinary deduction pursuant to section 1.167(a)-8, Income Tax Regs., for its adjusted basis in the retired depot.101 A deduction of that nature on the facts before us is available to petitioner only if it can show an abandonment, as that term is used in section 1.167(a)-8(a)(4). Under the sale and the exchange provisions above cited, the adjusted basis is applied in a manner which would preclude the taking of the sought ordinary deduction.102

Petitioner has not established that it is entitled to an ordinary abandonment loss deduction.103 The law is now clear that, when a taxpayer parts with improvements to real estate in connection with the sale of the underlying land, the taxpayer is not entitled to deduct the adjusted basis of the improvements as an ordinary abandonment loss unless he can establish that he reached a decision to abandon the improvements independently of, and not as an integral part of, the sale of the land. Fox v. Commissioner, 50 T.C. 813 (1968), affd. per curiam in an unreported order (9th Cir. 1970). See also Standard Linen Service, Inc v. Commissioner, 33 T.C. 1 (1959); Simmons Mill & Lumber Co. v. Commissioner, T.C. Memo. 1963-185. Compare Storz v. Commissioner, 68 T.C. 84, 97-98 (1977), revd. on another issue 583 F.2d 972 (8th Cir. 1978); Reeder v. Commissioner, T.C. Memo. 1980-165; Tanforan Co. v. United States, 313 F. Supp. 796 (N.D. Cal. 1970), affd. 462 F.2d 605 (9th Cir. 1972); cf. United California Bank v. Commissioner, 41 T.C. 437 (1964), affd. per curiam 340 F.2d 320 (9th Cir. 1965).104

A taxpayer may not take an ordinary abandonment loss deduction where his decision to abandon improvements is arrived at because of his decision to sell the underlying land. When an abandoment is motivated by an offer to purchase, the relationship of the claimed abandonment to the sale precludes an ordinary loss deduction. Fox v. Commissioner, supra. Cf. Standard Linen Service, Inc. v. Commissioner, supra; Simmons Mill & Lumber Co. v. Commissioner, supra. On the other hand, where the decision to abandon is arrived at for reasons unconnected with the sale, an ordinary deduction may be taken. Reeder v. Commissioner, supra. Cf. Storz v. Commissioner, supra.

Our findings show that the retirement of the. .Houston depot was not an isolated act that occurred independently of the sale. It was the offer to purchase the underlying land which motivated petitioner to decide that the depot would no longer be used in its business and should be retired from such use. While the evidence of record shows diminishing use of that facility by petitioner and by the public, and suggests that a depot, in that form, was no longer needed in petitioner’s business operations, it was not.until the Post Office began its efforts to buy the property that petitioner decided it would terminate its operations at the depot. We believe it is quite clear on this record that the retirement of the Houston depot was motivated by the offers made by the Post Office and would not have occurred had it not been for the sale transaction.

It is not necessary for us to decide the difficult question of whether the Post Office actually purchased the Houston depot when it acquired the underlying land. Pursuant to the principles outlined in the Fox case, it is possible to view improvements as having been disposed of as an integral part of the sale of the underlying land even where the improvements are technically not included in the sale transaction. Cf. Simmons Mill & Lumber Co. v. Commissioner, supra.

In Fox, the taxpayers entered into an option agreement with a buyer for the sale of improved land owned by the taxpayer. The buyer did not want the improvements and would have paid the same price for the land with or without them. While the form contract executed by the parties contained a reference to the purchase of improvements, a rider specifically permitted the taxpayers to “remove any or all improvements or salvage from the property.” 50 T.C. at 815. Although the taxpayers had the intention initially of moving the improvements, it became apparent, after the buyer exercised the option, that it would be too expensive to do so. As a result, the improvements were not removed by the taxpayers, and they claimed an abandonment loss in the amount of the unrecovered basis of the improvements (less certain salvage).

Although the claimed abandonment in Fox appeared on its face to be an integral part of the sale, the taxpayers argued that, at the time of the sale of the underlying land, they intended to utilize the improvements and their decision to abandon them was reached subsequent to, and independently of, the sale of the land. We acknowledged in our opinion that, even on those occasions when “the sale of the underlying property may be the generating force for a taxpayer’s determination as to what to do with the improvements,” a taxpayer may still be entitled to an ordinary loss deduction where he can show that, “at the time the transaction which resulted in the alleged abandonment took place,” his “state of mind” was such that he had a “fixed and meaningful intent to utilize” the improvements and that “there was a reasonable likelihood that such utilization would occur.” Fox v. Commissioner, supra at 818-819.

The taxpayers in the Fox case did not have the requisite intent to utilize the improvements and, as a result, could not take an ordinary loss deduction. We concluded that the unrecovered basis of the improvements should be considered only as an adjustment to the price paid by the buyer, thereby reducing the taxpayers’ gain on the sale.

The facts of the present case are similar to those of the Fox case in all significant respects. Here, as in Fox, the buyer sought to purchase only the underlying land and did not want, and was unwilling to pay for, the improvements. Petitioner, like the taxpayers in Fox, in consummating the sale, retained the right to remove the improvements at issue but did nót do so. The evidence of record in this case does not show that petitioner had any intention of utilizing the depot at the time of the sale. Instead, in view of the fact that petitioner was planning to use a replacement facility, the evidence clearly establishes a contrary intent.105

Petitioner has attempted to distinguish Fox on small factual points which do not appear to be of controlling significance. We do not regard the facts of this case as sufficiently different from those of the Fox case to warrant a different conclusion.106

We hold that petitioner retired the Houston depot as an integral part of a sale transaction and that, pursuant to the holding of this Court in the Fox case, the adjusted basis of the depot must be added to the adjusted basis of the property sold to determine petitioner’s gain or loss on the sale. Cf. Standard Linen Service, Inc. v. Commissioner, 33 T.C. at 18.

Accordingly, we agree with respondent’s position that petitioner is not entitled to an ordinary abandonment loss but is entitled to a loss under section 1231 in the amount of $200,560.75.107

For the first time on brief, petitioner makes the additional argument that it may take the sought deduction as an obsolescence adjustment to remaining useful life. Petitioner’s contentions in this regard are apparently based on sections 1.167(a)-9 and 1.167(a)-l(b), Income Tax Regs. Petitioner did not raise this matter in its pleadings nor did it address this question at trial, and neither the Court nor respondent was aware that this argument would be made. Under these circumstances, we are inclined to view the matter as not being properly before us. Estate of Horvath v. Commissioner, 59 T.C. 551, 555-557 (1973).

Even if we were to give consideration to petitioner’s “useful life” theory, petitioner would have to show the applicability herein of section 1.167(a)-8(a)(3), Income Tax Regs. See Coors Porcelain Co. v. Commissioner, 52 T.C. 682, 692-694 (1969), affd. 429 F.2d 1 (10th Cir. 1970). As we have pointed out above, that regulatory provision has no application on the facts of this case. Petitioner has not established that the present case is a proper instance in which to apply the regulations on which he relies or that the application of those provisions to such relevant facts as may be of record will produce the deduction which petitioner seeks. Cf. United California Bank v. Commissioner, 41 T.C. 437, 455-456 (1964), affd. per curiam 340 F.2d 320 (9th Cir. 1965).

Petitioner makes the alternative argument that, as a result of the transaction at issue, it made a contribution to the U.S. Post Office for which petitioner is entitled to a deduction under section 170.108

Petitioner’s alternative argument is based on the assumption that the Court, in concluding petitioner would not be entitled to an ordinary abandonment loss deduction, would base its conclusion on a finding that petitioner transferred the depot to the Post Office along with the underlying land. As a result, petitioner’s contentions under section 170 proceed from that factual premise. However, as can be seen from our discussion of the abandonment loss issue it was not necessary for us to make such a finding.109

Obviously, if petitioner never effected a transfer of the depot to the Post Office, the statutory requirements of a “contribution or gift * * * to or for the use of * * * the United States,” and of “payment * * * made within the taxable year” would not be satisfied.110

Further, even if we were to conclude that petitioner did transfer the depot to the Post Office, the statutory requirements would still not be met.

Inherent in the above-quoted language (and in the language of section 170(c)(1) which permits a deduction “only if the contribution or gift is made for exclusively public purposes”), is a requirement that a benefit be conferred by a taxpayer upon the U.S. Government (or upon the general public). Doty v. Commissioner, 62 T.C. 587, 590-593 (1974); Markham v. Commissioner, 39 B.T.A. 465, 471-472 (1939). In the Doty and Markham cases, we disallowed charitable deductions where the alleged governmental donee had not been benefited. See in this regard Rev. Rul. 77-232, 1977-2 C.B. 71, discussing the necessity under section 170(c)(1) for a governmental donee to “benefit from the contributions” and stressing the need for “contributions [to] be used in furtherance of whatever public functions the [donee] might perform.111 See also Citizens & Southern National Bank of S. C. v. United States, 243 F. Supp. 900, 905 (W.D. S.C. 1965), allowing a deduction under section 170(c)(1) in view of the “extraordinary public benefit.”112 Under section 170, a showing that a claimed contribution has benefited a qualified donee is clearly a prerequisite to deductibility. See Tate v. Commissioner, 59 T.C. 543, 550-551 (1973); Thriftimart, Inc. v. Commissioner, 59 T.C. 598, 615 (1973). Petitioner does not disagree.

In addition, it has been held that, in order to support a claimed deduction for a charitable contribution, a taxpayer must show an intent to benefit the donee. See Mason v. United States, 513 F.2d 25 (7th Cir. 1975), in which the court, in a case arising under section 170, discussed the “critical question” of whether the taxpayer “intended to confer a benefit on the charity.” 513 F.2d at 28.113 See also Knott v. Commissioner, 67 T.C. 681, 689-691 (1977), wherein we allowed a corporation to take a deduction under section 170, noting that the individuals in control of the corporation “intended” to transfer valuable property rights to a foundation; and Denver & Rio Grande Western Railroad Co. v. Commissioner, 38 T.C. 557, 584 (1962), wherein we allowed a deduction under section 170(c)(1), observing “that it was the purpose of the petitioner * * * that the [contributed] locomotive was to be displayed at a place where it would be to the benefit of the * * * community and to the public generally.”114

Initially, we should point out that petitioner has not been completely clear as to the nature of the contribution it claims to have made. Petitioner’s clearest statement is made on reply brief, wherein it states that the gift “was in terms of not requiring the Post Office to pay consideration in the full amount which would have had to be paid by the Post Office if it had proceeded to condemnation of the property in question.” Petitioner further states that the gift was not of the improvements (the depot); instead “the gift * * * was in generously foregoing its legal right to insist upon receiving full cash value for the improvements.”

The difficulty with this argument is the scant evidence in the record relating to condemnation. The evidence before us establishes neither the likelihood of condemnation proceedings nor the probable result of such proceedings.115 Nor does the record contain anything to show that the value of the alleged “gift” (not asserting a potential claim) would be measured by the fair market value of the depot, as petitioner seems to suggest. In view of the state of the record, we are unable to give any consideration to petitioner’s assertion that the foregoing of legal rights in this instance was a benefit amounting to a gift for purposes of section 170.

However, petitioner also appears to be making another argument. At trial and in its opening brief, petitioner seems to take the position that a “bargain sale” was made to the Post Office. Under that theory, which presumes that petitioner transferred the depot to the Post Office along with the land,116 the amount petitioner received in the sale transaction is subtracted from the total fair market value of the land and the depot. Cf. Waller v. Commissioner, 39 T.C. 665 (1963). The difference between these two amounts is petitioner’s contribution under section 170(c)(1), the theory being that the Post Office was benefited to that extent.

Consistent with the preceding discussion, before we are able to conclude a gift was made for purposes of section 170(c)(1), we must first determine if the United States in fact received a benefit to the extent of the difference. Since petitioner attributes this difference to the fact that the Government received the depot at no cost, the question to be resolved is whether the transfer of the depot resulted in a benefit to the Post Office.

In this regard, we believe it is significant that the Post Office manifested complete disinterest in the depot and paid nothing for it in the sale transaction. The Post Office wanted the land only for purposes of constructing a mail-handling facility. Thus, the receipt of the land with the depot on it was not advantageous to the Post Office. The depot was actually a liability; before the Post Office could use the site for its intended purpose, it had to have the structure demolished. More than likely, any benefit resulting from the transfer inured to petitioner, given the fact that petitioner was saved the expense of razing the depot, when it failed to remove all improvements within the time allotted.117 Thus, even accepting the premise that there was a transfer of the Houston depot, we are unable to conclude from the evidence of record in this case that petitioner conferred the requisite benefit upon the U.S. Post Office.118 Additionally, we are unable to view the transfer of the depot as one made “for exclusively public purposes,” as required by the statute, when it was clear to all concerned that the depot would not be so used. Further, it seems unlikely to us that petitioner can justifiably claim it had the intention of benefiting the United States since petitioner knew the Post Office did not want the depot and would have to demolish it.

Although the petitioner did not begin the negotiations, petitioner was nonetheless willing to give up the properties at issue. If petitioner was unhappy with what it was being offered, it was not required to continue negotiations or consummate the transaction. We believe that the depot was transferred to the Post Office as part of a commercial transaction in which petitioner negotiated for the best terms it could obtain given the circumstances.119 The fact that petitioner came to view these terms as unfavorable does not by itself justify a deduction under section 170. Moreover, the commercial nature of the transaction herein is another element serving to defeat petitioner’s contention that it made a charitable contribution under section 170. Audigier v. Commissioner, 21 T.C. 665, 670 (1954); see also Grinslade v. Commissioner, 59 T.C. 566, 574 (1973).120

Whether petitioner is viewed as having abandoned the depot or as having transferred it to the Post Office, petitioner has not satisfied the requirements of section 170 and is entitled to no deduction thereunder.

We decide this issue for respondent.121

V. Deductions Incident to Relocation Projects122

This issue presents the following question for our consideration:

Whether, upon relocation of segments of its railway line by governmental authorities for highway construction at the cost of those authorities, petitioner may deduct its basis in the track material replaced either as:

(a) An abandonment loss under section 165; or

(b) A retirement under the retirement-replacement-betterment method of accounting for depreciation, thus deductible under section 167.

FINDINGS OF FACT

Issue (rr)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

This issue involves relocation projects of the former Southern Pacific Co. and the Texas & New Orleans Railroad Co., hereinafter sometimes referred to individually or collectively as petitioner.

During the taxable years 1959, 1960, and 1961, petitioner participated with governmental bodies in several projects which involved the relocation of petitioner’s railroad lines. Four projects are at issue herein and are designated the Yountville project, the Mountain View project, the Houston project, and the Corpus Christi project.

The relocation projects at issue, with the exception of the Corpus Christi project, came about as a result of State highway construction. State authorities undertaking highway improvements and needing additional acreage found it more expedient to seek to move a railway line which was contiguous to the highway than to seek additional acreage from the nonrailroad contiguous owners. In the Yountville and Mountain View projects, petitioner conveyed right-of-way real property (on which the existing rail line was located) to the State of California, and the State in turn conveyed substitute right-of-way real property (on which the relocated rail line was constructed) to petitioner. In the Houston project, to the same end, petitioner and the State of Texas granted easements or licenses in their respective properties to each other.

The Corpus Christi project was occasioned by the removal of a city-owned bridge at the entrance to the Port of Corpus Christi. Petitioner had used the bridge to provide railroad service to the port area lying south of the ship channel. A new bridge approximately 3.8 miles to the west had been constructed by public authorities, and the removal of the existing bridge required that petitioner be provided with an alternate route.

All of the projects at issue were completed with the approval of the Interstate Commerce Commission (ICC), where such approval was required.

As described more fully below, each of the four projects at issue came about as the result of an agreement between petitioner and a governmental entity (i.e., the State of California and agencies of the State of Texas). Because the governmental entities had the power to condemn, some of petitioner’s personnel thought that condemnation might result if an agreement was not reached.

The agreements relating to each of the projects at issue and the dates on which they were entered into are as follows:

Date of agreement Railroad123 Project location

Sept. 16, 1958 SP Yountville, Calif.

Jan. 5, 1959 T & NO Houston, Tex.

Apr. 15, 1960 SP Mountain View, Calif.

May 27, 1960 T & NO Corpus Christi, Tex.

Pursuant to these agreements, petitioner performed the work of dismantling the original railway line and constructing the replacement line. Costs incurred by petitioner were reimbursed by the governmental body involved. The States of California and Texas reimbursed petitioner for the costs petitioner incurred in constructing the replacement railroad lines at Yountville, Mountain View, and Houston. In each of these projects, there was credit given by petitioner against amounts payable by the States in an amount equal to the assigned salvage value of the materials recovered and retained by petitioner. In the Corpus Christi project, the track materials recovered upon dismantling the old rail line were retained by the city, and some of the materials (to the extent feasible) were used by the city in helping construct new rail line on the substitute right-of-way.

The agreement relating to the Yountville project provided that 7,521 feet of branch main track in the vicinity of Yountville, Calif., would be removed and replaced by approximately 6,875 feet of track at a location averaging about 300 feet southwest of the replaced track.

The State of California agreed: (a) To “pay the entire cost and expense of the highway changes and railroad relocation and reimburse Railroad for any cost incurred by Railroad”; (b) to perform all necessary grading and install drainage and fences on the new railroad right-of-way; (c) to grant title to track and all other railroad facilities located on the new right-of-way to the railroad; and (d) to make payments of costs within 30 days of receipt of bills from petitioner.

Petitioner agreed to perform the relocation on the Yountville project with its own forces. On completion of the railroad tracks in the new location, petitioner agreed to “remove and/or relocate existing trackage * * * and credit salvage recovered therefrom to the State.” Petitioner agreed, as the final step, to convey the old right-of-way to the State. Both parties agreed to maintain their facilities at their respective new locations.

The agreement relating to the Mountain View project provided for the relocation of 935 feet of track at Mountain View, Calif., in order that the track and a new road would pass beneath a freeway. The new track was to be 232 feet longer than, and a maximum of 325 feet distant from, the old track. The provisions of this agreement were similar to those contained in the Yountville agreement.

The agreement relating to the Houston project provided for the removal of an existing railroad bridge, the construction of a new railroad bridge, and the relocation of a portion of petitioner’s tracks, in order to accommodate the construction of a highway. The relocated 913.7-foot roadbed was parallel to, and 35 feet north of, the old 913.7-foot roadbed. The provisions of this agreement were similar to the provisions in the Yountville agreement.

The agreement relating to the Corpus Christi project called for the governmental bodies which were a party to the agreement to construct an interchange yard, a new line of track approximately 5 miles long, and to improve existing trackage owned by one of the governmental bodies on the north side of the ship channel.

Petitioner and another railroad agreed to construct a railroad yard to be jointly owned and operated by them. Petitioner agreed to remove certain portions of its track adjacent to the removed bridge, as well as certain track located in Corpus Christi. Other track, terminals, and freight yards were to be shifted by petitioner to the new joint yard. The governmental bodies involved in that project agreed to bear all of the costs and expenses incurred by petitioner on the project. The agreement further provided that rail and other track material recovered from the project by petitioner were to be furnished to the governmental bodies (in fact, the city of Corpus Christi).

Basically, the above-discussed agreements made by petitioner with the various governmental entities called in each instance for the removal of an original line and the relocation of that line as part of one project.124 In substance, pursuant to these agreements, petitioner transferred an operating railway line to a governmental body and in turn received an operating railway line as a substitute for the line given up. The substitute line performed the function for petitioner that the original line had performed. The relocation projects did not alter petitioner’s position in any essential way, either operationally or economically. The relocated railway line was substantially a continuation of the original line; it was not substantially different in character from the original line replaced.

Petitioner used the retirement-replacement-betterment method of accounting in accordance with the accounting requirements of the ICC as set forth in the Uniform System of Accounts for Railroad Companies, for property in their track accounts (which accounts included rail, ties, and ballast) for the years 1959, 1960, and 1961. Under this method, no depreciable life or salvage value is determined at time of installation of the track. The full initial cost of the track as an original installation is capitalized, as are the costs of later additions and betterments. When any rail or other track element is replaced with rail or other track element of the same weight, the capital account is not disturbed. Instead, operating expenses are debited in the amount of the cost of the replacement rail or other track element and cost of labor expended in the replacement, reduced by the assigned salvage value of the rail or other track material recovered. Such assigned values are charged to materials and supplies. When rail or other track element is replaced with rail or other track element of better quality, the same procedure is followed except that an amount reflecting the betterment is added to the capital account. When rail is retired without replacement, the cost or other amount recorded for the asset retired as reflected in the capital account is removed from the capital account and is charged to expenses, reduced by the assigned salvage value of the rail recovered.

The Interstate Commerce Commission’s 1957 issue of its Uniform System of Accounts for Railroad Companies prescribed special rules regarding contributions by governmental agencies towards the cost of constructing railroad tracks and facilities. For the years 1959, 1960, and 1961, those special rules included provisions covering the crediting of amounts representing donations and grants to account 734, “donations and grants.” The amounts representing donations and grants so credited to account 734 were also debited to appropriate property accounts.125 Where the cost of new railroad line constructed at the expense of the States exceeded the cost of the old railroad line, the excess was accounted for, during the years at issue, as a donation to the railroad (as, for example, was the case in the Yountville Project).126 Donation accounting is not in controversy in this issue.

The accounting rules of the Interstate Commerce Commission require, in the case of exchanges of real property, that the cost of the acreage conveyed become the recorded cost of the acreage acquired.127 In instances where existing railroad track upon old rights-of-way are replaced by construction of new railroad track upon new rights-of-way without any participation by governmental agencies, the old railroad track is retired as in a retirement without replacement and the investment in the new railroad track is capitalized as an original installation.

The controversy in this issue relates to rail line facilities consisting of track assets (rail and other track material) accounted for under the retirement-replacement-betterment (RRB) method of accounting, capital investments for which are recorded in primary property accounts for book purposes.

Generally, incident to a relocation project, petitioner would make a bookkeeping entry which would reduce the track investment (property) account by the book value (cost) of the removed material. Concurrently, petitioner would make a balancing debit (addition) to the operating expense account. Subsequently, to account for the completion of construction, petitioner would make a bookkeeping entry which would increase the property account. The amount of the entry was equal to the amount previously subtracted from the property account (i.e., the book value of the removed track material). Further, petitioner would make a balancing credit (subtraction) to the operating expense account.128 While all of the entries were not made simultaneously (and sometimes occurred in different years), their net effect was to result in no change in the track investment account and no change in the operating expense account. The book cost of the removed material remained on petitioner’s books after the completion of the relocation project, and the entries made to the operating expense account amounted to a wash and did not increase or decrease that account.129

In its bookkeeping, petitioner did not reduce the book value of the removed rail by the salvage value of any removed rail which it retained.130 Petitioner’s agreements with the governmental entities called for petitioner to be reimbursed for the expenses which it incurred in connection with a relocation project. On those occasions when petitioner (and not the Government) retained the rail which had been removed in the course of a project, the salvage value of such rail was allowed as a credit against the amounts to be reimbursed by the Government. In such instances, petitioner would add the salvage value of the retained rail to its materials and supplies account.

In its consolidated income tax returns for the taxable years 1959, 1960, and 1961, petitioner deducted, in connection with relocation projects during those years, some of the amounts which petitioner had subtracted from the track investment accounts when it dismantled the original railway lines (i.e., petitioner deducted the book value of some of the removed materials). In claims for refund filed for the years at issue, petitioner claimed additional such amounts as deductions. Some of these claimed deductions have now been resolved by stipulation of the parties. The remaining deductions have not been allowed by respondent. The amounts remaining in controversy (and the years and projects to which they relate) are set forth below:

Amounts Additional deducted amounts in Location in returns claims and Year Railroad of project and disallowed not allowed Totals1

1959 SP Yountville, Calif. $19,105.07 — $19,105.07

1960 T & NO Corpus Christi, Tex. 75,508.12 $62,904.20 2138,412.32

1961 T & NO Houston, Tex. — 4,536.58 4,536.58

1961 SP Mountain View, Calif. — 4,346.22 4,346.22

OPINION

Issue (rr)

During the years 1959,1960, and 1961, petitioner participated with governmental entities in several projects which involved the relocation of small segments of petitioner’s railway lines.

Three of the relocation projects at issue herein came about as a result of State highway construction when real property on which a railway line was located was needed for highway improvements. The fourth relocation project at issue, the Corpus Christi project, was occasioned by the removal of a city-owned bridge used by petitioner, which necessitated that petitioner be provided with an alternate route, for its railway line.

In each instance, petitioner performed the work of dismantling the original railway line and constructing the replacement line. Costs incurred by petitioner were reimbursed by the governmental body involved.131

Petitioner employed the retirement-replacement-betterment method of accounting, which we have described in our findings of fact. We have also set forth in our findings the entries made by petitioner on its books to reflect the accounting for these four projects. The end result of the book entries was to leave the property accounts and the operating expense accounts as they were before the entries were made; i.e., the property accounts still included the cost of the replaced track assets and the operating expense account was neither increased nor decreased as a result of these transactions. In other words, after the reversing entries were made, the books did not reflect either a gain or a loss upon the removal and replacement of the track assets involved in any of these four projects.

Petitioner argues that the amounts by which it initially reduced its property accounts for the track materials removed (that is, the cost bases of those items) are deductible either as abandonment losses under section 165 (allowing deductions for losses sustained during the taxable year) or as retirements under section 167 (allowing depreciation deductions).132 We do not agree with petitioner that the dismantling of its railway lines in connection with the relocation projects gave rise to the deductions petitioner seeks to take herein. On the facts of this case, we hold that neither section 165 nor section 167 can be availed of to support the claimed deductions.

Petitioner’s first contention appears to be that the amounts at issue represent abandonment losses deductible under section 165. That provision allows “as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.” Cf. sec. 1.165-2(a), Income Tax Regs.

Initially, we believe that a deduction under section 165 is not available because petitioner has failed to demonstrate that it sustained a loss in these transactions. As petitioner readily agrees, the objective of these projects was to relocate petitioner’s tracks at no cost to petitioner so the governmental authorities could use petitioner’s original rights-of-way for their own purposes. It is clear that this is what happened, and petitioner suffered no economic loss on any of the projects after they were completed. Petitioner would have us bifurcate the transactions for both economic and bookkeeping purposes, treating the removal of its original tracks as one transaction and the replacement with the new tracks as separate transactions. The removal of the original tracks would thus be an abandonment of those track materials, as the initial bookkeeping entries suggest. However, we see no reason or justification for treating these projects as though they involved two separate transactions, removal and replacement. They were each entered into as complete projects and probably would not have been agreed upon without encompassing the cost-free replacement aspect as well as the removal. Viewed as such, we fail to understand how petitioner could have sustained a loss, either actually or book-wise, that would qualify as a deduction under section 165. Cf. Los Angeles & Salt Lake Railroad Co. v. United States, 86 Ct. Cl. 87, 21 F. Supp. 347 (1937).

But even if the amounts at issue constitute losses under section 165, we believe petitioner is precluded from taking any deduction with respect thereto by virtue of the provisions of section 1031.

Section 1031 provides that “No gain or loss shall be recognized if property held for productive use in trade or business or for investment * * * is exchanged solely for property of a like kind to be held either for productive use in trade or business or for investment.”133 In Koch v. Commissioner, 71 T.C. 54 (1978), we stated (pp. 63-64):

The basic reason for allowing nonrecognition of gain or loss on the exchange of like-kind property is that the taxpayer’s economic situation after the exchange is fundamentally the same as it was before the transaction occurred. “[I]f the taxpayer’s money is still tied up in the same kind of property as that in which it was originally invested, he is not allowed to compute and deduct his theoretical loss on the exchange, nor is he charged with a tax upon his theoretical profit.” H. Rept. 704, 73d Cong., 2d Sess. (1934), 1939-1 C.B. (Part 2) 554, 564; Jordan Marsh Co. v. Commissioner, 269 F.2d 453, 455-456 (2d Cir. 1959), revg. a Memorandum Opinion of this Court on another point; Biggs v. Commissioner, 69 T.C. 905, 913 (1978). The rules of section 1031 apply automatically; they are not elective. Cf. Horne v. Commissioner, 5 T.C. 250, 256 (1945). The underlying assumption of section 1031(a) is that the new property is substantially a continuation of the old investment still unliquidated. Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 268 (1958).

Cf. Starker v. United States, 602 F.2d 1341, 1352 (9th Cir. 1979).

It is not disputed by the parties that, as to the rail lines involved in the instant relocation projects, both the original railroad lines and the lines which replaced them were “held for productive use in [petitioner’s] trade or business.” But there is disagreement on the question of whether there was an “exchange” of “like kind” property.

Again, in making this determination, we are not disposed to treat each project as though it were comprised of various distinct and unrelated transactions. Petitioner would have us look separately at the individual steps of the relocation projects and hold that, although the reciprocal transfers of right-of-way properties were within the purview of section 1031, the transactions involving track were not exchanges under that Code provision. Petitioner points out that on three occasions it retained the track it salvaged from the original line and did not transfer it to the governmental bodies; therefore, there could be no exchange. On the Corpus Christi project, when petitioner did not retain the track, petitioner asks us to conclude there was a sale of the track to the city of Corpus Christi.

Petitioner is ignoring the basic agreements it made with the governmental entities, calling in each instance for the removal of the original railway line and the relocation of that line as part of one project. We believe we have no alternative, based on the record before us, but to view the “successive steps” of each relocation project as “integrated parts of a single transaction” in which one operating railway line was exchanged for another operating line. Century Electric Co. v. Commissioner, 15 T.C. 581, 592 (1950), affd. 192 F.2d 155 (8th Cir. 1951), cert. denied 342 U.S. 954 (1952).

In the Century Electric case, which involved the predecessor of section 1031 under the 1939 Code, the Court of Appeals stated (192 F.2d at 159)—

the controlling policy and purpose of the section * * * [is] the nonrecognition of gain or loss in transactions where neither is readily measured in terms of money, where in theory the taxpayer may have realized gain or loss but where in fact his economic situation is the same after as it was before the transaction.

* * *

The transaction here involved may not be separated into its component parts for tax purposes. Tax consequences must depend on what actually was intended and accomplished rather than on the separate steps taken to reach the desired end. * * *

The evidence herein establishes that each relocation project at issue constituted an exchange within the purview of section 1031. The various components of each project were clearly “interdependent parts of an overall plan.” Biggs v. Commissioner, 69 T.C. 905, 914 (1978), on appeal (5th Cir., Oct. 23, 1978). See also Barker v. Commissioner, 74 T.C. 555, 566 (1980). In substance,134 pursuant to the agreements signed by petitioner and each of the governmental bodies, petitioner transferred an operating railway line to the Government, and the Government in turn transferred an operating railway line to petitioner as a substitute for the line given up. The substitute line performed the function for petitioner that the original line had performed. After each relocation project, petitioner was in essentially the same position that it was in before the project, both operationally and economically.

When each of the relocation projects involved in the present case is viewed in its entirety, it becomes apparent that in the three instances when petitioner retained the track materials, petitioner was in effect being partially reimbursed by the governmental bodies for work performed in connection with the projects. This is the only reasonable conclusion that can be drawn from the fact that the amount of actual reimbursement made to petitioner was reduced by the salvage value of the retained track assets. In the one instance when petitioner did retain track materials, there was no such reduction in the reimbursement from the governmental body. The manner in which the parties dealt with the dismantled track is fully consistent with our conclusion that petitioner transferred each railway line, including all of the components which made it operational, to the governmental body involved in each transaction. In every instance, it is readily apparent that, under the pertinent agreements, the parties regarded the Government as entitled to the recovered track materials. Government retention of the track in connection with the Corpus Christi project is further verification of that fact. Nothing in the record supports petitioner’s contention that the Corpus Christi project involved a sale of track assets to the city;135 the retention of track materials on that occasion was merely one of the elements necessarily involved in the exchange of one operating railway line for another.

In light of the foregoing discussion, there can be little doubt that these exchanges of railway lines involved “like kind” properties, as that term is used in section 1031(a).136 The money received by petitioner related to its construction costs and was an essential part of the contractual arrangements for the exchanges; petitioner was merely being reimbursed. See Biggs v. Commissioner, supra at 914, 917. If the governmental bodies had paid an unrelated party to construct the railway lines to be used in the exchanges, there would be no question that section 1031(a) would apply; the fact that petitioner performed the necessary work does not make that provision any less applicable. Cf. 124 Front Street, Inc. v. Commissioner, 65 T.C. 6, 17-18 (1975). This is particularly true in the present case where undoubtedly petitioner was best suited to perform the relocation work. Looking, as we must, at the totality of the transaction (i.e., at what petitioner gave up and at what petitioner received), we believe it is clear that the instant exchanges involved “like kind” properties within the contemplation of the statute. Biggs v. Commissioner, supra.

It appears from our findings that petitioner’s economic situation after each project was “fundamentally the same as it was before the transaction occurred” (Koch v. Commissioner, supra), and that the replacement railway line was “substantially a continuation of the old investment still unliquidated.” Commissioner v. P. G. Lake, Inc., 356 U.S. 260, 268 (1958).137 As a result, we hold that the various transactions and events comprising each relocation project in this case “were part of an integrated plan intended to effectuate an exchange of like kind properties, the substantive result of which was an exchange within the meaning of section 1031.” Biggs v. Commissioner, supra at 914-915.138 Accordingly, the losses, if any, would not be recognized.139

Alternatively, petitioner relies on section 167 to support its claims and argues that the amounts at issue, if not deductible as losses, are deductible as depreciation.

Under section 167, a depreciation deduction for property used in the trade or business is allowed under certain methods of depreciation specified in the statute or under “any other consistent method” which produces a reasonable annual allowance for the exhaustion, and wear and tear of the property.140

It is well settled that the retirement-replacement-betterment (RRB) method, employed by petitioner in accounting for the assets under discussion, is essentially a method of depreciation, and, as such, it is an acceptable method for calculating a “reasonable allowance” for the purposes of section 167. See Boston & Maine Railroad v. Commissioner, 206 F.2d 617 (1st Cir. 1953), revg. on other grounds 16 T.C. 1517 (1951); Chesapeake & Ohio Railway Co. v. Commissioner, 64 T.C. 352, 361-366 (1975); Louisville & Nashville Railroad Co. v. Commissioner, 66 T.C. 962, 993-995 (1976), on appeal (6th Cir., June 2, 1978), and the cases cited therein. See also Spartanburg Terminal Co. v. Commissioner, 66 T.C. 916, 936-937 (1976).

We have explained how the RRB method works in our findings of fact and will not repeat the explanation here.

In Boston & Maine Railroad v. Commissioner, supra, the court explained the difference between RRB accounting and straight-line depreciation, pointing out that under the RRB method—

there are no annual depreciation charges as such, and hence no annual adjustments are made in the book values of the various assets. * * * * * * The assumption is that once the system is functioning normally and the retirements are staggered fairly regularly, the charges to expense on account of equipment wearing out or otherwise disappearing from service are spread out and stabilized and hence will approximate the results under straight-line depreciation. * * * However, under the retirement system the total capital account (i.e., the book value of the assets) is always higher, since under that system no adjustments are made in this account until an item is actually retired. [206 F.2d at 619.]

In the Chesapeake & Ohio case, supra at 360, we observed that the annual deduction for “depreciation” under the retirement-replacement-betterment method “consists of two elements: (1) The cost of replacements including the replacement component of betterments (plus labor cost and less salvage value), and (2) the cost of retirements without replacement (plus labor cost and less salvage value).”

In sum, the retirement-replacement-betterment method is a method of depreciation and, in the circumstances described above, is an appropriate means for determining the allowable depreciation deduction under section 167.

Under the RRB method, the only way petitioner would be entitled to a depreciation deduction for the amounts claimed would be by showing that its track and track elements that were removed were retired without replacement.

Again, petitioner would have us scrutinize only certain aspects of each relocation project rather than analyze each project as a whole. We believe, in this context as well, it is essential to look at each relocation project in its entirety and not break it down into its component parts. Indeed, when petitioner’s book accounting for the entire transaction is examined, it is apparent that even petitioner, once it had made all pertinent entries, regarded each project as a unit and not as a series of independent transactions.

It is further apparent from an examination of petitioner’s books that the asset accounts and the operating expense account were, ultimately, unchanged as a result of the relocation projects. Once petitioner had made all book entries relating to the projects, nothing in the balances (as stated in the relevant accounts) indicated that anything had occurred; petitioner’s investment in the original railway line continued as the investment in the line which was substituted for it, and petitioner showed no operating expenses on its books relating to the relocation projects. It is clear from the foregoing entries that, in applying the RRB method to the projects at issue, petitioner did not show any retirements on its books.

Petitioner argues that only a portion of its accounting under the RRB method is pertinent for tax purposes and urges the Court to look only at the entries in which amounts were subtracted from the asset accounts and added to the operating expense account. We are told that the subsequent entries reversing the foregoing debits and credits constitute a mere “book accounting convention” and are of “no relevance whatsoever” and should be ignored. We disagree because we believe that the totality of the pertinent entries correctly reflects what was intended to and did actually happen. There was a substitution or replacement for the removed assets which was intended to and did make petitioner whole with no cost to it. The reversing book entries correctly reflected this, and in the end, did not show any retirement under the RRB method.

The restoration of the amounts at issue to the relevant asset accounts shows that petitioner’s position was unchanged as a result of the relocation projects.141 In this respect, petitioner’s book entries reflect the reality of the transactions and the substance of events which have a bearing on the tax consequences flowing from the relocation projects.142 We do not view the facts of this case as establishing that petitioner permanently terminated the use of the railway lines in its business; rather, the lines were merely relocated and continued in operation. While petitioner may have terminated its use of some specific assets and, in one sense, can be said to have retired them from service, it clearly did not effect retirements for RRB purposes. Petitioner had no intention of having the lines “disappear from service” (see Boston & Maine Railroad v. Commissioner, supra, 206 F.2d at 619), and petitioner effected the relocations in such a manner as to remain in the same operational and economic position.

Given the circumstances of this case, we do not agree with petitioner that the relocations or substitutions under discussion were the equivalent of (or in any way involved) retirements under the RRB method of accounting. Accordingly, under the authorities discussed above, these amounts are not proper deductions under section 167.

This result is fully consistent with the provisions of section 1031(d), quoted in note 133. Under section 1031(d), where property is acquired in an exchange described in section 1031, the basis of the acquired property is the same as the basis of the property exchanged (with certain adjustments when appropriate).

The obvious impact of this rule, as far as section 167 is concerned, is to permit a taxpayer to continue to depreciate the acquired property in basically the same manner as the taxpayer depreciated the property it gave up. Cf. Century Electric Co. v. Commissioner, 15 T.C. at 595, 192 F.2d at 160.143 Thus, when section 1031 applies to an exchange, the rule of subsection (d) operates to prevent an extraordinary depreciation deduction by limiting a taxpayer to essentially the section 167 deductions that would have been available to him had the exchange not taken place.

The fact that the present case involves RRB depreciation, and not ratable depreciation, does not justify a different rule. In fact, petitioner’s book entries under the RRB method, as described above, were compatible with the requirements of subsection (d).

It is clear that the allowance of the depreciation deductions claimed herein would conflict with the provisions of section 1031(d) and that, for this additional reason, we must conclude that the relocation projects at issue, as exchanges falling within the scope of section 1031(a), do not permit deductions for depreciation under section 167.144

We decide this issue for respondent.

VI. Deduction of Estimated Payroll Taxes on Earned Vacation Pay145

This issue presents the following question for our consideration:

Whether, under section 461, petitioner may accrue and deduct in 1961 an estimate of its 1962 payroll taxes on vacation pay earned by its employees in 1961 and paid to them in 1962.

FINDINGS OF FACT

Issue (bbb)

Most of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

Among the affiliated companies included in the consolidated Federal income tax return filed by the former Southern Pacific Co. for the taxable year ended December 31, 1961, were the companies listed below. The following listing includes only those affiliates as to which there is a controversy between the parties regarding the issue presently under discussion:

Former Southern Pacific Co. (merged with Texas & New Orleans Railroad Co.)

Northwestern Pacific Railroad Co.

Pacific Electric Railway Co.

Petaluma & Santa Rosa Railroad Co.

San Diego & Arizona Eastern Railway Co.

Southern Pacific Pipe Lines, Inc.

Union Terminal Warehouse

Visalia Electric Railroad Co.

Southern Pacific Transport Co.

St. Louis Southwestern Railway Co.

The former Southern Pacific Co. and its affiliates (except for Southern Pacific Pipe Lines, Inc.) were subject to the Railroad Retirement Tax Act (RRTA)146 and to the Railroad Unemployment Insurance Act (RUIA).147 For the year 1962 (and for several years preceding 1962), these corporations were required to pay an RRTA tax equal to a specified percentage of that portion of each employee’s monthly earnings which did not exceed $400, and the corporations were similarly required to make an RUIA contribution equal to a specified percentage of that portion of each employee’s monthly earnings which did not exceed $400.

Southern Pacific Pipe Lines, Inc., was subject to the Federal Insurance Contribution Act (FICA)148 and to the Federal Unemployment Tax Act (FUTA).149 For the year 1962 (and for several years preceding 1962), Southern Pacific Pipe Lines, Inc., was required to pay a FICA tax equal to a specified percentage of that portion of each employee’s annual earnings which did not exceed $4,800, and the corporation was required to pay a FUTA tax equal to a specified percentage of that portion of each employee’s annual earnings which did not exceed $3,000.

The above-named companies are sometimes hereinafter referred to collectively as petitioner. The amounts payable by these companies under RRTA, RUIA, FICA, and FUTA are sometimes hereinafter referred to collectively as payroll taxes.

During the years 1954 through 1961, petitioner charged on its books to appropriate operating expense accounts the wages and salaries which it paid. Payroll taxes were charged to railway tax accruals. Petitioner employed the accrual method of accounting and in each year estimated and accrued the amounts that would be paid to its employees in the subsequent year while they were on vacation. These accrued estimates of vacation pay were also charged to appropriate operating expense accounts (except in 1954).

The accounting rules prescribed by the Interstate Commerce Commission required charging vacation pay accruals to approximately 200 separate operating expense accounts. Such charges had to be made monthly. To minimize bookkeeping, the practice was adopted of utilizing a “standing reserve” for estimated vacation pay and related payroll taxes liabilities, which was distributed among all those accounts, and thereafter no further accounting with respect to those accounts was necessary unless the original estimates were revised.

This practice of using a “standing reserve” technique called for actual payments during the year to be charged to operating expenses, rather than cleared through the reserve, and as a consequence, monthly entries to the approximately 200 separate accounts were kept to a minimum. The final result for each year was the same as if actual payments had been cleared through the reserve and detailed monthly charges to those accounts had been made, i.e., total charges to operating expense for the year equaled the amount of the accrued estimated liability adjusted to correct prior year over- or under-accruals.

Because of the use of the “standing reserve” technique, the initially established “reserve” for estimated vacation pay liabilities in 1954, as thereafter revised, was increased or decreased annually by the amount by which subsequent year estimates were in amounts greater or lesser than the “reserve” as it stood at the time of each estimate. The “reserve” amount as revised annually represented the amount of estimated liability accrued for each year.150

For book accounting purposes, petitioner estimated and accrued in each year the payroll taxes attributable to the accrued vacation payments. Because actual payment of both the vacation pay and the related payroll taxes was deferred until the following year, the estimated vacation pay and related payroll taxes were credited, for balance sheet purposes, to “unaudited liabilities.” In 1961, under new instructions from the Interstate Commerce Commission, the payroll taxes attributable to accrued vacation pay began to be credited to “other taxes accrued.”

To estimate the proper amount of these payroll taxes to accrue in a given year, the companies subject to the Railroad Retirement Tax Act and the Railroad Unemployment Insurance Act developed and employed a formula. The amounts actually paid during the year under RRTA and RUIA were divided by the gross payroll for the year, and the result151 was multiplied by the amount of the following year’s vacation pay accrued during the year. This formula may be represented as follows:

RRTA + RUIA Gross payroll X Vacation pay accrual = Payroll taxes attributable to vacation pay

This formula produced an estimate of the subsequent year’s payroll taxes attributable to the subsequent year’s vacation pay. The same procedure was followed by Southern Pacific Pipe Lines, Inc., with reference to the Federal Insurance Contribution Act and the Federal Unemployment Tax Act, to which that company was subject.

The foregoing formula was designed to produce an estimated combined RRTA and RUIA (or FICA and FUTA) rate less than the statutory rate152 to adjust automatically for the fact that actual earnings could be in excess of the earnings base.153 If the statutory rate increased, the effect thereof was estimated by applying a factor (the percentage which the estimated combined rate was of the statutory combined rate) to the amount of the rate increase, and the lesser estimated rate increase was used. The estimated combined rate was applied to the estimated liability for the following year’s vacation pay to produce a figure representing an estimate of the payroll taxes that would be payable on the vacation pay.

At the end of 1961, petitioner had no way of knowing or estimating how many employees, at the time they took their vacations in 1962, would have earnings which exceeded the base amounts enumerated in the respective payroll tax statutes.154

The schedule, on page 629, relating to the year 1961, shows amounts appearing on the books (in various accounts) of the relevant companies. For the purposes of this case, these amounts have been assembled into the folio-wing categories: (1) Accrued Estimate of Vacation Pay for 1962; (2) Accrued Estimate of Payroll Taxes Payable in 1962 on 1962 Vacation Pay; (3) Annual Payroll (including Accrued Estimate of Vacation Pay for 1962); and (4) Payroll Taxes on Annual Payroll (including Accrued Estimate of Payroll Taxes Payable in 1962 on 1962 Vacation Pay).155

It was impossible for petitioner to check the accuracy of its accrued estimates of the payroll taxes at issue since no records

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were kept to show how much of the payroll taxes actually paid on an employee’s earnings related to that employee’s vacation pay.

The computations on the books of accrued payroll taxes on accrued vacation pay were made without any specific reference to payroll tax returns. These computations were made by an accounting officer, and the payroll tax returns were prepared independently by payroll accounting personnel.

In preparing and filing payroll tax returns, petitioner reported employer tax liability with reference to the period for which wages and salaries generating the payroll tax liability were paid. In the case of payroll taxes on vacation pay, these taxes were reported with reference to the period in which the vacations were taken by the employees.

The payroll tax returns did not separately identify any amounts of payroll tax as relating to wages and salaries attributable to vacation pay. Vacation pay was not separately identified or identifiable in payroll accounting. Vacation pay consisted simply of a continuation of regular wages and salaries, and only the operating departments knew whether the employees receiving wages and salaries for any payroll period were on vacation.

The parties have settled an issue in this case involving the question of whether the amounts accrued for book purposes by petitioner for estimated vacation pay should be allowed as deductions for income tax purposes for the year of accrual as reported in the consolidated returns. Such deductions have been claimed for tax purposes since 1949. The parties have agreed that such deductions shall be allowed beginning with the year 1961.

The year 1961 was chosen as the year of transition because in that year labor contracts were amended to make the right of employees to vacations fully vested at the end of the current year without any possibility of forfeiture.156

The parties have further agreed that the provisions for full vesting set forth in the January 18, 1961, amendment to the agreement with the Brotherhood of Locomotive Engineers may be taken as representative for purposes of this case. That amendment changed section 8 of the agreement to read as follows:

The vacation provided in this Agreement shall be considered to have been earned when the employed has qualified under Section 1 hereof [setting forth vacation rights]. If an employee’s employment status is terminated for any reason whatsoever, including but not limited to retirement, resignation, discharge, non-compliance with a union-shop agreement, or failure to return after furlough he shall at the time of such termination be granted full vacation pay earned up to the time he leaves the service including pay for vacation earned in the preceding year or years and not yet granted, and the vacation for the succeeding year if the employee has qualified therefor under Section 1. If an employee thus entitled to vacation or vacation pay shall die the vacation pay earned and not received shall be paid to such beneficiary as may have been designated, or in the absence of such designation, the surviving spouse or children or his estate, in that order of preference.

Under the union contracts, petitioner was not required to release an employee for a vacation. If petitioner did not release an employee for a vacation in any part of the year, it was obligated to pay the employee a cash allowance in lieu of vacation. While it was the policy of petitioner to encourage all its employees to take their earned vacation leave, there was no way of knowing or estimating at the end of 1961 how many employees would in fact receive a cash allowance in lieu of a vacation.

In filing the consolidated income tax return for the year 1961, petitioner did not deduct the accrued estimates of payroll taxes attributable to 1962 vacation pay.157 Only those payroll taxes actually paid during the year were deducted.158

In its petition filed with the Court on July 9,1969, petitioner did not claim the payroll taxes at issue as a deduction. However, in an amendment to petition filed with the Court on May 23, 1973, petitioner stated:

The Commissioner erred in failing to allow deduction of payroll taxes with respect to accrued obligations of members of the former Southern Pacific Company consolidated group to pay employee compensation, in the amounts of $134,846.00 and $70,523.00 for the taxable years ended December 31,1959 and 1961, respectively.

In view of the settlement of the issue involving the deduction of estimated vacation pay accruals and in view of the facts of record that have been developed as to this issue, the petitioner, on March 13, 1975, filed an additional amendment to petition. Petitioner’s claim as to this issue now relates only to the year 1961, and petitioner now asserts that the former Southern Pacific Co. and its affiliates are entitled to deduct for 1961 the following amounts representing the 1961 book accruals of payroll taxes on estimated vacation pay:

Former Southern Pacific Co . $1,333,754

Northwestern Pacific Railroad Co . 17,988

Pacific Electric Railway Co . 32,669

Petaluma & Santa Rosa Railroad Co ... 289

San Diego and Arizona Eastern Railway Co . 3,462

Southern Pacific Pipe Lines Inc . 1,780

Union Terminal Warehouse . 2,011

Visalia Electric Railroad Co . 222

Southern Pacific Transport Co . 13,301

St. Louis Southwestern Railway Co . 102,000

Total . 1,507,476

OPINION

Issue (bbb)

Petitioner employed the accrual method of accounting and, during the taxable year 1961, estimated and accrued the amounts that would be paid to its employees as vacation pay in 1962. Under union contracts, the employees’ rights to the 1962 vacations vested in 1961. On its 1961 consolidated income tax return, petitioner deducted the accrued vacation pay, and respondent now agrees that the deduction is allowable.

For 1961 book accounting purposes, petitioner estimated and accrued the payroll taxes attributable to the accrued 1962 vacation pay. These payroll taxes would become due in 1962 when the employees were paid for their vacations. On its consolidated income tax return for the year 1961, petitioner did not deduct these accrued payroll taxes. By amendments to petition, the deductibility of these amounts has been placed in issue. Petitioner now contends that, under the accrual method of income tax accounting, the accrued payroll taxes relating to 1962 vacation pay were allowable deductions in 1961. Respondent contends the payroll taxes do not qualify for deduction in 1961 under section 461 and the regulations thereunder.159

Section 461(a) states the general rule that a taxpayer is allowed a deduction in “the taxable year which is the proper taxable year under the method of accounting used in computing taxable income.” The regulations elaborate on this general provision. For accrual basis taxpayers such as petitioner, section 1.461-l(a)(2), Income Tax Regs., provides as follows:

Under an accrual method of accounting, an expense is deductible for the taxable year in which all the events have occurred which determine the fact of the liability and the amount thereof can be determined with reasonable accuracy. * * * While no accrual shall be made in any case in which all of the events have not occurred which fix the liability, the fact that the exact amount of the liability which has been incurred cannot be determined will not prevent the accrual within the taxable year of such part thereof as can be computed with reasonable accuracy.

The “all of the events” test appearing in the quoted portion of the regulations was first enunciated in United States v. Anderson, 269 U.S. 422 (1926), wherein the Supreme Court stated (pp. 440-441):

Only a word need be said with reference to the contention that the tax upon munitions manufactured and sold in 1916 did not accrue until 1917. In a technical legal sense it may be argued that a tax does not accrue until it has been assessed and becomes due; but it is also true that in advance of the assessment of a tax, all the events may occur which fix the amount of the tax and determine the liability of the taxpayer to pay it. In this respect, for purposes of accounting and of ascertaining true income for a given accounting period, the munitions tax here in question did not stand on any different footing than other accrued expenses appearing on appellee’s books. * * *

It is apparent from the Anderson holding and from the principles set forth in the regulations160 that petitioner must satisfy two requirements before it can properly deduct the accrued payroll taxes during the taxable year at issue:

(1) All of the events which determine petitioner’s liability must have occurred during 1961. See World Airways, Inc. v. Commissioner, 62 T.C. 786, 797 (1974); Thriftimart, Inc. v. Commissioner, 59 T.C. 598, 611-613 (1973); Oberman Manufacturing Co. v. Commissioner, 47 T.C. 471, 477 (1967). This requirement prevents the deduction of an expenditure that might never be made. World Airways, Inc. v. Commissioner, supra at 802; Mooney Aircraft, Inc. v. United States, 420 F.2d 400, 406 (5th Cir. 1969).

(2) Petitioner must be able to estimate with reasonable accuracy during 1961 the amount of the expenditure to be made in the subsequent year. See World Airways, Inc. v. Commissioner, supra at 797, 805; see also Crescent Wharf & Warehouse Co. v. Commissioner, 59 T.C. 751, 759-760 (1973), revd. on another point 518 F.2d 772 (9th Cir. 1975). This requirement provides an element of certainty, although it is not essential that the precise amount of the expenditure be definitely ascertained. Peoples Bank & Trust Co. v. Commissioner, 50 T.C. 750, 755 (1968); see also Brown v. Helvering, 291 U.S. 193 (1934), Harrold v. Commissioner, 192 F.2d 1002, 1006 (4th Cir. 1951).

The failure to satisfy either requirement of this two-step test is fatal to petitioner’s claim. Crescent Wharf & Warehouse Co. v. Commissioner, supra at 759. See Wien Consolidated Airlines, Inc. v. Commissioner, 528 F.2d 735 (9th Cir. 1976), affg. 60 T.C. 13 (1973).

We conclude that petitioner has not satisfied the first requirement above (that the liability be fixed) and is, therefore, not entitled to accrue and deduct the payroll taxes at issue. We need not decide whether petitioner has satisfied the second requirement (that the amount of the liability be reasonably estimable).

Wé believe it is significant that each of the taxes at issue had a maximum salary base upon which they were computed (RRTA: $400 monthly; RUIA: $400 monthly; FICA: $4,800 annually; and FUTA: $3,000 annually). At the end of 1961, petitioner had no way of knowing which employees would take their vacations at a time when their earnings would exceed the base amounts. Theoretically, at least, it was possible for all employees’ earnings (exclusive of vacation pay) to exceed the base amounts with the result that no payroll taxes would be owing on the 1962 vacation pay. It is, therefore, clear that, at the end of 1961, all of the events which determined petitioner’s liability for payroll taxes on 1962 vacation pay had not occurred. As we observed above, it was possible that a substantial portion of the vacation pay would not be subject to a payroll tax at all.

In Turtle Wax, Inc. v. Commissioner, 43 T.C. 460 (1965), the taxpayer, a corporation employing an accrual method of accounting, sought to accrue and deduct in 1958 and 1959 the amounts to be paid to its employees in 1959 and 1960, respectively, as vacation pay. In holding that the taxpayer could not properly accrue these amounts, we stated (43 T.C. at 466-467):

Under an accrual method of accounting, the deduction of an item depends upon whether all the events have occurred which determine the liability of the taxpayer to pay it; a liability does not accrue as long as it remains contingent. United States v. Anderson, 269 U.S. 422; Brown v. Helvering, 291 U.S. 193; and Denver & Rio Grande Western Railroad Co., 38 T.C. 577, 572.

* * * We think it follows that on December 31,1958 and 1959, the liability for vacation pay was still contingent on completing the 1,800 hours of service and all the events had not yet occurred which would determine petitioner’s liability to pay the amounts of $7,393.80 and $2,467.33, respectively.

In the case at bar, as in the Turtle Wax case, it was essential to have certain information about each employee before there could be a determination of the liability to pay the amounts sought to be accrued. In both cases, this information could be obtained only in the year subsequent to the year in which the accrual was attempted. In Turtle Wax, it was necessary to ascertain whether or not the employee’s hours of employment had exceeded the minimum requirement for purposes of vacation pay. In the instant case, it was necessary to ascertain whether or not the employee’s earnings had exceeded the maximum requirement for purposes of payroll taxation. The present case is similar to the Turtle Wax case in that the liability to pay the amounts in issue is contingent on an event which will occur in the year subsequent to the year before the Court; prior to the occurrence of that event, the petitioner’s liability to pay the amounts cannot be determined. It follows that the amounts involved herein, like the amounts at issue in Turtle Wax, cannot properly be accrued. See also Tennessee Consolidated Coal Co. v. Commissioner, 15 T.C. 424, 431 (1950).

Basically, petitioner’s argument is that there is no substantive difference between the accrued vacation pay and the related payroll taxes. Petitioner contends that since the vacation pay was vested and accruable and thereby qualified for a deduction, the same treatment should be accorded the payroll taxes at issue under basic accrual concepts.

Regardless of the close relationship between the two items, we have concluded that the contingencies and uncertainties associated with petitioner’s estimated liability for the payroll taxes at issue are too great to permit their deduction. In addition to Turtle Wax, Inc. v. Commissioner, supra, see, e.g., World Airways, Inc. v. Commissioner, supra at 802, and Trinity Construction Co. v. United States, 424 F.2d 302, 305 (5th Cir. 1970). By the end of 1961, petitioner’s liability to pay the vacation pay had become fixed. But its liability to pay tax thereon had not become fixed and could not become fixed until the vacation pay was paid and it could be determined whether all or a part of it was in excess of the amount of wages on which the tax had to be paid.

In Union Pacific Railroad Co. v. United States, 208 Ct. Cl. 1, 16-22, 524 F.2d 1343, 1348-1352 (1975), an accrual basis taxpayer sought to accrue and deduct on its 1942 tax return the payroll taxes which were to be paid in 1943 on 1943 vacation pay. The 1943 vacation pay had been earned and accrued in 1942. In disallowing the claimed payroll tax deductions, the Court of Claims noted that the tax statutes at issue subjected to tax only the first $300 of compensation paid to any employee in any calendar month. The court pointed out that the taxpayer therefore did not know at the end of 1942 the extent to which its employees’ 1943 vacation pay would be taxed under these statutes. In response to the taxpayer’s claim that, even with the $300 ceiling, it was able in 1942 to estimate the amount of the payroll taxes with reasonable accuracy, the court stated (524 F.2d at 1351-1352):

While the amount of a tax may be reasonably estimated and need not be precisely known, liability for the tax must have attached and cannot be approximated or estimated. “[Tjhe fact that the percentage of items which will be paid can be estimated with reasonable accuracy is not sufficient to support accruals. The individual items must represent fixed liabilities.” Denver & Rio Grande Western Railroad Co. v. Commissioner, supra [38 T.C. 557, 572]. The accruability test is not whether there is certainty of payment, or if a reasonable estimate can be made, but whether there is certainty of liability. Trans-California Oil Co., 37 B.T.A. 119, 127 (1938). Here, liability was not certain or fixed. The effect of the $300 provision was to make the liability for tax uncertain, until the time when the employee actually went on vacation or received both pay and vacation pay. Liability for payroll tax was thus under the “all events” test not certain or fixed in 1942. Texaco-Cities Service Pipe Line Co. v. United States, supra [170 F. Supp. 644, 645]: Helvering v. Russian Finance & Construction Corp., 77 F.2d 324, 327 (2d Cir. 1935).

In Eastman Kodak Co. v. United States, 209 Ct. Cl. 365, 370-378, 534 F.2d 252, 256-260 (1976), the Court of Claims reached a similar result in a case involving the FICA tax which, during the year there at issue, subjected only the first $4,800 of an employee’s annual compensation to tax. In disallowing the claimed payroll tax deduction, the court stated (534 F.2d at 260):

Although this case differs from Union Pacific in that the tax ceilings are yearly rather than monthly, the principle remains the same. Plaintiff cannot demonstrate that it knew in December 1964 when a given employee would take his 1965 vacation. Thus Kodak could not know in 1964 whether the employee would take the vacation before or after said individual employee’s salary reached the 1965 ceiling. Plaintiff could not determine precisely as of the end of 1964, the fact of tax liability on vacation pay earned by each individual employee. * * *

Petitioner cites various cases to support its claimed deduction, including United States v. Anderson, supra; United States v. Olympic Radio & Television, Inc., 349 U.S. 232 (1955); Texaco Cities Service Pipe Line Co. v. United States, 145 Ct. Cl. 274, 170 F. Supp. 644 (1959); Thriftimart, Inc. v. Commissioner, supra. These and other cases cited by petitioner are inapposite. In the case at bar, liability was not determinable until a specific condition was satisfied. “All of the events” necessary to establish liability in 1961 did not occur in that year. In none of the cases relied upon by petitioner was a deduction permitted where a similar unsatisfied condition prevented the fixing of liability. Given this crucial distinction, we are unable to agree that the cases cited by petitioner are supportive of petitioner’s position. It is well settled that “the accrual of an item of expense is improper where the liability for such item in the taxable year is contingent upon the occurrence of future events.” Putomca Corp. v. Commissioner, 601 F.2d 734, 739 (5th Cir. 1979), affg. 66 T.C. 652, 660 (1976). The reason for this rule is simply that “When * * * the obligation to pay is contingent upon the happening of some future event, there is no certainty that it will be paid or will accrue.” Helvering v. Russian Finance & Construction Corp., 77 F.2d 324, 327 (2d Cir. 1935). We believe this rule is particularly applicable on the facts of the instant case.

Petitioner cites section 446(a) and section 1.446-l(a)(l), Income Tax Regs., for the proposition that “taxable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books,” and petitioner argues that since it had been using the accrual method in accounting for the payroll taxes at issue for book purposes, it should properly employ that method for tax purposes as well. We do not believe petitioner’s argument stands up in the face of section 1.446-l(c)(l)(ii), Income Tax Regs., which provides that, for a taxpayer under the accrual method “deductions are allowable for the taxable year in which all the events have occurred which establish the fact of the liability giving rise to such deduction and the amount thereof can be determined with reasonable accuracy.” This portion of the regulations under section 446 employs language which is similar to that appearing in section 1.461-l(a)(2), Income Tax Regs., and, for the reasons given in the preceding discussion, the amounts at issue in this case do not qualify for a deduction under either regulatory provision.161

Petitioner cites section 463,162 which was added to the Code in 1974, to support its contentions. That section, with qualifications not here pertinent, permits an accrual basis taxpayer to elect to deduct the subsequent year’s vacation pay (if otherwise deductible under section 162) by making a “reasonable addition to an account representing the taxpayer’s liability for vacation pay earned by employees before the close of the taxable year.” In enacting this section, Congress was reacting to the strict requirements of Rev. Rui. 54-608,1954-2 C.B. 8, which held that “No accrual of vacation pay can take place until the fact of liability to a specific employee has been clearly established and the amount of the liability to each individual employee is capable of computation with reasonable accuracy.” Petitioner suggests that the enactment of section 463 was an implicit rejection of the concepts underlying Rev. Rui. 54-608, and that, in view of this rejection, it is improper in the instant case to regard specific information such as was required in the ruling as necessary for the accrual and deduction of the payroll taxes at issue.

We believe a careful reading of the pertinent Senate Finance Committee report shows that Congress was not rejecting any of the underlying concepts which served as a basis for the revenue ruling. Instead, it is readily apparent that Congress was making an exception to the established accrual rules by permitting the deduction of certain amounts which were nonaccruable because they did not represent a fixed liability:

The application of Revenue Ruling 54^608 results in the denial of a deduction in a year where the accrual of vacation pay has not been clearly fixed with respect to specific employees. * * *

The committee’s bill provides for an election by a taxpayer who computes his income by the accrual method of accounting to obtain a deduction as a trade or business expense * * * for both the vested and contingent amounts of vacation ;pay * * * which were earned by the taxpayer’s employees before the close of the taxable year and payable during that year or within 12 months thereafter. * * *

If a taxpayer is deducting vested vacation pay liabilities with respect to a vested plan, he need not make the election provided in the bill in order to continue to deduct the vested liabilities.

[S. Rept. 93-1375, pp. 7-10 (1974), 1975-1 C.B. 522, 523. Emphasis supplied.]

Furthermore, section 463(a) states that a taxpayer’s “liability for vacation pay earned before the close of the taxable year shall include amounts which, because of contingencies, would not (but for this section) be deductible under section 162(a) as an accrued expense.” It is beyond question that section 463 allows the accrual of an otherwise nonaccruable item.

There is nothing in the legislative history associated with section 463 which suggests that Rev. Rul. 54-608 is an improper interpretation or application of the law.163 We believe it is fairly obvious that, if specificity were not a requirement of the law, Congress would not have found it necessary to enact special legislation negating that requirement for vacation pay accruals.164

Even if we were to assume, arguendo, that basic accrual concepts do not require specificity of the nature described in the revenue ruling in connection with vacation pay,165 it would not automatically follow that specific information is not required to support the deduction of payroll taxes relating to the vacation pay. In the case of payroll taxes, as we have noted before, there is much more uncertainty as to what amounts, if any, will be deducted. The deduction of vacation pay, unlike payroll taxes, is not dependent upon an employee’s earnings being below a specified salary base.

Petitioner, referring to various revenue rulings dealing with FICA and FUTA, argues that respondent has taken inconsistent positions over the years on the question of whether payroll taxes are accruable as a deduction. Only one of these rulings deals precisely with the question of accruability of FICA and FUTA taxes attributable to earned vacation pay. Rev. Rul. 69-587, 1969-2 C.B. 108, holds that such payroll taxes are deductible by an accrual method employer only when they are actually paid. Other rulings provide more general rules for accruability, and in the case of FUTA, acknowledge the deductibility of at least a portion of the taxes prior to actual payment. See Rev. Rul. 74r-70, 1974-1 C.B. 116, restating under current law positions previously taken in Rev. Rul. 70-507, 1970-2 C.B. 104, and G.C.M. 19692, 1938-1 C.B. 148. Compare I.T. 2960, XV-1 C.B. 98.166

While the express language of these rulings is not generally favorable to the petitioner’s case, petitioner has attempted to develop a theory which follows in part and rejects in part the positions taken in the rulings. Petitioner argues at length that, under this theory, respondent cannot consistently deny the accrual and deduction of the FICA, FUTA, RRTA, and RUIA taxes at issue.

We find it unnecessary to apply petitioner’s theory or to find a consistency in the respondent’s many rulings. Our reasons are twofold. First, the result we reach today is fully consistent with the result reached in the only ruling directly on point. Rev. Rul. 69-587, supra. Second, none of the rulings cited above, including Rev. Rul. 69-587, discusses the effect of the factors which we have considered significant in reaching our conclusions herein. As a result, while we have carefully examined all of the respondent’s rulings which bear on this question, we have not relied upon them in making our determination.167

To summarize, we conclude and hold that the estimated payroll taxes which petitioner seeks to accrue and deduct in 1961 do not qualify under section 461 because they fail to satisfy the first requirement (fixed liability) of the two-step test found in United States v. Anderson, 269 U.S. at 440-441, and in sec. 1.461-1(a)(2), Income Tax Regs.168 See also World Airways, Inc. v. Commissioner, 62 T.C. at 797. As our discussion herein has shown, all of the events which determined petitioner's liability for the 1962 payroll taxes did not occur in 1961. See Union Pacific Railroad Co. v. United States, 524 F.2d at 1348-1352; Eastman Kodak Co. v. United States, 534 F.2d at 256-259; Turtle Wax, Inc. v. Commissioner, 43 T.C. at 466-467. Petitioner may, therefore, not deduct the amounts at issue in 1961.

Respondent has made an additional argument to support his view that the payroll taxes at issue cannot be accrued in 1961. His alternative position is that liability for payroll taxes does not become fixed under the law until the wages to which they relate are paid. In support of this contention, respondent makes reference to various statutory and regulatory provisions and to case authority, including the opinion of the Supreme Court in Otte v. United States, 419 U.S. 43, 55 (1974). See also Rev. Rul. 69-587, 1969-2 C.B. 108.

Petitioner contends that, in making this argument, respondent has confused an employer’s liability to remit payroll taxes to the Government (which arises when wages are actually or constructively paid) with the employer’s liability to pay the taxes (which petitioner claims arises when the wages to which they relate are earned).169

In view of our determination herein that petitioner’s liability to pay the payroll taxes did not arise in 1961 and in view of the fact that we are not called upon herein to determine the precise moment in 1962 when petitioner’s liability was fixed (since only the year 1961 is before us), it is not essential, for the purpose of deciding this case, for us to consider respondent’s alternative argument. Even if we were to reject respondent’s position that payroll taxes accrue only when wages are paid, it would remain our view that the payroll taxes involved in the instant case were not accruable in 1961.

We decide this issue for respondent.

VII. Deduction of Penalties for Violations of Federal Statutes170

This issue presents the following question for our consideration:

Whether the monetary penalties incurred and paid by petitioner during its taxable years 1959 through 1961 as a result of violations of the Safety Appliance Act (45 U.S.C. secs. 1-16) and the Twenty-Eight Hour Act (45 U.S.C. secs. 71-74) are deductible under section 162 as ordinary and necessary business expenses.

FINDINGS OF FACT

Issue (zz)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

This issue involves penalties incurred by the former Southern Pacific Co., the Texas & New Orleans Railroad Co., the Northwestern Pacific Railroad Co., and the St. Louis Southwestern Railway Co., hereinafter sometimes referred to collectively as petitioner.

Account 551, under the Interstate Commerce Commission’s (ICC) issue of the Uniform System of Accounts for Railroad Companies applicable to the years in controversy, reads, in pertinent part, as follows:

551. Miscellaneous Income Charges.

This account shall include items, not provided for elsewhere, properly chargeable to income account during the fiscal year. Among the items which shall be included in this account are:

Penalties and fines for violation of the Interstate Commerce Act or other Federal and State laws when not specifically provided for elsewhere. * * *

In accordance with the ICC accounting requirements, the former Southern Pacific Co. and certain of its subsidiaries, including the Texas & New Orleans Railroad Co., debited to Account 551 (and to similar accounts for nonrailroad companies) and deducted as an expense for book purposes amounts representing the described fines and penalties.

In the consolidated returns filed by the former Southern Pacific Co. for years 1959,1960, and 1961, the fines and penalties incurred and paid by the Texas & New Orleans Railroad Co. were deducted as “Other Deductions” in computing income tax liability. However, the fines and penalties incurred and paid by the former Southern Pacific Co. and its other subsidiaries were eliminated as deductions for tax reporting purposes and were instead shown as Schedule “M” items on the tax returns. On audit of said returns for the years 1959 through 1961, respondent disallowed the deductions claimed with respect to the Texas & New Orleans Railroad Co.

By amended petition, petitioner seeks a redetemination allowing the deductions claimed by the Texas & New Orleans Railroad Co. as well as a determination that those penalties incurred and paid by the former Southern Pacific Co. and other of its subsidiaries are deductible for tax purposes as ordinary and necessary business expenses.

Petitioner, by stipulation, advises that it is proceeding with this issue, for purposes of this case, only with respect to deductions claimed by reason of penalties incurred due to violations of 45 U.S.C. secs. 1-16 (Safety Appliance Act) and 45 U.S.C. secs. 71-74 (Twenty-Eight Hour Act [Care of Animals in Transit]).

As a result of the foregoing stipulation, deductions of penalties for violation of other statutes are not here involved. The deductibility of the following amounts in the indicated years remains at issue:

Jf5 U.S.C. secs. 1-16 1(5 U.S.C. secs. 71-71) Company (Safety Appliance Act) (Twenty-Eight Hour Act)

1959

Former Southern Pacific Co . $3,500 $700

Texas & New Orleans Railroad Co . 1,000 300

Northwestern Pacific Railroad Co . 1,250

St. Louis-Southwestern Railway Co . 250

Total . 6,000 1,000

I960

Former Southern Pacific Co . 6,230 700

Texas & New Orleans Railroad Co . 3,750 300

Total . 9,980 1,000

mi

Former Southern Pacific Co . 6,000 100

Texas & New Orleans Railroad Co . 3,550 300

Northwestern Pacific Railroad Co . 750

St. Louis-Southwestern

Railway Co . 500

Total . 10,800 400

Violations of 45 U.S.C. secs. 71-74, hereinafter the Twenty-Eight Hour Act, result from the willful and knowing continuous confinement of animals in railroad cars beyond the specified statutory time limit.171 Petitioner used due care in attempting to comply with the statute; however, various day-to-day occurrences in operations made compliance difficult. For example, clerical employees of petitioner sometimes erroneously recorded the time the animals to be transported were loaded on cars; employees at times failed to take into account the additional unloading time required when the animals were loaded on piggyback cars; and sometimes the train carrying the animals would be intentionally delayed in order to allow another of petitioner’s trains to use the railroad track because, in petitioner’s opinion, the movement of that other train was of greater importance.

Petitioner also used due care in seeking to avoid violations of the Safety Appliance Act. However, this statute imposes a strict liability standard and petitioner found it was not always capable of identifying and correcting all conditions, the existence of which would constitute violations of the statute.172 Petitioner incurred penalties during the years at issue for various violations of the statute including operation of trains on which the coupling and uncoupling apparatus was inoperative, the handhold on cars was insecure, or the handbrake was in disrepair and inefficient.

Violations of both the Twenty-Eight Hour Act and the Safety Appliance Act constitute a problem for the entire railroad industry.

OPINION

Iss'ue (zz)

This issue involves the deductibility of monetary penalties incurred by petitioner for violation of 45 U.S.C. secs. 1-16 (Safety Appliance Act), and 45 U.S.C. secs. 71-74 (Twenty-Eight Hour Act [Care of Animals in Transit]).

Both parties argue that the issue is to be decided under section 162(f), which provides:

No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

Section 162(f) was enacted as a part of the Tax Reform Act of 1969, but was specifically made applicable to all taxable years to which the 1954 Code applies.173 The purpose of this provision was to reflect the rule of various court decisions in which certain fines and penalties were held to be nondeductible. S. Rept. 91-552, 91st Cong., 1st Sess. (1969), 1969-3 C.B. 429, 596-598; Conf. Rept. 91-782, 91st Cong., 1st Sess. (1969), 1969-3 C.B. 644, 676-678. Prior to the enactment of section 162(f), a number of business expenses had been disallowed by the courts on the ground that allowance of the deductions would be contrary to Federal and State public policy. See S. Rept. 91-552, supra, 1969-3 C.B. at 596-597; Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30 (1958). Compare Commissioner v. Tellier, 383 U.S. 687 (1966).

The taxable years for which the deductions here in issue were claimed are 1959-61, 8 to 10 years before the enactment of section 162(f). It can be argued that section 162(f), per se, cannot affect petitioner’s tax liability for the years here involved despite the fact that Congress specifically made section 162(f) retroactive. Fortunately, we need not answer this conundrum in this opinion because we believe the penalties here involved are not deductible under either the law as it existed in the years 1959-61 or under section 162(f).

The basic issue is whether the penalties incurred and paid by petitioner during its taxable years 1959 through 1961 due to violations of the Safety Appliance Act and the Twenty-Eight Hour Act are deductible under section 162(a) as ordinary and necessary business expenses.

The Safety Appliance Act imposes an obligation on railroads engaged in interstate commerce to ensure that trains are equipped with specified operating and safety equipment and that such equipment is in good operating condition. A civil penalty of $250 for each violation of the act detected by the Interstate Commerce Commission is imposed upon the violating. carrier and is recoverable by the United States. The purpose of the statute is to protect employees of the carrier and others who might come in contact with the train from injury which might result due to defective safety or operating equipment. Baltimore & Ohio Railway Co. v. Jackson, 353 U.S. 325 (1957); Clark v. Atlantic Coast Line Railroad, 244 F.2d 368 (D.C. Cir. 1957).

The Twenty-Eight Hour Law provides that animals being transported in interstate commerce by rail cannot be confined for a period longer than 28 hours (36 hours if a release is executed by the shipper) without unloading the animals into pens for a period of at least 5 hours to allow rest, water, and feeding. The act imposes a civil penalty, recoverable by the United States, of not less than $100 nor more than $500 for each knowing and willful violation thereof. The purpose of the Twenty-Eight Hour Act is, as its title implies, to prevent cruelty to animals in transit. B. & O. Southwestern Railroad v. United States, 220 U.S. 94 (1911).

We have found that petitioner used all due care in attempting to comply with both of the Federal statutes in question and that, in the context of its daily operations, said violations were unavoidable and, further, that violations of the Twenty-Eight Hour Law and the Safety Appliance Act are commonly incurred by the railroad industry in general. Thus, the penalties incurred constituted ordinary and necessary expenses of doing business within the general meaning of those terms. Welch v. Helvering, 290 U.S. 111 (1933). However, in Tank Truck Rentals, Inc. v. Commissioner, supra, the Supreme Court, after acknowledging that the fines incurred by the taxpayer for violation of a State highway weight limitation law were unavoidable in the profitable operation of its truck-leasing business, nevertheless held that a finding of “necessity" could not be made if the allowance of the deduction would serve to frustrate a sharply defined public policy proscribing certain modes of conduct evidenced by a governmental declaration thereof.

In Tank Truck Rentals, the statutes involved were penal statutes enacted to protect the highways from damage and to ensure the safety of all persons using them. The Court found that the fines exacted for violating these statutes were punitive and for the purpose of enforcing the law, and disallowed the deduction because to allow it would frustrate the State policy by reducing the sting of the penalty prescribed by the State legislature. While the statutes here involved are civil and exact “penalties" instead of “fines,” the objective of the penalties was the same as the fines in Tank Truck Rentals: to enforce the law and protect employees from injury due to defective safety equipment and to prevent cruelty to animals in transit. We find no distinction between the “penalties” involved here and the “fines” involved in Tank Truck Rentals to justify a conclusion that allowing the deduction of these penalties for Federal income tax purposes would result in any less frustration of public policy than would have resulted from allowing the deduction of the fines involved in that case. In Commissioner v. Heininger, 320 U.S. 467, 473 (1943), the Court said: “Where a taxpayer has violated a federal or a state statute and incurred a fine or penalty he has not been permitted a tax deduction for its payment.”

The Supreme Court, in the most recent of these cases dealing with public policy, Commissioner v. Tellier, supra, reiterated the problem in this area — whether to disallow expenses which are ordinary and necessary under their traditional definitions when Congress clearly intended to tax only net income or to permit the public policy of a government to be frustrated by allowing deductions for such expenditures. The Court reviewed its earlier decisions and distilled therefrom the essence of the public policy doctrine.

Only where the allowance of a deduction would “frustrate sharply defined national or state policies proscribing particular types of conduct” have we upheld its disallowance. Commissioner v. Heininger, 320 U.S., at 473. Further, the “policies frustrated must be national or state policies evidenced by some governmental declaration of them.” Lilly v. Commissioner, 343 U.S., at 97. (Emphasis added.) Finally, the “test of nondeductibility always is the severity and immediacy of the frustration resulting from allowance of the deduction.” Tank Truck Rentals v. Commissioner, 356 U.S. 30, 35. In that case, as in Hoover Motor Express Co. v. United States, 356 U.S. 38, we upheld the disallowance of deductions claimed by taxpayers for fines and penalties imposed upon them for violating state penal statutes; to allow a deduction in those circumstances would have directly and substantially diluted the actual punishment imposed. [383 U.S. at 694.]

We therefore conclude that under the judicial law as it existed in 1959-61 the penalties paid by petitioner for violations of the Safety Appliance Act and the Twenty-Eight Hour Act are not deductible. And we reach the same conclusion if we apply section 162(f) of the Code to this issue.

Section 162(f), enacted as part of the Tax Reform Act of 1969 but made applicable to all taxable years to which the 1954 Code applies, prohibits deductions under section 162(a) for “any fine or similar penalty paid to a government for the violation of any law.”

The penalties in question were incurred by petitioner due to violations of Federal statutes and as such would seem to fall within the language of the section. Moreover, section 1.162-21(b)(1)(h), Income Tax Regs., defines a fine or similar penalty as including an amount paid as a civil penalty imposed by Federal, State, or local law. And section 1.162-21(c), Income Tax Regs., example (5) provides that a penalty invoked on account of a violation of the Safety Appliance Act is nondeductible.174

Petitioner contends respondent’s regulations constitute an erroneous interpretation of the law and as such are invalid, and that the penalties involved herein are deductible because they do not fall within the ambit of section 162(f). Petitioner begins with the premise that a “fine” is an extraction due to a violation of a criminal statute and “penalty” is one imposed on account of a civil infraction. Petitioner cites no authority for the proposition nor have we found any cases justifying such characterization. We are not convinced that this distinction between fine and penalty is appropriate. See Middle Atlantic Distributors, Inc. v. Commissioner, 72 T.C. 1136, 1143 (1979), a case decided subsequent to the filing of the briefs as to this issue, in which the words “fine” and “penalty” are not differentiated in the manner suggested by petitioner. See also section 1.162-21(b), Income Tax Regs., in which no distinction is made. However, respondent has not questioned this characterization either at trial or on brief and for purposes of this proceeding we shall accept the correctness of this premise.175 Petitioner claims that section 162(f) does not preclude the deduction of all civil penalties imposed by any law but only those which are “similar” to fines imposed by criminal statutes. It alleges that the penalties imposed under the Safety Appliance Act and the Twenty-Eight Hour law do not possess the requisite similarity and thus concludes said penalties are deductible.

We agree that the literal language of section 162(f) implies the existence of penalties imposed by law which are not within the intended scope of section 162(f) because Congress must have had some reason for including the word “similar” in the statute. Since that reason is not altogether clear from the wording of the statute and since respondent’s regulations make no distinction between penalties based upon the word “similar,” we deem it appropriate to look to the legislative history to discover the meaning intended by Congress. See Gilbert v. Commissioner, 241 F.2d 491 (9th Cir. 1957). Unfortunately, S. Rept. 91-552, supra, 1969-3 C.B. at 596-598, which accompanied the legislation enacting section 162(f), is both cryptic and somewhat ambiguous. However, Congress did make it clear that it was attempting to codify the general judicial position with regard to the deductibility of fines and penalties which existed at that time. See S. Rept. 91-552, supra, 1969-3 C.B. at 597; Conf. Rept. 91-782, supra, 1969-3 C.B. at 676. Two years later, the Senate Finance Committee attempted to more clearly explain what was meant to be included within the definition of “fines and similar penalties.” See S. Rept. 92-437, 92d Cong., 1st Sess. (1971), 1972-1 C.B. 600. Specifically, the committee, which had proposed section 162(f) by amendment to the House bill,176 disclaimed any intent, at the time of the section’s enactment, to limit the application of section 162(f) to criminal “penalties” and stated that its intent was to “disallow deductions for payments of sanctions which are imposed under civil statutes but which in general terms serve the same purpose as a fine exacted under a criminal statute.” S. Rept. 92-437, supra, 1969-3 C.B. at 600. The Committee also said at page 600:

On the other hand, it was not intended that deductions be denied in the case of sanctions imposed to encourage prompt compliance with requirements of law. Thus, many jurisdictions impose “penalties” to encourage prompt compliance with filing or other requirements which are really more in the nature of late filing charges or interest charges than they are fines. It was not intended that this type of sanction be disallowed under the 1969 action. Basically, in this area, the committee did not intend to liberalize the law in the case of fines and penalties.[177]

Thus, Congress, by use of the word “similar,” was not intending to distinguish between criminal and civil sanctions, but rather was intending to make a distinction between different types of civil penalties. If a civil penalty is imposed for purposes of enforcing the law and as punishment for the violation thereof, its purpose is the same as a fine exacted under a criminal statute and it is “similar” to a fine. However, if the civil penalty is imposed to encourage prompt compliance with a requirement of the law, or as a remedial measure to compensate another party for expenses incurred as a result of the violation, it does not serve the same purpose as a criminal fine and is not “similar” to a fine within the meaning of section 162(f). See Middle Atlantic Distributors, Inc. v. Commissioner, supra.

The statutory creation of this distinction comports with the Senate Finance Committee’s announced intent to codify the existing judicial position with regard to the deductibility of fines and penalties. See Tank Track Rentals, Inc. v. Commissioner, 356 U.S. at 34. This expressed congressional intent together with the judicial history on this area as previously discussed serves as convincing evidence that section 162(f), in its entirety, represents a codification of preexisting decisional law concerning fines and penalties. See Trucker v. Commissioner, 69 T.C. 675, 679 n. 4 (1978); Adolf Meller Co. v. United States, 220 Ct. Cl._ , 600 F.2d 1360 (1979).

The question remains whether petitioner’s civil violations are “similar” to fines within the meaning of section 162(f) so as to prohibit their deduction. Petitioner believes that, in order for a civil penalty to be “similar” to a fine and thus within the scope of the statute, the penalty must be one imposed on account of the commission of an act which evidences that “reprehensible conduct” which normally accompanies the violation of a criminal law. Petitioner further believes that the actions or omissions which resulted in the imposition of the penalties involved herein, such as the failure to detect and correct defective safety or operating equipment or the retention of animals in railroad cars beyond the statutory time limitation because of scheduling priorities, do not constitute such reprehensible conduct. We must disabuse petitioner.

It is clear from the 1971 Senate Report178 and the Supreme Court decisions discussed above that penalties imposed by civil statutes for purposes of enforcing the law and punishing violations thereof are not permitted to be deducted in determining net income. Thus, the appropriate consideration is not the type of conduct which gives rise to the violation resulting in the penal imposition but is the purpose which the statutory penalty is to serve.179 To interpret the meaning of “similar” in the manner proposed by the petitioner would introduce a totally new test of questionable application to the Commissioner, taxpayers, and the courts which is not justified by a reading of either prior Supreme Court cases or the legislative history and would add confusion to an area Congress specifically sought to clarify.

Petitioner also contends herein that the penalties it incurred fall outside the scope of the public policy doctrine and consequently outside the scope of section 162(f) because the purpose of the penalties was simply to promote compliance with the Federal statutes and because the infractions it committed were not violative of sharply defined public policies which would be frustrated if petitioner were permitted to deduct the costs of its acts. Assuming, arguendo, the public policy doctrine is still viable in this context, we disagree.

As we pointed out in our discussion above, petitioner committed violations of both the Safety Appliance Act and the Twenty-Eight Hour Act. Each statute evidences a defined public policy and imposes a civil penalty as retribution for a violation of that policy. If a deduction of the penalties were allowed for tax purposes, it would take some of the sting out of the penalties and would frustrate the public policy. Thus, the penalties incurred by petitioner fall precisely within the scope of the public policy doctrine finally enunciated by the Supreme Court (see Commissioner v. Tellier, 383 U.S. at 694), and, as above discussed, within the ambit of sec. 162(f).180 See Tucker v. Commissioner, supra; Uhlenbrock v. Commissioner, 67 T.C. 818, 824 (1977); May v. Commissioner, 65 T.C. 1114, 1116-1117 (1976). See also Patton v. Commissioner, 71 T.C. 389, 390-391 (1978). Cf. Great Northern Railway Co. v. Commissioner, 40 F.2d 372, 373 (8th Cir. 1930), cert. denied 282 U.S. 855 (1930).181

The penalties at issue are therefore not properly deductible under section 162.

We decide this issue for respondent.

VIII. Freight Car Useful Life182

This issue presents the following question for our consideration:

Whether, for purposes of the depreciation deduction under section 167, the useful life of the freight cars acquired by petitioner after 1944 was 30 years, as claimed by petitioner on its tax returns for the years at issue, or 20 years, as claimed herein.

FINDINGS OF FACT

Issue (ll)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

This issue involves the freight cars of the predecessor Southern Pacific Co., the former Southern Pacific Co., the Central Pacific Railway Co., and the Texas & New Orleans Railroad Co., hereinafter sometimes referred to collectively as petitioner.

In 1953 and 1954, the Revenue Service conducted an audit of the consolidated income tax returns filed by the predecessor Southern Pacific Co. for 1945, 1946, and the period ending September 30, 1947, and by the former Southern Pacific Co. for the periods ending December 31,1947 and 1948. In the course of the audit of these returns, it was agreed that petitioner would segregate its freight car acquisitions since 1944 into a new grouping (group 5) and depreciate these cars at 3 percent, allowing a 10-percent salvage. This rate translated into a 30-year useful life. Prior to that time, petitioner had employed a 30-year useful life for its freight cars acquired before 1945 (group 1 through group 4), and this practice was continued for those cars.

The use of a 30-year useful life for the group 5 freight cars (sometimes hereinafter referred to as the “postwar” cars) resulted from discussions, in 1953, between Revenue Service engineer, G. V. Robinson, and petitioner’s representatives, Cyril M. Bill, of petitioner’s accounting department, and Spencer S. Wemett, petitioner’s auditor of capital expenditures. It was their combined considered judgment that a 30-year useful life, excluding casualties, with 10 percent salvage for the postwar freight cars was reasonable. Petitioner’s representatives believed the 30-year life to be correct.

Petitioner continued to employ a 30-year life for its postwar freight cars on its consolidated income tax returns for the years 1949 through 1961, and no adjustment was made by respondent to this claimed life for these years.183 It was important to petitioner’s management to file Federal income tax returns for each of the years 1949 through 1961 which set forth a determined amount of tax which they could reasonably rely upon in their management decisions as close to the final answer.

In 1948, petitioner’s chief engineer and superintendent of motive power were of the view that a service (useful) life of 20 to 25 years for freight cars might be justifiable and proposed that petitioner depreciate its cars on that basis. However, contemporaneous data did not support this estimate, and the Interstate Commerce Commission indicated it would not approve a change in petitioner’s depreciation rates. Petitioner’s management did not formally adopt or propose a lower useful life.

In 1951, petitioner’s management proposed a 27-year useful life for freight cars to the ICC, an estimate which the ICC accepted. In 1954, a 25-year life for the freight cars of the Texas & New Orleans Railroad Co. was proposed. The ICC rejected this claim as unsubstantiated and prescribed a 28-year life.184

In 1957, petitioner’s accounting department suggested to the Association of American Railroads that the AAR should propose a 25-year useful life for freight cars to the Revenue Service in connection with a useful life study being undertaken by the Service.

During the years at issue, Cyril M. Bill was assistant income tax auditor for petitioner. By that time, he had come to believe that a 30-year useful life was too high. Bill did not have the responsibility for preparing petitioner’s income tax returns for those years, and his views were not adopted by the management officials, who did have that responsibility when they made their claim as to useful life.

After World War II, petitioner’s freight cars carried increased loads. Shippers began to demand longer freight cars with wider doors. The postwar freight cars acquired by petitioner were generally larger, with stronger decking and supporting structure to accommodate larger loads. Because of the increased capacity, the component parts of the freight cars, including the truck frames, were stronger.

During the postwar years, various factors affected the useful life of freight cars, some factors tending to increase useful life and some tending to decrease it.

During that period, the following improvements made to petitioner’s freight cars tended, for the most part, to make the cars or their components stronger and more durable:

1. Trucks with longer spring travel and snubbing devices.

2. Stronger truck side frames and floors.

3. Steel wheels.

4. Higher capacity draft gears and improved couplers.

5. Higher capacity brake beams and improved airbrake equipment.

6. Roller bearings and improved lubricators.

7. Improved cushioning throughout.

On the other hand, the following postwar factors produced some increased physical deterioration of petitioner’s freight cars and thus tended to make them less durable:

1. Increased daily mileage.

2. Increased loadings.

3. Increased impacts (e.g., in switching and connecting the cars).

4. Changes in method of loading and unloading cars.

Increased utilization is not a major factor in the life of a freight car, and petitioner did not retire cars on the basis of mileage per se, but rather on the basis of the cars’ condition.

The factors tending to decrease useful life and the factors tending to increase useful life counteracted each other and, together, had a minimal net impact on the useful life of the postwar cars during the years at issue.

During the mid-1950’s, petitioner began a gradual process of reducing the extent to which it rebuilt its freight cars. By the late 1950’s, rehabilitation work was limited and repairs were made for purposes of general overhaul and to keep the cars in safe operating condition. During the same period, running maintenance facilities were improved. The ultimate impact of this change of repair policy on the useful lives of the postwar cars was not clearly established during the years at issue.

During the years 1959,1960, and 1961, petitioner’s mechanical department was scheduling retirements of freight cars that were approximately 27 years old. Such scheduling was merely a recommendation by the mechanical department to the management officials. In practice, a freight car would not be retired until such time that its physical condition necessitated that it be taken out of service. A car could continue in service for a number of years even though it was part of a class that had been put on a retirement schedule.

While economic or financial considerations played some role in retirement decisions, such considerations were not as significant during and prior to the years at issue as was the actual condition of the freight cars. However, when the Revenue Service in 1962 adopted more liberal depreciation guidelines and promulgated Rev. Proc. 62-21, 1962-2 C.B. 418,185 it became more profitable for petitioner to retire or replace freight cars than to rehabilitate them. Other events occurring subsequent to the years at issue had a similar effect.

A study prepared by petitioners and submitted to the ICC in 1962 showed that, during the period 1935-61, petitioner retired 22,849 freight cars. Those cars had been in service for a total of 685,582 years. The study thus shows an average life of 30 years.

For years after 1961, the ICC permitted petitioner to use a lower service (useful) life, but in so doing, the ICC did not determine that petitioner had been using too low a rate of depreciation during the years 1959, 1960, and 1961. This change of ICC position was promulgated in 1963, and it was based in part on data furnished by petitioner in that year.

In 1974, a study was conducted for petitioner by A. V. Fend of the Stanford Research Institute. Fend used data from petitioner’s submissions to the Interstate Commerce Commission (Form A) through the year 1973. Fend’s method of statistical analysis (using the Iowa curves) produced “an estimate of average service life” for petitioner’s postwar freight cars — a “rough approximation” of 20 years. The validity of this estimate depended upon the history of retirements during the years 1962-73. It, therefore, was not based upon information available to petitioner’s management officials who had to exercise judgment on the useful life of petitioner’s freight cars at the end of 1959, 1960, and 1961. Fend was unable to approximate useful life for the postwar freight cars under his method using solely data available during the years at issue.

In an attempt to ascertain a factual basis for Fend’s 20-year estimate, Fred A. Schooley, also of the Stanford Research Institute, made additional studies for petitioner in 1974. One such analysis indicated that during a period of increased mileage there were increased freight car retirements and suggested there might be a causal relationship. Another such analysis indicated that during a period of decreased maintenance expenditures there were increased freight car retirements and suggested a causal relationship. Both of these studies (and supporting material) used data from years subsequent to 1961, not available to petitioner’s management officials who estimated a 30-year life on the pertinent tax returns. Without the post-1961 data, Schooley was unable to establish the suggested correlations.

In another analysis, Schooley attempted to show that a 30-year useful life for petitioner’s postwar freight cars was too high, using a modification of the “reserve ratio test” of Rev. Proc. 65-13, 1965-1 C.B. 759. That test, in conjunction with an examination of other factors, has been used to illustrate trends in depreciation, but it is not by itself a suitable means for making an estimate of useful life or for determining with certainty the propriety of petitioner’s depreciation practices.

Subsequent to the years at issue, respondent used a method of statistical analysis known as the “retirement rate” or “annual rate” method in an attempt to confirm the 30-year life claimed on petitioner’s returns.186 This method essentially involves a process of averaging retirements over a number of years, taking into account the ages of cars retired as well as the ages of cars on hand. It is recognized that the “retirement rate” method will yield valid estimates of the life of a freight car where the retirement patterns have stabilized over a sufficient period of time. However, because it is an averaging technique, some applications of the method can be insensitive to changes in those patterns (or to trends affecting those patterns) which commence at the end of the time period being examined.

In filing petitioner’s consolidated Federal income tax returns for the years at issue, the management officials responsible for preparing the returns selected a 30-year useful life for freight cars. In view of the information available to these officials concerning the past life of the cars and the conditions affecting the cars at the end of the years 1959, 1960, and 1961, their estimate of a 30-year life for the postwar freight cars was reasonable. There was no clear and convincing indication as of the end of these years that anything had occurred that would significantly shorten the useful life of the postwar cars.187

OPINION

Issm (LI)

This issue arises during the years 1959, 1960, and 1961, and involves claims under section 167 for additional depreciation with respect to freight cars acquired by petitioner subsequent to 1944. (These cars are sometimes referred to herein as the “postwar” freight cars.) In an amendment to petition, petitioner claims that the postwar cars had a useful life of 20 years, rather than the 30-year life which served as the basis for its depreciation deductions in its tax returns for the years at issue.188 Obviously, if petitioner is correct in its assertion that these freight cars are to be depreciated over a shorter span of years, petitioner will be entitled to increased annual deductions under section 167.189

In considering petitioner’s contentions herein, we are guided by section 1.167(a)-l(b), Income Tax Regs., which provides (in part):

The estimated remaining useful life may be subject to modification by reason of conditions known to exist at the end of the taxable year and shall be redetermined when necessary regardless of the method of computing depreciation. However, estimated remaining useful life shall be redetermined only when the change in the useful life is significant and there is a clear and convincing basis for the redetermination.

To a similar effect, see section 1.167(b)-0(a), Income Tax Regs., which provides:

The reasonableness of any claim for depreciation shall be determined upon the basis of conditions known to exist at the end of the period for which the return is made. It is the responsibility of the taxpayer to establish the reasonableness of the deduction for depreciation claimed. Generally, depreciation deductions so claimed will be changed only where there is a clear and convincing basis for a change.

Despite the wording of the regulations, petitioner insists that it is not required to show a “clear and convincing basis” for changing the 30-year useful life which it claimed on its returns. Petitioner believes it can satisfy its burden of proof as to this issue merely by producing evidence which would “reasonably support” the 20-year useful life it now claims. In taking this position, petitioner relies on the “reasonable approximation” language of Burnet v. Niagara Falls Brewing Co., 282 U.S. 648, 655 (1931), and the reference to that case in Western Terminal Co. v. United States, 412 F.2d 826 (9th Cir. 1969). See also Arms v. Commissioner, 626 F.2d 693 (9th Cir. 1980), affg. T.C. Memo. 1977-249.

We believe petitioner is confusing a standard that has been used by the courts at times in deciding whether a taxpayer has carried his burden of proving that the useful life he has claimed is a “reasonable approximation” (see, for example, Spartanburg Terminal Co. v. Commissioner, 66 T.C. 916, 929 (1976), and Chesapeake & Ohio Railway Co. v. Commissioner, 64 T.C. 352, 379 (1975), applying the Niagara Falls Brewing Co. test, and see also Durovic v. Commissioner, 65 T.C. 480, 505 (1975), affd. 542 F.2d 1328 (7th Cir. 1976)), with the standard used in the regulations for changing the useful life previously used, which requires a “clear and convincing basis” for such a change.

The above-quoted language from the two sections of the regulations first appeared in section 1.167, Income Tax Regs., promulgated in 1956 (see T.D. 6182), subsequent to the enactment of the 1954 Code. Section 1.167(a)-l, Income Tax Regs., deals with depreciation in general, and subparagraph (b) thereof deals with the useful life in particular. Section 1.167(b)-0, Income Tax Regs., relates to methods of computing depreciation, and subparagraph (a) thereof provides in general that any reasonable and consistently applied method of computing depreciation may be used or continued in use under section 167. Paragraph (a)-l(b) provides that useful life may be re determined, and paragraph (b)-O(a) provides that the method may be changed, only where there is a “clear and convincing basis” for the redetermination or change. We surmise that his language was predicated on and intended to reflect the Commissioner’s policy with respect to depreciation adjustments announced in Rev. Rui. 90,1953-1 C.B. 43, clarified by Rev. Proc. 57-18,1957-1 C.B. 748. In Rev. Rui. 90, after discussing the judgmental nature of depreciation, the Commissioner stated that effective May 12, 1953, it would be the policy of the Service, generally, not to disturb depreciation deductions, and he instructed Revenue employees to propose adjustments in depreciation deductions only where there was a “clear and convincing basis” for a change. While the revenue ruling was directed primarily to Revenue employees, the language in the two sections of the regulations quoted above is not limited to the Revenue Service. It clearly supplies a standard for making changes in the methods for computing depreciation and the useful lives of the assets previously used in such computations, whether proposed by the taxpayer or the Revenue Service.

Under the circumstances here, where petitioner is attempting to redetermine the useful life of certain freight cars, it must first prove there is a “clear and convincing basis” for such a change. If petitioner can cross that hurdle, it would then have the normal burden of proving a more reasonable approximation of useful life than the 30-year life claimed on its returns by providing sufficient evidence to permit a reasonable determination of what the shorter life should be.

Petitioner would be correct in applying the reasonable approximation standard herein if it were merely trying to establish the appropriateness of the useful life it had claimed on its returns. But the instant case does not present a situation where the Commissioner has issued a statutory notice asserting a greater useful life than that used by the taxpayer. Instead, we have before us a case in which the petitioner has based a refund claim on its contention that the useful life which it employed on its tax returns was incorrect and should be decreased. Thus, petitioner is seeking a redetermination of useful life (and not merely attempting to support its initial determination), and petitioner therefore falls precisely within the purview of the above-quoted regulatory provisions. See Estate of Bryan v. Commissioner, 364 F.2d 751, 754 n. 4 (4th Cir. 1966), affg. T.C. Memo. 1963-182; Cohn v. United States, 259 F.2d 371, 377-378 (6th Cir. 1958).190

Accordingly, the cases discussing the evidentiary standard for supporting a taxpayer’s initial determination are not on point.191 Petitioner, seeking to change its initial determination, must show the asserted “change in the useful life is significant” and must prove “there is a clear and convincing basis for the redetermination.” Sec. 1.167(a)-l(b), Income Tax Regs.; see also sec. 1.167(b)-0(a), Income Tax Regs. Petitioner has cited no authority, and we have found none, which would negate this regulatory standard.

This requirement that petitioner must show a clear and convincing basis for a change in useful life is appropriate for an additional reason. While the useful life which petitioner claimed on its tax returns is not binding on petitioners, we view such a claim as constituting evidence against petitioner which must be rebutted. See Leonard Refineries, Inc. v. Commissioner, 11 T.C. 1000, 1008, (1948); United States v. Farrell, 35 F.2d 38, 41 (D. Conn. 1929).192 When this factor is added to petitioner’s normal burden of proof herein, the “clear and convincing” evidentiary-standard seems amply justified.

Petitioner contends that the position taken on its tax returns is of minimal significance herein because “the determination of a 30-year life was not made by the former Southern Pacific Company but rather by one of respondent’s agents.” Our analysis of the record, as shown in our findings, discloses that the corporate management was in agreement with the use of a 30-year life for its postwar cars and that petitioner was in no manner compelled to employ a useful life as determined by respondent’s agents. Although the evidence does not adequately explain the thinking of the corporate management responsible for filing petitioner’s returns, it must be concluded that these officials considered all relevant factors and determined that 30 years was an acceptable estimate of the useful life of the postwar freight cars. The contrary conclusion urged by petitioner is not warranted by the evidence of record.193 We therefore regard the claims on petitioner’s tax returns as some evidence of a 30-year useful life for the postwar freight cars. Leonard Refineries, Inc. v. Commissioner, supra. See note 192 supra.

Having set forth the extent of petitioner’s burden of proof as to this issue, we must now consider whether petitioner has met that burden.

We cannot find on the record before us that there is a clear and convincing basis for changing the useful life. While there is evidence that would suggest that by the years here involved some changes in the use of the freight cars were occurring, we do not find that evidence sufficient to determine a more reasonable approximation of the useful life of the cars than the 30 years used, or that any decline in the useful life was significant.

Petitioner contends that during the 1950’s it increased the operating speed of its freight cars, put heavier loads on the cars, changed its loading and unloading practices, and discontinued the making of heavy repairs to the cars. These circumstances, argues petitioner, caused the postwar freight cars to have a useful life shorter than 30 years.

Unfortunately, we are only concerned with freight cars that were put in service after 1944 so that, during the tax years here involved, petitioner had had only 14 to 16 years’ actual experience with those cars, a shorter period than the useful life claimed by either party. To adequately analyze the retirement experience of petitioner with these cars, we would have to look to the retirements subsequent to the years here involved. That retirement experience would be of doubtful reliability, not only because such information was not available to anyone by the end of 1961, but also because the economics of repairing or replacing freight cars changed radically in 1962 with the adoption by petitioner of the shorter guideline lives established by respondent in that year.

As can be seen from our findings, there were various factors which had an effect on the useful life of the freight cars acquired by petitioner after the war. Some of these factors tended to decrease useful life, while others had the opposite effect. For example, increased daily mileage, increased loadings, and increased impacts in switching yards were all factors which, we are told, had a negative impact on the life of the cars. On the other hand, the postwar cars were generally larger than the earlier versions, accommodating larger loads, and they were constructed with stronger decking and supporting structure and with other more durable component parts. These improvements had a positive impact on freight car life. Considered together, these positive and negative factors tended to counteract each other, and their net impact on useful life was minimal. Even if it could be said that these various factual elements weighed slightly on the side of decreasing useful life, petitioner has not shown that they operated to produce a substantial net decrease in the life of the postwar cars, as petitioner contends.

During the late 1950’s, petitioner limited the rehabilitation work on its freight cars and concentrated instead on general overhaul and improved running maintenance. Petitioner asserts that this policy change adversely affected useful life. Our scrutiny of the record in this regard does not convince us that, during the years here pertinent, the changes in petitioner’s rebuilding program substantially reduced freight car life. Evidence concerning the effects of the policy shift was fairly general in nature and not based on specific information pertaining to the years 1959, 1960, and 1961. There appears to be insufficient data upon which to base any firm conclusions with respect to the results of the reduced rehabilitation work during this period. Petitioner has failed to establish that its change in repair policy had any significant negative impact on the useful life of the postwar cars during the years at issue.

The same can be said with respect to much of the evidence offered by petitioner to prove that any of the factors relied on by petitioner caused a significant reduction in the useful life of the freight cars acquired after World War II. Many of the factors relied upon were phased in over the period 1945 to 1961 and not enough experience was gained during that period to abstract a meaningful prognosis of just what effect those factors would actually have on the useful life of the cars. Some of petitioner’s employee-witnesses surmised that some of the factors would shorten the useful life of the cars, while others testified that certain improvements in design would tend to extend the useful life of the cars. We are convinced from the record as a whole that, while there was a belief on the part of some of the employees that the newer cars would have a shorter useful life, there was no consensus as of December 31,1961, on the part of the management officials responsible for making the final decisions on the rate of depreciation that the post-war cars had a significantly shorter useful life than the 30 years used for the freight car fleet in the past; nor was there a consensus as to what a reasonable life expectancy for the postwar cars might be. We are in a similar position, viewing the evidence as of 1961. While we believe that on the whole the heavier use of, and the reduction in major overhaul of, the postwar cars more than offset the improvements made in the cars and reduced their useful life to some extent, we are unable to determine that the reduction was significant or what useful life would be more reasonable than that used on the returns.

Petitioner appears to be of the view that, even where there are no concrete changes currently affecting the life of an asset, expectations for the future can have a bearing on useful life. Petitioner relies on Burnet v. Niagara Falls Brewing Co., supra, and Moise v. Burnet, 52 F.2d 1071 (9th Cir. 1931). In the unique circumstances presented by those obsolescence cases, future expectations were taken into account by the courts where the taxpayers knew, in the year of the deductions, that their businesses would probably be terminated by virtue of a constitutional amendment.

Neither of these cases bears a sufficient similarity to the present case to warrant its application to the present circumstances. We have found no authority which would, on the facts of this case, warrant the reliance by petitioner solely on its future expectations. To the contrary, it is clear that before petitioner can prevail herein, it must justify the additional depreciation it now claims by showing the conditions during the years at issue which accelerated the exhaustion of its equipment and by showing that such conditions did actually reduce the life of the equipment during those years. Roundup Coal Mining Co. v. Commissioner, 20 T.C. 388, 396-397 (1953); H. E. Harman Coal Carp. v. Commissioner, 16 T.C. 787, 803 (1951), affd. on this point 200 F.2d 415 (4th Cir. 1952); Sherin v. Commissioner, 13 T.C. 221 (1949); Copifyer Lithograph Carp. v. Commissioner 12 T.C. 728 (1949).

Petitioner devotes considerable discussion on brief to the views of A. V. Fend of the Stanford Research Institute. Using data from petitioner’s ICC submissions through the year 1973, Fend made a statistical analysis in 1974 which petitioner believes offers some support to its contention that the freight cars at issue had a 20-year useful life.194 We do not attribute to this analysis the significance that petitioner seems to attach to it, and our findings reflect this fact.

At the trial of this issue, it was made amply clear by petitioner that Fend’s analysis and testimony were not being offered as proof of a 20-year life. Indeed, this evidence is singularly unsuitable for the purpose of proving useful life in this case for the reason that Fend admittedly employed data in his study from the years 1962 to 1973. Fend testified that, without the data from these years, he would not have been able to reach any specific conclusions as to useful life of the postwar cars at the end of 1959,1960, and 1961.195 Since the information relied on by Fend in making his analysis was not available for consideration at the end of the years at issue, his conclusions cannot be relied on herein. The post-1961 statistics which Fend employed were obviously not available to petitioner for the making of its contemporaneous determination of useful life.

In our analysis of the extensive record as to this issue, we must limit our consideration to those facts which were actually known.to petitioner or were reasonably ascertainable at the close of the years 1959, 1960, and 1961. Airport Building Development Corp. v. Commissioner, 58 T.C. 538, 541 (1972); Morganton Full Fashioned Hosiery Co. v. Commissioner, 14 T.C. 695, 703 (1950); secs. 1.167(b)-0(a) and 1.167(a)-1(b), Income Tax Regs. To the extent that petitioner’s reevaluation of useful life is not based on such facts but is instead based on facts relating to events occurring subsequent to the years at issue, it is not relevant for our present purposes. Clearly, any estimation of useful life which makes use of hindsight does not provide an appropriate basis upon which to make a redetermination. Western Terminal Co. v. United States, supra; Johnson v. Commissioner, 302 F.2d 86, 88 (4th Cir. 1962), cert. denied 371 U.S. 904 (1962), affg. T.C. Memo. 1961-205; Durovic v. Commissioner, 65 T.C. at 505.

Not the least of the difficulties with hindsight reevaluations is the fact that changes in conditions in subsequent years can make evidence relating to those years particularly misleading. Economic factors tending to induce retirements became more significant in the years subsequent to 1961. For example, when the Revenue Service in 1962 promulgated Rev. Proc. 62-21, 1962-2 C.B.. 418, it may have become more profitable for petitioner to retire or replace freight cars than to rehabilitate them. Prior to that time, the physical condition of the cars was the predominant consideration in petitioner’s retirement decisions. As a result, any hindsight studies which take into consideration the post-1961 retirements may produce a distortion of useful life as of the end of 1959,1960, and 1961.

While petitioner acknowledges that useful life may not be determined on the basis of hindsight, petitioner asserts that evidence relating to subsequent events may be considered for the purpose of corroborating the soundness of prior estimates.

Regardless of the validity of this premise, it is of little help to petitioner in the case at bar. Petitioner’s argument assumes that its management officials had in fact estimated a useful life during the years at issue that was lower than the life they chose to use on the tax returns. This assumption is not supported by the evidence of record. The only prior estimate shown by the record to have been made by these officials for tax purposes is the 30-year useful life on petitioner’s returns. See note 198 infra. If we were to consider evidence relating to subsequent events, we would not be doing so to corroborate the estimate on petitioner’s returns but to change that estimate. The use of hindsight for such a purpose is plainly inappropriate. On the facts of this case, reliance on Fend’s analysis and conclusions, for even corroborative purposes, would not be compatible with the requirement that we limit our consideration to “conditions known to exist” at the end of the taxable year. Secs. 1.167(b)-0(a) and 1.167(a)-l(b), Income Tax Regs.196

In support of some of its factual conclusions, petitioner relies in part on certain statistical analyses prepared in 1974 by Fred A. Schooley, also of the Stanford Research Institute. Schooley, who based his studies on data in petitioner’s records, made no attempt to estimate useful life. Instead, he sought to correlate various factual data “to determine a mathematical relationship which might provide a rational explanation for a decrease in service life.” Petitioner believes Schooley’s analyses lend credence to the view that the useful life of the postwar freight cars was less than 30 years. However, because Schooley also employed data from years subsequent to those at issue and because the validity of his studies was dependent upon such hindsight data, Schooley’s analyses and conclusions, like those of Fend, provide no assistance to petitioner.197

Petitioner points to certain acts of the Interstate Commerce Commission to support its contentions herein, particularly to actions taken subsequent to the years at issue. Even assuming that we could look to post-1961 events, we would not view as helpful to petitioner’s case the fact that in 1963 the ICC authorized petitioner to use a shorter life for its freight cars. The ICC at no time stated that the useful life used by petitioner during 1959, 1960, and 1961 was too high, and the ICC did not permit any change to useful life in those years. Moreover, the factors which the ICC takes into account for rate-making purposes and the factors which this Court must take into account for tax purposes do not necessarily comport in all particulars, nor are the controlling principles and legislative objectives in computing depreciation necessarily the same. Cf. Thor Power Tool Co. v. Commissioner, 439 U.S. 522, 541-543 (1979); Louisville & Nashville Railroad Co. v. Commissioner, 66 T.C. 962, 1001 (1976), on appeal (6th Cir., June 2, 1978).198

Given the factors which we must take into consideration, and limiting our analysis to facts in the record arising in and prior to the years at issue, we believe that for tax purposes, applying tax principles, it has not been shown that there is a clear and convincing basis for redetermining the useful lives of these freight cars.

Finally, petitioner argues that the statistical approach relied on by respondent to confirm the 30-year life claimed on petitioner’s returns was not an acceptable method for calculating the useful life of the postwar freight cars. We recognize that the “retirement rate” method used by respondent and the other statistical methods discussed at trial all have their faults and their virtues.199 The “retirement rate” method, for example, is most reliable when retirement patterns have stabilized, but it can at times be insensitive to recent changes in policy affecting retirements.

Respondent presented the testimony of experts who, taking into consideration the policy changes which petitioner claims reduced the useful life of its postwar freight cars, but basing their opinions largely on factual data obtained from petitioner, were of the view that the 30-year life used by petitioner on its tax returns was a reasonable estimate of the useful lives of the cars in question.

While we are not convinced from this record that petitioner’s policy changes affected its retirement patterns to such an extent as to render the “retirement rate” method ineffective for our present purposes, we have nevertheless not relied on respondent’s statistical analyses. None of the various statistical studies discussed by the parties controls the outcome herein.200 The result we reach as to this issue is dictated by the fact that the evidence adduced at trial concerning the conditions at the end of 1959, 1960, and 1961 was simply insufficient, under the applicable standard, to establish that the useful life claimed on petitioner’s returns was erroneous.

Accordingly, we must conclude that petitioner has not established a clear and convincing basis for a significant modification of the 30-year life for freight cars claimed on its returns for the years 1959, 1960, and 1961, by reason of conditions known to exist or reasonably ascertainable at the end of each of these years.

We decide this issue for respondent.

IX. Deduction of Embankment Expenditures201

This issue presents the following two questions for our consideration:

Whether the retroactive deduction by petitioner of expenditures to maintain and protect railroad embankments and other railroad facilities during the years 1959, 1960, and 1961, which expenditures were capitalized on petitioner’s returns for those years, constitutes a change in petitioner’s method of accounting, requiring the consent of the Commissioner of Internal Revenue under section 446(e).

Whether expenditures by petitioner to maintain and protect railroad embankments and other railroad facilities during the years 1959, 1960, and 1961 are deductible as ordinary and necessary business expenses under section 162 or whether such expenditures are nondeductible under section 263(a) and must be capitalized.

FINDINGS OF FACT

Issue (yy)

Some of the facts relating to this issue have been stipulated by the parties, and those facts, with associated exhibits, are incorporated herein by this reference.

This issue involves amounts expended by the former Southern Pacific Co. and the Texas & New Orleans Railroad Co., hereinafter sometimes referred to collectively as petitioner.

During the years 1959, 1960, and 1961, the former Southern Pacific Co. completed work projects at various locations. The amounts expended on these projects are shown in the listing below, along with the number of the Authority for Expenditure (also sometimes referred to as a “GMO,” standing for “General Manager’s Order”) issued for each project and the location of the project:

GMO No. Location Amount expended

1959

68653 Cochran, Ore. $3,922

73366 Ilmon, Calif. 2,559

74264 Serrano, Calif. 2,792

74526 Livermore, Calif. 3,092

74744 Montalvo-El Rio, Calif. 25,983

75349 Nacimiento, Calif. 1,699

76653 Verdi, Nev. 3,542

76818 Ligurta, Ariz. 3,012

76819 Ligurta, Ariz. 1,306

76820 Ligurta, Ariz. 1,805

76966 Ligurta, Ariz. 1,741

77439 Ligurta, Ariz. 2,098

1960

74270 Drake, Calif. 10,105

77292 Gaviota, Calif. 7,467

78065 Ligurta, Ariz. 1,493

79409 Coyote Largo, N. Mex. 2,007

79474 Canby, Calif. 373

80182 Granite Spur, Ariz. 1,751

80613 Gold Run, Calif. 734

1961

80482 Hilt, Calif. 498

81405 West Palm Springs, Calif. 735

81682 Wymala-Red Rock, Ariz. 1,449

82040 Santa Margarita, Calif. 1,358

82700 Manhattan, Oreg. 2,673

82871 Liberal, Oreg. 3,811

During the years 1959, 1960, and 1961, the Texas & New Orleans Railroad Co. completed work projects at various locations. The amounts expended on these projects are shown in the listing below, along with the number of the Authority for Expenditure for each project and the location of the project:

GMO No. Location Amount expended

1959

580960 Lull, Tex. $6,291

590019 Falfurrias, Tex. 731

590111 Schulenberg, Tex. $2,084

590703 Flatonia, Tex. 2,642

1960

600193 Eurnice, La. 865

600248 Zavalla, Tex. 2,203

600309 Lake Charles, La. 2,368

600387 Osman, Tex. 1,185

1961

590126 San Antonio, Tex. 3,353

600873 Collado, Tex. 1,796

610024 San Antonio, Tex. 2,719

610274 Longfellow, Tex. 898

610425 Longfellow, Tex. 2,246

610462 Liberty, Tex. 773

610480 Kenedy, Tex. 1,318

610536 Mathis, Tex. 1,021

610580 Beaumont, Tex. 1,781

Each of these work projects of the former Southern Pacific Co. and the Texas & New Orleans Railroad Co. during the years at issue was directed at repairing damage to rail lines, embankments, and related facilities or at correcting defective conditions posing an imminent threat to the rail lines, embankments, and related facilities. The conditions which necessitated these work projects and the damage or potential damage resulting from these conditions are, in summary, as follows:

Changed waterflow patterns and concentrated water runoff eroding embankments and flooding tracks (caused, e.g., by the changed course of a river or creek or by the construction of highways, buildings, dikes, storm drains, etc.);

Water currents (frequently a new or more rapid pattern) exposing and weakening the footings of bridges and trestles and eroding the embankments at the ends of such structures;

Wave action and ship propeller wash and other erosive factors weakening seawalls and embankments and battering trestles;

Defective drainage boxes and drainage ditches and other factors causing water pockets and the settling of fill with resultant settling of track;

Storms eroding embankments or blocking culverts;

Earthquakes causing culverts to sag; and

Drifting sand covering and blocking tracks.

The actual work performed by the former Southern Pacific Co. and the former Texas & New Orleans Railroad Co. to correct these conditions and repair the damage may be summarized as follows:

Repairing and extending existing culverts, pipes, boxes, drainage ditches, tunnel liners, etc., and construction of new ones;202

Repairing existing seawalls, dikes, bulkheads, jetties, revetments, etc., and construction of new ones;

Reinforcing existing bridges and trestles by the paving of stream beds, the erection of protective walls, and the addition of supports and extensions to trestles; and

Erecting of sand fence.

None of the work projects described above undertaken during the years 1959, 1960, and 1961 would have been undertaken if a railroad embankment, bridge, or other facility needing protection had not been in existence. None of the projects involved the installation of protective materials at the time of initial construction of the railroad facilities.

The protective facilities discussed herein were expected to continue functioning for more than 1 year. Although the work projects produced items or benefits that extended beyond the year of construction, they were undertaken only to preserve the integrity and operating condition of the existing railroad facility and not to produce assets of independent value and utility.

All of the work projects currently at issue can be placed in two general categories. The first category covers those projects basically falling within the classification of repairs. Such repairs, including extending and strengthening existing culverts and other protective structures, were made when storms, earthquakes, and other natural forces caused damage affecting the stability and security of the rail line and its related facilities. The second category covers those projects basically falling within the classification of preventative maintenance. Such maintenance was undertaken to forestall predictable damage that was about to result from changed waterflow conditions or other natural causes or from manmade changes to the terrain. In this situation, the originally constructed protective features became inadequate when the conditions changed, and premature loss of the rail facilities was threatened.

Some of the projects at issue clearly fall into the first category and some clearly fall into the second. A substantial portion of the projects, however, contain elements of both categories.

All of the projects described above, whether falling in the first category, in the second, or in both, were directed at correcting an existing defective condition, and failure to perform the work (falling into either or both categories) would have resulted, within a relatively brief period of time, in the serious undermining of the rail line and the disruption of rail service.

The work projects did not improve the railroad facilities. The projects merely restored the facilities to their prior state of utility by reinstating the usual efficient operations that existed prior to the change of conditions. The work projects did not serve to increase the value of the railroad lines; instead, they prevented the premature loss of value that would have resulted had the defective conditions which gave rise to the projects been left unattended.

Work projects similar to the ones described above are a continuing activity on petitioner’s railroad lines. There were similar projects in years prior to the years at issue, and there have been further similar projects in subsequent years.203

Interstate Commerce Commission (ICC) accounting rules have, for a number of years, required capitalization of expenditures for work projects such as those here in issue, and, as to such expenditures in years prior to 1959, petitioner (and its predecessors) followed the requirements of ICC accounting for both book and income tax purposes.204 In filing its consolidated income tax returns for the years 1959,1960, and 1961, petitioner followed book accounting205 and did not deduct the expenditures here in issue.

In its petition filed with the Court on July 9,1969, petitioner did not claim the work project expenditures as a deduction. However, in an amendment to petition, filed with the Court on May 23,1973, the petitioner stated (in part):

(yy) The Commissioner erred in failing to allow deductions in the aggregate amounts of $70,022.00, $31,498.00 and $26,430.00 for the taxable years ended December 31,1959,1960, and 1961, respectively, by reason of expenditures by the former Southern Pacific Company and Texas and New Orleans Railroad Company for rail embankment protection.”

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(1) The former Southern Pacific Company and its railroad subsidiaries, in filing consolidated returns for the taxable years ended December 31, 1959, 1960, and 1961, did not deduct costs incurred by them in projects to modify existing culverts, trestles, walls and pipes to alter or divert water flow which erodes rail embankments.

At the trial of this issue in December 1974, respondent, for the first time, formally made the assertion that the deduction of the work project expenditures during the years at issue would constitute a change in petitioner’s method of accounting, which change petitioner could not effect without the consent of the Commissioner of Internal Revenue. No such consent has been requested or obtained. Petitioner has not sought the Commissioner’s permission since petitioner does not view the deduction of the work project expenses as a change in its method of accounting.

At the time of trial, the parties stipulated to the amounts of the deductions at issue, as follows: 206

Year Former Southern Pacific Texas & New Orleans Totals

1959 $58,274 $11,748 $70,022

1960 24,875 6,621 31,496

1961 10,524 15,905 26,429

Total 93,673 34,274 127,947

On brief, petitioner has abandoned its claims as to two projects involving detector devices at Jasper, Oreg., and Dixie, Ariz. The Jasper project involved an expenditure by the former Southern Pacific Co. of $4,723 in 1959. The Dixie project involved an expenditure by the former Southern Pacific Co. of $945 in 1960. Accordingly, the claimed deduction for 1959, relating to the former Southern Pacific Co., is reduced by $4,723 (from $58,274 to $53,551), and the claimed deduction for 1960, relating to the former Southern Pacific Co., is reduced by $945 (from $24,875 to $23,930).

The schedule on page 679, covering the years 1959,1960,1961, and subsequent years, shows total railway operating revenues, capital expenditures, total investments, net taxable income, railway operating expenses, and depreciation of the former Southern Pacific Co. (designated “SPCo.” on the schedule) and the former Texas & New Orleans Railroad Co. (designated “T & NO” on the schedule). These amounts are shown in comparison with amounts claimed as deductions.207

The amounts claimed herein as deductions for each of the years 1959, 1960, and 1961 are relatively insubstantial when compared with the total railway operating revenues, the capital expenditures, the total investment, the net taxable income, the total railway operating expenses, and the total claimed deprecia-

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tion of the former Southern Pacific Co. and the Texas & New Orleans Railroad Co. during each of those years.

OPINION

Issue (yy)

During the years 1959, 1960, and 1961, petitioner expended various amounts on work projects that were directed at maintaining and protecting railroad embankments and bridges and related rail facilities. These work projects involved repairing damage caused by storms, earthquakes, and other natural forces, and they involved preventative maintenance to forestall predictable damage resulting from changed waterflow conditions or other natural causes or from manmade changes to the terrain.

In its consolidated tax returns for the years 1959, 1960, and 1961, petitioner, following the requirements of the Interstate Commerce Commission for book accounting, capitalized the amounts expended on these work projects.

Petitioner has now concluded that these amounts should properly have been expensed during 1959,1960, and 1961, and, in an amendment to petition, petitioner has asked the Court to permit their deduction.

Respondent argues that this requested change from capitalization to deduction of the amounts expended on the work projects amounts to a change in petitioner’s method of accounting. Respondent contends that petitioner has not obtained the required consent of the Commissioner for this change and is therefore not entitled to the sought deductions.

The question of the deductibility of the expenditures at issue was raised by petitioner in its amendment to petition, filed in May 1973. In his answer to the amendment to petition, filed in June 1973, respondent merely denied the assignment of error and the allegations of fact covering this issue and did not raise as a matter in controversy the question of whether the taking of these deductions would constitute a change in petitioner’s method of accounting. Petitioner’s first formal notification that the change-of-accounting-method question would be raised by respondent came at the time of the trial of this issue. Petitioner argues that the burden of proof as to this new theory should therefore be upon respondent. Under the circumstances described above, we would agree with petitioner that the burden should be upon respondent to show the asserted change of accounting method. Schuster’s Express, Inc. v. Commissioner, 66 T.C. 588, 593-594 (1976), affd. 562 F.2d 39 (2d Cir. 1977). Estate of Falese v. Commissioner, 58 T.C. 895, 898-899 (1972); McSpadden v. Commissioner, 50 T.C. 478, 491-494 (1968). However, as petitioner acknowledges, the placement of burden of proof is of little practical importance in this instance. Our conclusion as to this issue would be the same regardless of which party has the burden of proof. See Considine v. Commissioner, 74 T.C. 955 (1980).

Respondent’s position is based on section 446(e). That section provides:

Except as otherwise expressly provided in this chapter, a taxpayer who changes the method of accounting on the basis of which he regularly computes his income in keeping his books shall, before computing his taxable income under the new method, secure the consent of the Secretary or his delegate.

This principle is reflected in section 1.446-l(e)(2)(i), Income Tax Regs., which provides that—

a taxpayer who changes the method of accounting employed in keeping his books shall, before computing his income upon such new method for purposes of taxation, secure the consent of the Commissioner. Consent must be secured whether or not such method is proper or is permitted under the Internal Revenue Code or the regulations thereunder.

Court decisions dealing with the above-cited provisions and their predecessor sections have recognized the broad authority that is given to the Commissioner. The Commissioner has wide discretion to permit or deny a requested change. Brown v. Helvering, 291 U.S. 193, 204 (1934). In view of this wide discretionary power, the failure of the Commissioner to grant permission can only be challenged by a showing that the Commissioner’s decision was arbitrary or an abuse of discretion. Schram v. United States, 118 F.2d 541, 544 (6th Cir. 1941); Casey v. Commissioner, 38 T.C. 357, 386 (1962); Advertisers Exchange, Inc. v. Commissioner, 25 T.C. 1086, 1093 (1956), affd. per curiam 240 F.2d 958 (2d Cir. 1957). It is not sufficient for a taxpayer merely to show the correctness of the new method; that fact alone cannot justify a change without the Commissioner’s consent. Wright Contracting Co. v. Commissioner, 316 F.2d 249 (5th Cir. 1963), affg. 36 T.C. 620 (1961). Moreover, even where a taxpayer’s new method of accounting would be more correct than his prior method, the consent of the Commissioner is essential in order to effect a change. H. F. Campbell Co. v. Commissioner, 53 T.C. 439, 448 (1969), affd. 443 F.2d 965 (6th Cir. 1971).208

In addition, consent is required when a taxpayer, in a court proceeding, retroactively attempts to alter the manner in which he accounted for an item on his tax return. If the alteration constitutes a change in the taxpayer’s method of accounting, the taxpayer cannot prevail if consent for the change has not been secured. Casey v. Commissioner, supra at 385-386; Cubic Corp. v. United States, an unreported case (S.D. Cal. 1974, 34 AFTR 2d 74-5895, 74-2 USTC par. 9667), affd. per curiam 541 F.2d 829 (9th Cir. 1976).

In the case at bar, it is undisputed that consent has been neither requested nor obtained. Additionally, there is no indication of any abuse of discretion by the Commissioner.

The question before us, therefore, is whether, on the facts of this case, the petitioner’s attempt to deduct items which it had previously capitalized on its tax returns for the years at issue amounts to a change in the petitioner’s method of accounting. If the deduction of these items would constitute such a change, then the respondent’s position must be upheld in view of the consent requirement of the statute and regulations. Casey v. Commissioner, supra; Cubic Corp. v. United States, supra.

Section 1.446-l(e) (2) (ii) (a), Income Tax Regs., provides that “a change in the method of accounting includes a change in the overall plan of accounting for gross income or deductions or a change in the treatment of any material item used in such overall plan.” It is also pointed out therein that “A material item is any item which involves the proper time for the inclusion of the item in income or the taking of a deduction.”

Section 1.446-l(e) (2) (ii) (b), Income Tax Regs., provides, inter alia, that the term “change in method of accounting” does not include (1) the “adjustment of any item of income or deduction which does not involve the proper time for the inclusion of the item of income or the taking of a deduction,” and (2) “a change in treatment resulting from a change in underlying facts.” It is also stated therein that—

a correction to require depreciation in lieu of a deduction for the cost of a class of depreciable assets which had been consistently treated as an expense in the year of purchase involves the question of the proper timing of an item, and is to be treated as a change in method of accounting.[209]

An examination of the statutory and regulatory provisions and of the pertinent case law leads us to the conclusion that a change in the treatment of the expenditures at issue would constitute a change in petitioner’s “method of accounting” for these items.210 It is clear that, over the years, these expenditures have been treated by both the Interstate Commerce Commission and petitioner as “the cost of a class of depreciable assets,” within the purview of section 1.446-l(e) (2) (ii) (b), Income Tax Regs. Under that regulatory provision, a change from capitalizing and depreciating such a class of assets to expensing them “involves the question of proper timing.”211 It follows, therefore, that the expenses in controversy fit the definition of “material item” under section L446-l(e)(2)(ii)(a), Income Tax Regs. Accordingly, the deductions sought herein by petitioner would effect a change in its “method of accounting” under section 446(e). Such a change cannot be made without the requisite consent.

Petitioner believes the fact that the expenditures at issue were relatively small in amount should have a bearing on the “material item” question. In addition to the factors enumerated in the regulations, various courts, including this Court, have considered an inquiry into comparable dollar amounts as pertinent to a determination of the materiality of an expenditure. See Witte v. Commissioner, 513 F.2d 391 (D.C. Cir. 1975), and the cases cited therein at note 4; and see Cincinnati, New Orleans & Texas Pac. Ry. Co. v. United States, 191 Ct. Cl. 572, 424 F.2d 563 (1970).212 Moreover, this Court has suggested that an expenditure can be of such a substantial nature that it can be viewed as “material” under the regulations, irrespective of its size in comparison to other items. See Dorr-Oliver, Inc. v. Commissioner, 40 T.C. 50, 55 (1963).

We do not think the expenditures involved herein can escape classification as a “material item” merely by virtue of their relative insubstantiality. We find it hard to view the claimed deductions of $65,299, $30,551, and $26,429 during the years at issue as immaterial, despite the fact that they may be overshadowed by much larger figures appearing on petitioner’s accounting statements. Such amounts must be viewed as material in any context.213 While the claimed deductions may be small when compared to petitioner’s total income and expenditures, the tax dollars involved cannot be considered minimal.

If we were to adopt petitioner’s view that the amounts involved herein are not a “material item,” then we would be granting the petitioner a license to change back and forth from capitalizing to expensing when to do so would work to its tax advantage. As we point out below, such a practice would not properly reflect income and would impose unacceptable uncertainties in the area of tax administration.

Petitioner makes reference to Chicago, Burlington & Quincy Railroad Co. v. United States, 197 Ct. Cl. 264, 455 F.2d 993 (1972), revd. on another issue 412 U.S. 401 (1973), in which the Court of Claims allowed the deduction expenses similar to those involved in the case at bar. Petitioner argues that the Chicago, Burlington & Quincy opinion amounts to a “change in underlying facts,” as that term is used in section 1.446-l(e)(2)(ii)(6), Income Tax Regs., making it permissible for petitioner to alter its treatment of the work project expenditures without having such new treatment fall within the scope of the term “change in method of accounting.”

We do not regard the issuance of the Chicago, Burlington & Quincy opinion as being within the purview of the term “change in underlying facts.” The Chicago, Burlington & Quincy case involved a court determination as to the treatment by another taxpayer of certain items under the tax law. The promulgation of that opinion did not create a change in the factual circumstances surrounding the making of the expenditures by petitioner during the years at issue. See examples (3) & (Q, sec. 1.446-l(e)(2)(iii), Income Tax Regs. We find no change in underlying facts which justifies a change from capitalizing to expensing the expenditures involved herein, and we find nothing in the Chicago, Burlington & Quincy opinion which requires a conclusion that petitioner’s proposed alteration in the treatment of the work project expenses would not be a change in its method of accounting.214

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