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

Arnold I. Weber and Alan S. Beinhorn, for the petitioner. James Booher, Vernon R. Balmes, Lawrence G. Becker, Eugene H. Ciranni, Randall G. Dick, Thomas F. Kelly, William E. Saul, and Nicholas G. Stucky, for the respondent. Drennen, Judge: 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 Cars 7

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 pool 10 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 cars 14 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:

Disallowed 1 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 2 4,550

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 reports 19 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 Amounts 43

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 report 44 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 12,1961 49 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 Expenses 66

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 predecessors 67 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, petitioner 75 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 basis 78 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 c

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