# Southern Pacific Transp. Co. v. Commissioner

> United States Tax Court · December 31, 1980 · 75 T.C. 497

URL: https://www.frixlaw.com/law-library/cases/4484347

## Case

- **Full name:** Southern Pacific Transportation Company v. Commissioner of Internal Revenue
- **Court:** United States Tax Court
- **Decided:** December 31, 1980
- **Citations:** 75 T.C. 497; 1980 U.S. Tax Ct. LEXIS 1
- **Precedential status:** Published
- **Opinion:** Opinion of the court by Drennen
- **Judges:** Drennen
- **Cited by:** 139 later opinions in the Frix Law Library

## Citator (automated)

- No negative treatment found by the automated citator. That is not the same as a confirmation that the case is good law; read the citing cases.
- Full citator and citing cases: https://www.frixlaw.com/law-library/cases/4484347

## How later opinions describe it (automated extraction)

- concluding that if a civil penalty is imposed “as a remedial measure to compensate another party for expenses incurred as a result of the violation,” the deduction of the penalty is not barred by section 162(f)
- noting that “consent is required when a taxpayer ... retroactively attempts to alter the manner in which he accounted for an item on his tax return.”
- holding that the taxpayer's accounting records, standing alone, could not establish the cost basis of its assets

## Opinion text

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 ^
91 — 40 38 1953 90 H LO
100 — 29 31 1954 97 CO
$20 113 $20 39 1955 101 05 CO IS o CO
20/25 104 20/25 29 1956 109 00 UO CO CO o CO t O rH
25 112 25 51 1957 114 rH CO 05 LO o CO o rH rH
30 114 30 33 1958 122 Th ^ CQ T? o CO co rH rH
30 128 30 48 1959 125 05 M o CO 05
30 129 30 47 1960 125 C71 05 o CO co rH rH
30 (included in FSP) 1961 131 o LO rf*» -3 © CO
Initially, the salvage value of petitioner s relay rail was based, generally, on one-half of its cost when new. Through the early 1940’s, a $20 salvage value roughly approximated, in most years, both (1) 50 percent of the cost of the relay rail when it was new, and (2) 50 percent of the cost of new rail at the time the relay rail was picked up. However, by the late 1940’s and early 1950’s, it became apparent that a $20 figure bore no relationship to the steadily increasing cost of new rail.
In 1952, the Interstate Commerce Commission indicated its concern about petitioner’s failure to employ a salvage value for relay rail which was “a fair and reasonable value * * * based on current prices.” However, no action was taken in that year to have petitioner make any changes in its books.
On July 15,1955, the ICC advised petitioner as follows:
Exception No. 2: Stock Prices of Scrap and Secondhand Bail. The stock prices of $5 a net ton for scrap rail and $20 for secondhand relaying rail applied at time rail is released from tracks, were established many years ago when the cost of new rail and the market value of scrap and secondhand rails were far lower. Obviously, such stock prices are now not representative of the value of the rail, and they should, therefore, be increased to more closely conform to actual current values. The low stock prices now in use result in understating the value of material and supplies, the property investment account for heavier relaying rails applied in betterments, and to some extent affect operating expenses by accounting periods. * * *
On May 2, 1956 , petitioner’s vice president and general auditor, P. J. Kendall, responded to the ICC, as follows:
Effective with our annual inventory to be taken April 30,1956, stock prices of scrap and secondhand rail are being increased from $5 and $20 a net ton to $10 and $25 a net ton, respectively.
While there is still a difference between the increased stock prices, referred to above, and current values, the current market prices are subject to wide range changes, as experienced in the past. Therefore, we feel that it is best to allow a margin between stock prices and market values in order to avoid continual adjusting of prices with resultant confusion and lack of standardization.
In January of 1957, the ICC advised petitioner:
The prices received by your company for sales of secondhand rail have advanced with the increases in new rail prices. The current price being received for sales of industry grade of relay rail is approximately $55.00 per gross ton and for other grades is approximately $65.00 to $75.00 per gross ton. * * * The stock prices of used other track material also are understated. The continued wide margin between stock prices and actual values results in considerable understatement in asset values. Consideration should be given to increasing stock prices to more nearly represent current values and to meet the requirements of section 7(d) of the general instructions for road and equipment accounts.
In response, petitioner told the ICC it would increase the salvage value of its relay rail from $25 to $30 a net ton.
Petitioner used a $30 salvage value for its relay rail for book and tax purposes during 1959,1960, and 1961. During the years in controversy, the stipulated market value of the relay rail at issue was as follows:
Year FSP T & NO StLS
1959 $69.81 $71.47 $68.44
1960 70.73 71.08 70.84
1961 73.49 76.61 71.16
The statutory notice in this case gives the following as the explanation for the relay rail adjustments in controversy:
You used Interstate Commerce Commission valuations in determining salvage values for track materials retired or replaced and transferred to supplies or scrap accounts. It is determined that you must use fair market value at the time such materials are replaced or retired in computing salvage value. See Exhibit H, attached, for the detailed computation.
Exhibit H consists of two sets of computations. Pages 257 and 258, therein, show respondent’s original approach on audit which was based on cost, and allowing 20-year amortization. Pages 258A through 258C show the adjustment made in the statutory notice which was based on fair market value at the time the rail was picked up, with no amortization.
OPINION
Issues (l) and (ccc)
Under the retirement-replacement-betterment (RRB) method of accounting, used by petitioner 270 during the years at issue for both book and tax purposes, when petitioner laid original track, it capitalized the costs attributable to the rail and track materials. In the course of its track maintenance, petitioner would remove worn used rail from its track bed with the intention of reusing that rail in areas with lower density traffic. Such rail picked up for reuse is referred to as “relay” rail. Under the RRB method, the cost expensed (and deducted) in connection with the replacement or retirement of the track is reduced by the salvage value of the relay rail.
The question before us is whether the salvage value of the relay rail is determined by reference to its current fair market value, 271 as respondent contends, or by reference to some lesser amount, 272 as petitioner contends.
By increasing the salvage value of the relay rail, respondent is obviously reducing petitioner’s operating expenses and thereby increasing petitioner’s income for the year in which the rail was picked up.
The present issue is raised only as to relay rail which is subsequently laid as an addition or betterment. Under the RRB method, when relay rail is laid in straight replacement, the amount (i.e., salvage value) which had been subtracted from the operating expense account is, at the time of the replacement, added back to the operating expense account. Thus, a “wash” occurs within a short period of time, and it is of no practical importance what figure is used as the salvage value of the relay rail. However, when relay rail is laid as an addition, the salvage value figure is capitalized, 273 and any offsetting increase to operating expense is postponed, often for many years. 274 Because there is no immediate “wash” in the latter situation, when respondent increases the salvage value of relay rail subsequently laid as an addition or betterment, he effectively increases petitioner’s income for the year in which that rail was picked up.
This question of the salvage value of relay rail has been the subject of much litigation, and respondent’s position, as set forth in Rev. Rui. 67-145,1967- 1 C.B. 54 , 275 and Rev. Proc. 68-46,1968- 2 C.B. 961 , 276 has been consistently upheld. The use of fair market value to determine salvage value in this context has been approved by this Court in Seaboard Coast Line Railroad Co. v. Commissioner, 72 T.C. 855 (1979), on appeal (5th Cir., Feb. 29, 1980), and in Louisville & Nashville Railroad Co. v. Commissioner, 66 T.C. 962 (1976), on appeal (6th Cir., June 2, 1978); 277 by the Court of Claims in Missouri Pacific Railroad Co. v. United States, 204 Ct. Cl. 837 , 497 F.2d 1386 (1974), and in Chicago, Burlington & Quincy Railroad Co. v. United States, 197 Ct. Cl. 264 , 455 F.2d 993 (1972), revd. on another issue 412 U.S. 401 (1973); 278 and by the Court of Appeals for the Eighth Circuit in United States v. St. Louis-San Francisco Railway Co., 537 F.2d 312 (8th Cir. 1976), affg. an unreported case (E.D. Mo. 1975, 35 AFTR 2d 75-1317, 75-1 USTC par. 9395 ). 279
In view of this extensive authority, we reach the same conclusion herein and hold that the salvage value of petitioner’s relay rail is the fair market value of that rail at the time it was picked up. Nothing in the record as to this issue convinces us that a different result should obtain. We do not believe any useful purpose would be served by addressing ourselves to every one of petitioner’s many contentions on brief since we believe those arguments are, for the most part, fully discussed (and rejected) in the cited cases. Having carefully considered petitioner’s views as to this issue, we see no reason to depart from the position adopted by this Court in the Seaboard Coast Line and Louisville & Nashville cases. We reaffirm that position.
Petitioner argues unconvincingly that respondent’s determination as to this issue was arbitrary and that he therefore has “the burden of coming forward with substantial evidence to make out a prima facie case.” Petitioner claims that respondent had no legal rationale for making the adjustments to salvage value and dismisses respondent’s position herein as a litigation tactic unsupported by authority. Petitioner also points to some of the (now abandoned) contentions made by respondent in the pretrial stages of this case.
Although the many cases dealing with the relay rail issue were not decided at the time the adjustments at issue were initially made, these cases clearly demonstrate that the position taken by respondent in this case and in Rev. Rul. 67-145, supra, is based on a sound legal rationale. They further demonstrate, as we point out herein, that petitioner’s application of the RRB method resulted in an overstatement of its operating expenses during each of the years at issue and, therefore, did not clearly reflect income. In such circumstances, respondent has broad discretion to recompute taxable income. See sec. 446(b); Seaboard Coast Line Railroad Co. v. Commissioner, supra at 875. The fact respondent may not have taken his present position in prior years is not indicative of an abuse of that discretion. Dixon v. United States, 381 U.S. 68 (1965); Seaboard Coast Line Railroad Co. v. Commissioner, supra at 875. Further, to the extent petitioner is suggesting that certain of respondent’s pretrial concessions as to this issue place an additional burden on respondent to explain the basis of his actions, petitioner is in error. See Gobins v. Commissioner, 18 T.C. 1159, 1168-1169 (1952), affd. per curiam 217 F.2d 952 (9th Cir. 1954). See also Mills v. Commissioner, 399 F.2d 744, 749 (4th Cir. 1968), affg. T.C. Memo. 1967-67 . 280
In short, we have been shown no basis for shifting to respondent the burden of going forward with the evidence, and that burden, accordingly, remains on petitioner. Cf. Figueiredo v. Commissioner, 54 T.C. 1508, 1513 (1970), affd. by unpublished order (9th Cir. 1973). 281 Even if respondent’s motivations and procedures in making the instant adjustments were such as to negate the usual presumption of correctness attaching to his determinations, 282 the result we reach today would be no different. Based on all of the evidence of record and the legal principles applicable thereto, we would still conclude that respondent’s determination is correct. See Nat Harrison Associates, Inc. v. Commissioner, 42 T.C. 601, 617-618 (1964).
Additionally, we reject petitioner’s contention that its book accounting does not distort income and, therefore, should be controlling for tax purposes. Petitioner relies on section 446(b), which provides that respondent cannot change a regularly used “method of accounting” unless the method “does not clearly reflect income.” See the discussion of section 446 in the portion of this opinion entitled “Issue (g): Welded Rail.” In view of the fact that petitioner calculated the salvage value of its relay rail in a manner which did not clearly reflect its income, we must conclude that the approach followed by petitioner in accounting for the relay rail on its books is not controlling herein. Louisville & Nashville Railroad Co. v. Commissioner, supra at 998; United States v. St. Louis-San Francisco Railway Co., supra.
Petitioner argues at great length that it applied the RRB method in a manner fully consistent with the accounting requirements of the Interstate Commerce Commission and that respondent should be bound by the ICC rules. However, as we point out in the portions of this opinion entitled “Issue (g): Welded Rail” and “Issue (ll): Freight Car Useful Life,” the position of that agency, even if supportive of petitioner’s contentions, is not determinative of tax consequences. Our decision herein is controlled by established principles of tax law as articulated in the controlling cases, and the fact that accepted industry accounting practice may suggest a different result does not alter the validity of those principles. See Thor Power Tool Co. v. Commissioner, 439 U.S. 522 (1979).
In an alternative argument, petitioner contends that, if respondent’s position is upheld, it should be permitted to assign a zero salvage value to its relay rail. Petitioner’s argument in this respect is based on a theoretical application of the RRB method which treats rail replacements as mere repairs. Under petitioner’s theory, rail replacements would be deductible without having to be reduced by the salvage value of relay rail. This approach is obviously inconsistent with the established rules of the RRB method, and petitioner cites no authority to justify such a radical departure from its customary manner of accounting for replacements. Petitioner simply suggests that, as a consequence of respondent’s contentions herein, the Court should decide that salvage value is to be disregarded when replacement costs are deducted.
We find it unnecessary to discuss in detail the theoretical maze through which petitioner travels to reach this conclusion. Petitioner’s strained argument is totally incompatible with the decided cases dealing with relay rail and the RRB method. The cases have consistently held that a low salvage value for relay rail (below fair market value) is inappropriate for RRB purposes. Obviously, a nonexistent salvage value would be even more objectionable. By the same token, if a low salvage value for relay rail does not clearly reflect income under the RRB method, see, e.g., Louisville & Nashville Railroad Co. v. Commissioner, supra at 998; United States v. St. Louis-San Francisco Railway Co., supra, then a zero salvage value would reflect income even less clearly. We have been shown no reason to depart from the rationale of the decided cases in this area, and we decline to do so.
Petitioner bases a further alternative argument on its view that the use of fair market value to determine the salvage value of relay rail will, by virtue of reducing operating expenses, have the indirect effect of taking “appreciation in value” into income during each of the years at issue. As a result, petitioner makes the admittedly “fanciful” contention that this “appreciation in value” should be taxed as a capital gain under the provisions of section 1231. 283 We find no merit in this contention.
Even aside from the problems which necessarily arise in attempting to apply section 1231 to the facts of this case, this alternative argument must fail because it is based on a faulty premise. It is now clear that the use of fair market value in the present context does not create taxable income in the form of unrealized appreciation. In rejecting such a theory in Seaboard Coast Line Railroad Co. v. Commissioner, supra at 872, we stated:
This argument has also been considered and decided adversely to petitioner on the ground that what is involved is simply a reduced deduction. United States v. St. Louis-San Francisco Railway Co., 537 F.2d at 315 ; Chicago, Burlington & Quincy R. Co. v. United States, 455 F.2d at 1012 .[ 284 ]
It follows, therefore, that this is not an appropriate instance in which to discuss the conversion of ordinary income into capital gain. Here, too, we must reject petitioner’s alternative argument. 285
Finally, petitioner argues that, if respondent’s position is upheld, he must be viewed as effecting a change in petitioner’s “method of accounting,” as that term is used in section 481. 286 Section 481 prescribes that certain adjustments are to be made in the computation of taxable income when the “method of accounting” employed to calculate taxable income in a given year is different from the one the taxpayer previously used. The purpose of section 481 “is to prevent any income from escaping tax or being doubly taxed solely because of such change in method.” Hanover Insurance Co. v. Commissioner, 69 T.C. 260, 273 (1977), affd. on another point 598 F.2d 1211 (1st Cir. 1979), cert. denied 444 U.S. 915 (1979). Petitioner believes the application of that Code section in this case will result in adjustments which will produce additional deductions during the years in controversy.
The actual result flowing from the application of section 481 is not apparent from the record. The parties limited their presentation at trial to matters bearing on the salvage value issue, but they did so with the understanding that, if it became necessary, they would be able at a subsequent stage of these proceedings to address themselves to the question of adjustments under section 481. Our discussion is therefore limited to the question of whether petitioner can be regarded, for the purposes of section 481, as being required to use a different “method of accounting” to compute its taxable income when the salvage value of relay rail is determined by reference to its current fair market value. Without such a change of accounting-method, section 481 will not apply. See Schuster’s Express, Inc. v. Commissioner, 66 T.C. 588 (1976), affd. without published opinion 562 F.2d 39 (2d Cir. 1977, 40 AFTR 2d 77-5293, 77-2 USTC par. 9495 ).
Under the applicable regulations, a “method of accounting” includes not only a taxpayer’s overall plan of accounting for gross income or deductions, but also the taxpayer’s accounting treatment for any “material item” within the overall plan. Secs. 1.481-l(a)(l) and 1.446-l(e)(2)(ii)(a), Income Tax Regs. 287 Where the accounting treatment of a given item involves the proper time to include the item in income or to deduct it, the item is viewed as “material” under the regulations, and any change in the treatment of that item is considered a change in the taxpayer’s “method of accounting”; conversely, where the matter of proper timing is not involved, a change in the accounting treatment of an item will not be considered a change in the taxpayer’s “method of accounting.” Secs. 1.446-l(e)(2)(ii)(a) and 1.446-l(e)(2)(ii)(6), Income Tax Regs. See Schuster's Express , Inc. v. Commissioner, supra at 597.
There can be little doubt in the present case that respondent is changing the treatment of a “material item.” Under the RRB method used by petitioner, an increase in the salvage value of a given quantity of relay rail which is subsequently laid as an addition 288 will, because of the impact on operating expenses, have an effect on the timing of petitioner’s deductions.
As we point out above, when petitioner lays rail in replacement, the result of its accounting procedure is to reduce its replacement deduction by the salvage value of the relay rail. That salvage value is subsequently deducted when the relay rail (relaid as an addition) is retired in a later year. When respondent increases the salvage value, he reduces even further the deduction in the first year and, correspondingly, he increases the deduction in the later year in an equal amount. Although respondent’s adjustment changes the amount deducted in each of the years, the total amount of petitioner’s deductions remains unchanged by the adjustment. 289
The net effect of respondent’s action is to move a portion of the deduction from the first year to the later year. The affected portion is equal to the difference between the salvage value advanced herein by respondent and the salvage value used by petitioner during the years at bar. 290 Thus, to the extent of this difference, the present issue involves a question of the proper year in which to take a deduction, and the regulatory “timing” requirement is satisfied. Connors, Inc. v. Commissioner, 71 T.C. 913, 919 (1979); Schuster’s Express, Inc. v. Commissioner, supra at 596-597. 291
It is clear, however, that even a change in treatment of a “material item” will not be viewed as a change in the taxpayer’s “method of accounting” where the new accounting treatment is the result of “change in underlying facts.” Secs. 1.446-l(e)(2)(ii)(6) and 1.446-l(e)(2)(iii), examples (3) and (4), Income Tax Regs. Respondent believes this exception to the general rule is to be applied in the present circumstances. We do not agree.
In the portion of this opinion entitled “Issue (yy): Deduction of Embankment Expenditures,” we addressed ourselves to petitioner’s argument that the issuance of an opinion by the Court of Claims (in which certain deductions were allowed) made it permissible for petitioner to alter its treatment of a “material item” under section 446. In rejecting petitioner’s contention that the promulgation of the opinion was within the purview of the term “change in underlying facts,” we observed that the court opinion did not create any change in the factual circumstances surrounding the making of the contested expenditures. We concluded that petitioner had changed its “method of accounting.”
Similarly, in connection with the present issue, the new accounting treatment is not the result of a change in any of the factual circumstances relating to the relay rail. We cannot accept respondent’s argument that his adjustment to petitioner’s salvage value figures is occasioned by a change in the “underlying fact” of fair market value. While it appears true that the market value of relay rail was increasing, we do not view respondent as merely adjusting an estimate of market value in order to account for that increase. Rather, the purpose of respondent’s adjustment herein is to establish fair market value as the applicable standard.
Our conclusion in this respect is compatible with the conclusions reached by the Court of Claims in Baltimore & Ohio Railroad Co. v. United States, 221 Ct. Cl. 16 , 603 F.2d 165 (1979), a case decided subsequent to the filing of the briefs as to this issue. The taxpayer in that case was a railroad which had consistently calculated the salvage value of its relay rail under the RRB method at 75 percent of the price for new rail. However, for the taxable year 1955, the taxpayer decided to use, instead, the fair market value of the relay rail as the measure of its salvage value. 292 The taxpayer initiated this change because during 1955 the fair market value of the used rail was less than 75 percent of the price of new rail. Thus, contrary to what is usually the case, the switch to the fair market value approach resulted in increased deductions for the taxpayer when it recovered its relay rail. Although the Government favored the use of fair market value, it argued that the taxpayer could not lawfully make this switch. The Government claimed the taxpayer’s change in the manner in which it calculated salvage value was a change in its “method of accounting” under section 446(e). Because the taxpayer had not obtained the required prior approval of the Commissioner for the new “method of accounting,” the Government argued the taxpayer was required to continue to value the relay rail in its customary manner. 293
In deciding that the taxpayer had not used a different accounting method and therefore did not need the Commissioner’s consent, the Court of Claims stated ( 603 F.2d at 170 ):
The 75 percent of new rail price formula used by plaintiff [taxpayer] on its 1955 books and tax returns, like the valuation formulas in Rev. Proc. 68-46 and Chesapeake and Ohio Railway Co., supra [ 64 T.C. at 392 ], is a formula designed to reflect fair market value. [Fn. ref. omitted.]
As a result, the court concluded that the taxpayer had simply replaced one method of estimating fair market value with another. “Such a switch,” the court held, “is not a change in accounting method, but a mere change in the underlying facts brought about by the adoption of a more accurate valuation formula.” 603 F.2d at 170 . The court added, however, that if the taxpayer’s previous valuation formula had been “based wholly or partially on historic cost of rail,” the switch to a fair market value approach would not be a “change in underlying facts.” 603 F.2d at 170 n. 11. In such an instance, the court concluded there would be change in “method of accounting,” under section 446.
In the instant case the Commissioner, and not the taxpayer, effected the change in the manner of determining relay rail salvage value, and the question of consent under section 446(e) is obviously irrelevant. 294 However, because a “method of accounting” under section 446 is also a “method of accounting” for the purposes of section 481, the views of the Court of Claims in the Baltimore & Ohio case are pertinent to our present inquiry.
The critical distinction between the present case and the Baltimore & Ohio case is that, here, the $30 salvage value figure used by petitioner during the years at issue was not an approximation of the fair market value of the relay rail. While it may have been the desire of the ICC during the years at issue that petitioner assign a value to salvage that was more closely in line with current market values, 295 it seems clear that petitioner did not do so.
The salvage value of $30 used by petitioner in the years before us was simply an “assigned value” which was in no way related to fair market value. At the request of the ICC, petitioner increased its assigned salvage value from $20 to $25 and from $25 to $30, but these small increases were obviously not intended to approximate fair market value. While the evidence does not establish with any precision the factors which petitioner considered in making its salvage value computation, the testimony of petitioner’s witnesses suggests that petitioner was, initially at least, utilizing a cost-less-depreciation approach, or attempting to estimate the salvage value of the rail when it would ultimately be sold for scrap. Furthermore, petitioner has always contended that salvage value cannot exceed cost, which it could very well do in a period of rapidly rising prices if salvage value is equated with fair market value. 296 But whatever the basis for petitioner’s assigned salvage value, it clearly was not based on fair market value of the relay rail when lifted. 297
In the Baltimore & Ohio opinion, the Court expressed the view that a change from a valuation formula based wholly or partially on cost to one based on fair market value would not be a “change in underlying facts” under the regulations. See 603 F.2d at 170 n.ll. The court noted that formulas based on cost “are conceptually different in that they are not designed to reflect fair market value,” 603 F.2d at 170 n. 9. However, we do not read the opinion of the Court of Claims as suggesting that the only time there would not be a “change in underlying facts” is when there is a switch from a cost figure for salvage to a market value figure. Rather the language in that case makes it clear that the court would have concluded there was no “change in underlying facts” if the taxpayer had been using any approach which was not directed at estimating fair market value. The soundness of such a result is readily apparent in a case like the one at bar in which respondent’s approach for calculating salvage value is totally inconsistent with petitioner’s and in which respondent’s use of fair market value does not find its justification in any altered circumstance involving the relay rail.
While we recognize that the accounting procedures, for inventories may differ from the accounting procedures for relay rail, several of the examples included in section 1.446-l(e)(2)(iii), Income Tax Regs., are consistent with our conclusion here. Example (5) provides that a change in the basis for valuation of inventories from cost to the lower of cost or market is a change in an overall practice of valuing items of inventory, and is therefore a change in “method of accounting.” Example (6) provides that a change requiring appropriate allocation of overhead is a change in “method of accounting” because it involves a change in the treatment of a “material item” used in the overall practice of identifying or valuing items of inventory.
We conclude that respondent’s adjustment is, therefore, not the result of a “change in underlying facts,” as that term is used in section 1.446-l(e)(2)(ii)(&), Income Tax Regs. Accordingly, we hold that, on the facts of this case, respondent’s adjustment to salvage value effects a change in petitioner’s “method of accounting” under section 481.
We decide the salvage value question for respondent and (to the limited extent it is before us) the section 481 question for petitioner.
XIII. Depreciation of Replacement Facilities 298
This issue presents the following questions for our consideration:
Whether petitioner received nonshareholder contributions to its capital under section 113(a)(8) of the 1939 Code, justifying depreciation deductions under section 167 of the 1954 Code, when (pursuant to various pre-June 22, 1954, transactions) petitioner acquired replacement railroad facilities which were paid for by governmental bodies.
Whether “terms letter” agreements entered into by the parties prior to the years at issue prevent petitioner from taking the depreciation deductions claimed herein.
FINDINGS OF FACT
Issue (aaa)
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 relates to various transactions, described below, which involved the predecessor Southern Pacific Co., the former Southern Pacific Co., the Central Pacific Railway Co., the Texas & New Orleans Railroad Co., and the El Paso & Southwestern Railroad Co,., hereinafter sometimes referred to individually or collectively as petitioner.
Subsequent to December 31,1920, and prior to June 22,1954, various governmental bodies bore the cost of the construction of assets for each of the above-named railroad companies. This construction at public expense of new railroad facilities was, in the typical case, done to replace facilities retired from service by reason of construction projects by public authorities. Twenty-one transactions are in dispute in which petitioner acquired such facilities. Information pertaining to the relevant projects is provided in the table on pages 748-749.
The amounts shown in the table on pages 748-749 do not include the costs of constructing the elements of grading and tunnel bores covered by Issue (pp) 299 in this case, totaling $10,774,722 in ICC Account 3 and $1,390,364 in Account 5. Also not included in the amounts above are further costs involving assets covered by Accounts 8 (ties), 10 (other track material), 11 (ballast), and 12 (tracklaying and surfacing), totaling in the aggregate $5,032,183. Further costs, totaling $2,250,211, pertaining to assets such as land, are also not included in the amounts shown in the table.
Additional information regarding each of the 21 transactions is provided below. In the summary which follows, the word “Government” is used to refer to the governmental entity (or contracting agency) listed in the table as having been involved in the named project, and the word “petitioner” is used to refer to the railroad listed for that project:
Shasta Dam. — A dam and reservoir to be constructed by the Government on the Sacramento River was to submerge approximately 36 miles of petitioner’s railroad line. The Government transferred new rights-of-way to petitioner, and a new railroad line was constructed, the Government paying for all construction on the substituted line.
Roseville “Hold Yard” Transfer — The Government leased certain land from petitioner and constructed trackage and appurtenances thereon (a “hold yard”) at its own expense. Under the lease, petitioner could require restoration of the premises to its original condition. Several years later, the lease was terminated by mutual consent, and petitioner gave notice that it wanted to have the premises restored. Restoring the yard
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to its original state would have involved considerable expense, and the Government felt it advantageous not to do so. Petitioner and the Government agreed that (1) the Government would transfer the improvements to petitioner for $25,000, and (2) petitioner would accept the improvements (the cost of which exceeded $25,000) in lieu of the performance by the Government of its obligation of restoration.
Tinemaha Dam — A dam and reservoir constructed by the Government in the Owens Valley was to submerge part of petitioner’s railroad line. The Government paid for the construction of a replacement for that portion of the railroad line over a new right of way.
Davis Monthan Air Force Base. — The construction of new runways by the Government necessitated the relocation of petitioner’s railway line. It was the intention of the Government to acquire a portion of the rights-of-way and facilities of petitioner required to construct this project and to make petitioner whole by the construction of new facilities. The parties agreed that the measure of just compensation to petitioner was the cost of physical relocation, alteration, and removal of petitioner’s existing facilities and the cost of acquisition of rights-of-way, and the replacement of facilities which existed on the abandoned line. The Government reimbursed petitioner for all costs incurred by petitioner in the performance of this contract. The relocation, rearrangement, or alteration of the facilities was to put petitioner as nearly as practicable in its existing condition as of the date of the contract. Any betterment which petitioner desired to install or construct superior in capacity or in quality to the previously existing facilities was to be at petitioner’s own expense.
Oakland, Calif., Crossover. — Incident to the construction of a separate grade and crossing where another railroad crossed over petitioner’s lines, replacement railroad facilities for petitioner were constructed. The Government paid for this construction.
Compton Creek Channel. — An agreement between petitioner and the Government (local) provided for a flowage easement and construction of a trestle over the Compton Creek flood control channel; it further provided that the Government (Federal) would bear the cost of reconstruction of the trestle if the channel were widened. When the channel was later widened, the Government (Federal) paid the cost of replacing the old trestle with a girder bridge. Additional flowage easements were given to the Government.
Verdugo Wash Channel. — The Government deepened the Verdugo Wash flood control channel across which petitioner had a railroad bridge at West Glendale, Calif. The deepening of the channel made it necessary to replace the existing bridge. The Government paid for the replacement, which was a 95-foot deck-plate girder span on concrete abutments.
Sepulveda Dam. — The construction of a dam by the Government as part of a flood control project was to result in the flooding of part of petitioner’s railroad line. The Government paid for the construction of a replacement of that portion of the line on a new right-of-way.
Fern Ridge Dam. — The construction of a dam and reservoir by the Government in Oregon as part of the Willamette River basin flood control project was to submerge a portion of petitioner’s railroad line which was below sea level. A 7,000-foot segment of roadbed and embankments was to be inundated by overflow and backwater and it became necessary to raise the line above the water level and to protect the side of the embankment facing the reservoir. The agreement between petitioner and the Government granted the Government the right to overflow all of petitioner’s rights-of-way and other property lying below a certain mean sea level. In return, the Government paid to petitioner the cost of elevating sections of track for an aggregate distance of 7,000 feet and to do other necessary work so that the subgrade of the track would not be less than 4 feet above the maximum high water level in the reservoir.
Eugene, Oreg., Highway Relocation. — The Government relocated and built the Pacific Highway through eastern Eugene. The highway construction required the removal of petitioner’s railroad line and the construction of new railroad line near the Springfield junction. The Government assumed the cost of the new line, except for the cost of concrete abutments for two structures to provide for a second track and other betterments.
Front Street, Coos Bay, Oreg. — Because the Government decided to relocate a highway, it became necessary for petitioner to remove part of its railway line and to construct a replacement for the removed portion. Costs were borne by the Government. Additionally, there was an exchange of land.
Vail, Ariz. — The Government’s expansion of Davis Monthan Air Force Base necessitated the removal of 14 miles of railroad line and the construction of a new line over a new right-of-way. The costs were paid for by the Government.
Lookout Point (Meridian) Dam. — The construction by the Government of a dam and reservoir on the Willamette River in Oregon necessitated the relocation of a portion of petitioner’s railroad line and the abandonment of certain of its facilities. In acquiring these assets, it was the Government’s intention to make petitioner whole by paying for the construction of the replacement line. By contract, petitioner agreed to convey the indicated assets and to accept the construction payments. The line involved was approximately 22 miles long and ran between Lookout and Jasper, Oreg.
Santa Clara River Bridge. — A reservoir owned by the Government broke, and the resultant flood washed out petitioner’s bridge across the Santa Clara River. A new bridge was constructed, and the expense was reimbursed by the Government pursuant to a claim filed by petitioner.
All American Canal Bridge. — The Government, in constructing the All American Canal, had to cross petitioner’s line in California, and it became necessary to construct a railroad bridge over the canal. The Government paid for the construction and was granted an easement under the bridge for the canal.
Harvey, La., Bridge. — Owing to the construction of the Louisiana-Texas Intracoastal Waterway by the Government, it became necessary to construct a moveable bridge to permit petitioner’s railroad line to cross a new canal. The moveable bridge replaced a draw bridge. The costs of constructing the bridge and raising and realigning the track were paid for by the Government.
Neches River Crossing. — Pursuant to an order of the Secretary of War, requiring petitioner to provide improved horizontal and vertical clearance for navigation where its railroad line crossed the Neches River in Texas, an existing swing span was replaced with a 230-foot bascule lift span. This change necessitated new bridge piers, new fenders, a new approach span, and other approach changes. The Government paid for part of the costs involved.
Baldwin, La., Bridge. — The Government constructed the new Charenton Drainage and Navigation Canal to provide a navigable connection to the Intracoastal Waterway and to provide for drainage. As a result, a 204-foot double-track swing bridge with approach girder bridges (together with appurtenances) was constructed to permit petitioner’s railroad line to cross the canal. The Government paid for the related costs. (This project is related to the two following projects; all three are covered by the same contract between petitioner and the United States Army Corps of Engineers.)
Wax Lake Outlet. — In connection with Government projects for the control of floods along the Mississippi River and some of its tributaries, a single-track bridge (comprised of three 400-foot main spans and two 70-foot approach girder spans), together with appurtenances, was constructed to carry petitioner’s railroad line over Wax Lake Outlet in Louisiana. All costs, except for a small section of siding, were paid for by the Government.
Berwick Bay. — In connection with the flood control projects mentioned immediately above, it was necessary to raise petitioner’s existing railroad bridge over Berwick Bay (Atchafalaya River) by 4 feet and to make changes to the approaches to the bridge. The Government paid for the construction costs.
Central Boulevard, Dallas, Tex. — The Government extended Central Boulevard onto petitioner’s right-of-way, and it was necessary to construct a replacement for petitioner’s railroad line to connect with other lines going into Dallas Union Passenger Station. Costs were borne by the Government.
The new facilities acquired by petitioner as a result of the above-described projects were constructed either by petitioner or on its behalf. The new facilities were owned entirely by petitioner. 300
In some instances, the newly constructed replacement lines paid for by the Government had advantages over the old lines. In other instances, the new lines had disadvantages when compared to the lines they replaced. For example, the lines constructed in connection with the Shasta Dam project had more advantages for petitioner than disadvantages, while the reverse was true for the lines constructed in connection with the Davis Monthan Air Force Base and Fern Ridge Reservoir projects. In still other instances, the advantages and disadvantages were viewed as balancing each other out.
Although new, unseasoned railroad line can require extraordinary maintenance for a period of years, petitioner was generally reimbursed by the governmental bodies for its expenses for extraordinary maintenance for a 5-year period. Ordinary maintenance costs remained the same in most cases.
Many of the public construction projects which gave rise to the transactions at issue involved the U.S. Army Corps of Engineers (hereinafter sometimes referred to as the corps) and, in those transactions, it was the corps with whom petitioner dealt in arranging for the reconstruction of its facilities.
Petitioner and the corps discussed the design and the engineering standards and requirements of the replacement facility. The purpose of these discussions was to assure there would be a replacement in kind of the old facilities, with similar loadings and comparable design criteria. For example, even if a steel trestle was to replace a wooden one, it would be designed for the same load limitation. The new facilities were not designed to produce operational advantages for petitioner (such as allowing for greater speeds), although occasionally such advantages may have been a fortuitous by-product of the reconstruction.
To the extent that the replacement facility would be a betterment (e.g., a two-lane bridge replacing a single-lane bridge, or heavier track replacing lighter track), petitioner would pay for the difference in cost. In this instance, there was bargaining between petitioner and the corps as to dollar amounts. Aside from this bargaining relating to betterments, the negotiating between petitioner and the corps was directed solely at producing railroad facilities with the same characteristics as the one being replaced and not at producing financial benefits or advantages for the respective parties.
Although the corps had a power of condemnation, the corps regarded condemnation as something to be used only as a last resort. In practice, this power was not exercised in railroad relocations.
A War Department circular letter of October 4, 1939, published by the Office of the Chief of Engineers and applicable to the corps, set forth directions for drafting special contracts for relocation or reconstruction of public utilities, including relocation of railroad lines submerged in Federal reservoir areas and reconstruction of bridges whose original sites were necessarily preempted by the United States. Because of the nature of the construction involved in relocation of railroad lines, it was usually considered to be “to the advantage of both parties that the railway company should itself carry out the rehabilitation in whole or in part, and that the United States should reimburse it for its just expenditures for that purpose.” It was noted that title to the facilities newly constructed at the expense of the United States did not pass to the United States, but instead the new facilities were constructed because “the United States has lawfully taken * * * certain tracks of a railway company * * * and is legally obligated to make compensation therefor.” Compensation would include reimbursement for “excess maintenance,” and this included not only the extra maintenance required while a new line became seasoned, but also the proportionately increased costs of maintenance due to “any increase in length of track.” (This last provision was qualified in 1950.) Because the railroad was “entitled only to be restored, as nearly as practicable, to status quo,” the cost of any betterments desired by the railroad to be incorporated in the new facilities being constructed to replace those being destroyed by the public project was required by the War Department to be borne by the railroad.
In the case of right-of-way land, as opposed to the structures and equipment, title to the railroad’s old right-of-way land had to vest in the United States, and the War Department’s circular letter stated that “titles to the new rights-of-way [when] acquired in the name of the United States * * * may be conveyed to the Railway Company upon completion of the relocation, by way of exchange for the company’s conveyance to the United States of its abandoned right-of-way.”
As to structures and equipment, the War Department’s circular letter prescribed that material of value in the old railroad line be salvaged, and because, “As a rule, their value is greater to the Railway Company * * * it is preferable that it salvage and take title to such property * * * and that corresponding credits be made to the United States therefor” by reducing reimbursements by the United States to the railroad for reimbursable costs borne by the railroad. Recent contract instructions include the remark that, “Of course, in the case of a railroad * * * the owner is entitled to salvage value, if any.” 301
It was never the intention of the Army Corps of Engineers to donate assets as a contribution to petitioner’s capital or in any way to improve petitioner’s financial state. The corps wanted only to replace in kind the facilities petitioner would no longer be able to use. The corps had no desire or purpose to increase petitioner’s business, or to produce a percentage of return on the reconstructed assets, or to decrease petitioner’s ordinary maintenance costs. It was never the intention of the corps that the replacement facilities should be compensation or payment for services rendered or should benefit petitioner commensurate with their value. The corps was unconcerned about matters relating to the production of income for petitioner.
In accounting for the transactions on its books, petitioner would subtract from its investment accounts the capitalized amount relating to the facilities retired from service and add to its investment accounts the cost of the new railroad facilities. For tax purposes, however, the total amount which petitioner added to the investment account for the new facilities was equal to the previously capitalized amount relating to the old facilities. Accordingly, there was no net change in petitioner’s tax basis by virtue of the construction projects. 302 Petitioner’s claim herein relates to the difference between the amounts which it capitalized on its books to reflect the new facilities and the lesser amounts which it capitalized for tax purposes to reflect those facilities.
This issue was raised by petitioner in its “Amendments to Petition,” filed on May 23, 1973 , and was amended in its “Amendment of Petition to Conform to the Proof at June 1975, May 1976 , and July 1977 Trials,” filed on February 9,1979. 303 The 1979 amendment states (in part) as to this issue:
(aaa) The Commissioner erred in failing to allow deductions for depreciation in the amounts of $330,697.00, $334,594.00, and $334,594.00 for the taxable years ended December 31, 1959, 1960, and 1961, respectively, with respect to certain property received by the former Southern Pacific Company and railroad subsidiaries as “donations” prior to June 22,1954.
OPINION
Issue (aaa)
This issue involves 21 transactions in which a governmental body, prior to June 22, 1954, paid for assets acquired by petitioner. In the typical case, a Government construction project in the vicinity of one of petitioner’s railroad lines necessitated the abandonment or removal of certain of petitioner’s facilities and the construction of new facilities to replace them. The costs of the replacement facilities were borne by the governmental body. 304
Petitioner claims it is entitled to depreciate the cost of these assets. 305 Petitioner premises this claim on its view that it acquired the assets as a result of nonshareholder contributions to its capital. Under section 113(a)(8) of the 1939 Code, the basis for depreciating such assets is “the same as it would be in the hands of the transferor,” with adjustments. 306
Respondent’s position is that the governmental bodies were not making contributions to petitioner’s capital and that, as a result, petitioner has no additional basis in the assets and is not entitled to the claimed depreciation deductions.
The leading case on this issue is United States v. Chicago, Burlington & Quincy Railroad Co., 412 U.S. 401 (1973). 307 There, the taxpayer (CB & Q), prior to June 22, 1954, had constructed facilities at highway-railroad intersections and elsewhere which were paid for out of Government funds appropriated to further public safety and improve highway systems. CB & Q claimed that the governmental subsidies were contributions to CB & Q’s capital under section 113(a)(8) of the 1939 Code and that the facilities were therefore depreciable by CB & Q. The Court of Claims had agreed with CB & Q. 308 The Supreme Court, however, held that the governmental subsidies were not contributions to capital and that the assets in question therefore had a zero basis and were not depreciable.
The Supreme Court acknowledged that, in determining whether or not there had been a nonshareholder contribution to capital, prior cases of the Court had examined the transferor’s motive or intent. Where the transferor had intended no contribution to capital (intending instead to pay for corporate services), the assets were held to be nondepreciable. Detroit Edison Co. v. Commissioner, 319 U.S. 98 (1943). On the other hand, where the transferor did intend to make a contribution to capital (seeking advantage for the general community but expecting no direct personal benefit), the assets were held to be depreciable. Brown Shoe Co. v. Commissioner, 339 U.S. 583 (1950).
Apparently concluding that the intent of the transferor is not a wholly satisfying independent criterion for determining whether or not there has been a nonshareholder contribution to capital, the Supreme Court observed that other features of such a contribution were “implicit” from the Detroit Edison and Brown Shoe opinions:
We can distill from these two cases some of the characteristics of a nonshareholder contribution to capital under the Internal Revenue Codes. It certainly must become a permanent part of the transferee’s working capital structure. It may not be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee. It must be bargained for. The asset transferred foreseeably must result in benefit to the transferee in an amount commensurate with its value. And the asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect. [ 412 U.S. at 413 .]
The Court applied these criteria to the CB & Q assets constructed with public funds. While the Supreme Court recognized that the assets may have possessed some of the characteristics of a contribution to capital (e.g., they were not payments for services provided by the taxpayer), the Court emphasized those characteristics which established the assets were not such contributions: (1) The facilities were not in any real sense bargained for and most likely would not have been built had the governmental bodies not required them. (2) Any economic benefit to the railroad was marginal, and no substantial benefit in terms of the production of income was foreseeable or taken into consideration by the governmental bodies. The facilities were constructed for the public benefit to improve safety and highway traffic flow, and the taxpayer’s need for capital funds was not considered. (3) The facilities were peripheral to the taxpayer’s business and did not materially contribute to the production of additional income. (“They simply replaced existing facilities or provided new, better, and safer ones where none otherwise would have been deemed necessary.” 412 U.S. at 414 .) Any incremental financial benefits (from lower accident rates, reduced expenses, and higher train speed) were incidental and insubstantial when compared to the amount sought to be depreciated. See 412 U.S. at 413-415 . Given these factors, the Court concluded that the governmental bodies had not made a contribution to CB & Q’s capital.
A similar contribution-to-capital question presented itself in Union Pacific Railroad Co. v. United States, 208 Ct. Cl. 1 , 524 F.2d 1343, 1375-1380 (1975). 309 That case involved, inter alia, “transactions in which the Federal Government paid the plaintiff [railroad] the cost of relocating or protecting such parts of its line as would be flooded or threatened by a rise in water level by reason of a Government dam about to be built,” as well as transactions related to highway construction in which a State or city government, “in the interest of public convenience and safety, * * * paid the cost of railroad highway crossings such as a new grade crossing or the replacement of a viaduct with a highway subway under the railroad’s line.” 524 F.2d at 1376 .
The Court held that the latter (highway-related) transactions were “governed by United States v. Chicago, Burlington & Quincy R. R., 412 U.S. 401 * * * (1973), in which substantially identical transfers were held not to effect contributions to capital.” 524 F.2d at 1376-1377 ; fn. ref. omitted. With regard to the dam-related transactions, the court stated ( 524 F.2d at 1378-1379 ):
The transfers in class 1, typified by a transfer by the Federal Government to the plaintiff to replace a portion of the right-of-way to be flooded by a projected dam, were matter-of-fact business transactions in which the parties made an equal exchange, without altruism or donative intent. The closest analogy is a condemnation proceeding; no one would contend that payment of a condemnation judgment or of a sum in settlement to avoid an eminent domain proceeding is a contribution to capital. In the words of the majority opinion in Chicago, Burlington & Quincy R. R., supra, the transfers in class 1 “simply replaced existing facilities” and “did not materially contribute to the production of further income by the railroad.” 412 U.S. at 414 , 93 S. Ct. at 2176 .
In Los Angeles & S. L. R. R. v. United States, 21 F. Supp. 347 , 86 Ct. Cl. 87 (1947), a railroad (actually a subsidiary of the present plaintiff) gave up a portion of its line to a mining company in need of the land for an extension of the mine’s tailings dumps and received in return a new line as a replacement. This court said that the new line, though costlier than the old, “was of no more use to the railway company than the old line and would not produce a cent more income” or increase the value of the railroad’s assets “by a single dollar.” 21 F. Supp. at 353 , 86 Ct. Cl. at 99-100 .
The court believed the dam-related transactions could be “summarily disposed of in the light of the characteristics of a contribution to capital set out in Chicago, Burlington & Quincy R. R., supra.” 524 F.2d at 1378 . The court interpreted the CB & Q case to preclude from the capital contribution category, transfers which were “essentially an exchange of values or a payment for a specific quid pro quo which left the * * * transferee no better off than before and did not materially contribute to the production of further or additional income.” 524 F.2d at 1379 .
The issue involved in the instant case also arose in Louisville & Nashville Railroad Co. v. Commissioner, 66 T.C. 962 (1976), on appeal (6th Cir., June 2, 1978). In that case, costs of constructing grade separations along the taxpayer’s track system and costs of grade-crossing safety devices and protective equipment were paid for by various governmental bodies prior to June 22, 1954. The taxpayer claimed depreciation on these facilities. In denying the deductions, we held there had been no contributions to the taxpayer’s capital within the purview of sections 113(a)(8) and 114(a) of the 1939 Code:
We have here applied the criteria outlined by the Supreme Court in Chicago, B. & Q. R. Co. case and conclude that the assets constructed or acquired with public funds do not qualify as contributions to capital. It is readily apparent that the facilities were not actually bargained for by the petitioner. It is also apparent that there was no intention on the part of the governmental bodies to contribute to the capital of petitioner and no consideration was given thereto. Construction of these facilities was prompted by considerations of public safety and the evidence suggests that the impetus for these new facilities generally came from the various States and their political subdivisions. Without such instigation by governmental bodies and absent any governmental subsidies it would appear highly unlikely, especially during some of the financially troubled periods here involved, that these facilities would have been constructed. Negotiations with the public authority generally involved the type of facility which would be constructed and in some instances the allocation, if any, of the cost between the parties. * * *
Any benefits received by the petitioner (such as the probability of lower accident rates and the ability to operate its trains at higher speeds) were incidental in nature and certainly not commensurate with the cost of the facilities. Moreover, it is evident that the grade separations and the grade-crossing safety devices were peripheral to petitioner’s business and there is no suggestion in the record that they made any material contribution to the production of income. * * * [66 T.C. at 992; fn. ref. omitted.]
It is apparent from the discussions in the foregoing cases that, if petitioner is to prevail herein, it must show, at least (1) that the transfers from the governmental bodies were bargained for by petitioner; (2) that the governmental bodies intended to contribute to petitioner’s capital (see the discussion below); (3) that it was foreseeable that each transfer would result in a benefit to petitioner commensurate with its value (and not merely a marginal benefit); and (4) that the relevant assets were employed in or contributed to the production of additional income in petitioner’s business (and did not yield merely incidental financial benefits or produce additional income which was insubstantial when compared with the amount of petitioner’s depreciation claim). 310
From our examination of the documentary and testimonial evidence in the record, we conclude that these characteristics are not present in the instant case.
Here, as in the cases discussed above, the facilities were necessitated by Government action and would not have been constructed or acquired by petitioner in the absence of such action. The only element of meaningful bargaining shown by the record relates to the extent that petitioner would pay for any betterments. 311 Other discussions between petitioner and the governmental bodies were concerned with the details of producing a replacement in kind. There were no negotiations directed at inducing the governmental body to provide a replacement since there was never any question that a replacement would be forthcoming. Petitioner was, therefore, never called upon to bargain for a transfer of property or for the payment of construction costs. As in the CB & Q case, the present transfers of property (and the payment of costs) came about as the result of what is in substance unilateral action by the governmental entities. See 412 U.S. at 414 . See also Union Pacific Railroad Co. v. United States, supra at 1378, wherein the court concluded that “assets granted by a governmental body for replacement of existing facilities, where none otherwise would have been deemed necessary, are not contributions to capital” because they were not “bargained for.”
Moreover, there was no intent on the part of the governmental bodies to contribute to petitioner’s capital and petitioner’s need for capital funds was not considered by them. The governmental entities could not have anticipated any substantial economic benefits to petitioner as a result of their actions since nothing they did could foreseeably produce such a result. As can be seen from our findings of fact relating to the Army Corps of Engineers, there was never any intention on the part of the Government to benefit petitioner in any respect. The sole intention was to replace in kind all railroad assets that were adversely affected by a given Government construction project. 312 There was no attempt by the Corps of Engineers to produce a superior railroad line or one which would improve petitioner’s operating capabilities, and there was, therefore, no reason to believe the replacement facilities would have any significant beneficial economic effect. Given the fact that the new line was a substitute for one which petitioner would no longer be able to operate, it was clear that any net benefit to petitioner would be minimal and not commensurate with the value of the replacement line.
Furthermore, as in the cited cases, the acquired assets at issue did not materially contribute to the production of any additional income for petitioner. Any benefits inuring fortuitously to petitioner by virtue of the newness of a replacement line (e.g., the ability to increase train speed where curves had been reduced) were merely incidental (see Louisville & Nashville Railroad Co. v. Commissioner, supra at 992), and do not appear on this record to have substantial financial impact. 313 Petitioner’s financial position was basically unchanged by the transactions.
In each instance, there was “essentially an exchange of values or a payment for a specific quid pro quo” which did not contribute to the production of additional income or leave petitioner any better off. Union Pacific Railroad Co. v. United States, supra at 1379. In short, we conclude that the transactions at issue herein did not possess sufficient attributes of a nonshareholder contribution to capital to bring them within the scope of section 113(a)(8) of the 1939 Code.
Petitioner argues that the Supreme Court, in the CB & Q case, has eliminated the intent of the transferor as a relevant consideration. Our reading of that case indicates to us that it is still important to ascertain whether the transferor intended to make a contribution to the transferee’s capital. The CB & Q case merely suggests it is necessary to examine several characteristics of a transfer, and not intent alone, to determine its status as a capital contribution. In Springfield Street Railway Co. v. United States, 217 Ct. Cl. 89 , 577 F.2d 700, 703 (1978), the Court of Claims pointed out that, in CB & Q, the Supreme Court “clearly affirmed the viability of the ‘intent of the transferor’ test. At the same time, however, the Court recognized that more than evidence of a nonshareholder’s intent to make a capital contribution is required.” To the same effect, see Louisville & Nashville Railroad Co. v. Commissioner, supra at 992, wherein we applied the CB & Q criteria and found that “there was no intention on the part of the governmental bodies to contribute to the capital of petitioner” and that the assets at issue did not possess other relevant characteristics of a contribution to capital. See also Union Pacific Railroad Co. v. United States, supra at 1379, wherein a payment by a town for construction costs of “sanitary privies” was held to be a contribution to the taxpayer’s capital because, inter alia, “the town intended * * * to confer a benefit upon the railroad.” 314 Therefore, although the Supreme Court has moved away from viewing the transferor’s motivation as the sole criterion (cf. State Farm Road Corp. v. Commissioner, 65 T.C. 217, 226 (1975)), we are unable to agree with petitioner that the transferor’s intentions no longer have any pertinence under the CB & Q opinion. 315 Accordingly, in concluding above that the governmental bodies made no capital contributions, we relied in part on the evidence of record relating to their motivations. 316
In an attempt to distinguish the 21 transactions at issue from the transactions in the CB & Q case, petitioner points to the fact that the facilities in this case are directly involved in railroad operations while the facilities in CB & Q were not. In our view, an inquiry into whether a given asset is directly or indirectly used in business operations would not, by itself, be determinative of the question of whether the asset is a contribution to capital. At most, such an inquiry might be relevant for the purpose of analyzing the nature of the benefit to the recipient and the income-producing potential of the asset. In the present case, our analysis of all relevant factors in the record has led us to conclude that the facilities at issue were not capital contributions.
A further attempt by petitioner to show a difference between this case and the CB & Q case is based on the assumption that petitioner would have built the new facilities in any event. In contrast to the facilities in the CB & Q case, which most likely would not have been built had it not been for governmental action, petitioner asserts that the new railroad lines in the instant case would have been built, irrespective of the action of the governmental bodies, by virtue of the fact that petitioner’s old lines were about to become unusable. We find this asserted distinction to be without merit because it focuses on only one aspect of a total transaction and therefore is completely at odds with the realities of the situation. Petitioner is attempting to gloss over the actual context in which the construction costs at issue were incurred. 317
The transactions in dispute are similar to the ones discussed in the portion of this opinion entitled, “Issue (rr): Deductions Incident to Relocation Projects,” which also involved the replacement of segments of railroad lines in connection with public projects. In that issue, petitioner sought deductions under section 165 or section 167 for its cost basis in the track materials removed from the discontinued railroad line. 318 For various purposes, petitioner sought to have us bifurcate the transactions and treat the removal of the old railroad line and its replacement with the new railroad line as separate events with independent tax significance. In denying the claimed deductions, we concluded that it was necessary to look at each relocation project in its entirety and not break it down into its component parts since the removal and replacement were mutually dependent parts of one transaction. We viewed each transaction as involving the exchange of one operating railroad line for another, with petitioner ending up in essentially an unchanged position both operationally and economically.
Petitioner’s argument in the present case is also an attempt to bifurcate the projects in a manner inconsistent with the realities of the transactions. For the reasons similar to those given in our discussion of Issue (rr), we must view these transactions, as well, as a unit. It seems obvious that the replacement facilities would not have been constructed were the governmental bodies not about to take action which would destroy the usefulness of the existing railroad lines. The construction of a new line was, therefore, not an independent event, but one which was necessitated by Government action. Here, too, we believe the facts show there was an exchange of one operating railroad line for another, with no significant change in petitioner’s position. 319 Viewed in this light, the instant transactions clearly lacked several significant characteristics of a contribution to capital. See Union Pacific Railroad Co. v. United States, supra.
While there may, in fact, be distinctions which can be drawn between the present transactions and the CB & Q transactions, we do not believe they are sufficiently substantive to warrant the result petitioner seeks.
Finally, as we noted earlier in this opinion, some of the projects seem to differ somewhat from the typical factual pattern we have been discussing. On brief, the parties dealt with all of the 21 transactions as though they'were factually similar. However, the evidence of record, skimpy as it is in this respect, suggests that in at least three instances, the transactions were different. While our general conclusions herein are applicable to those instances as well, we believe some additional comment is necessary.
Roseville “Hold Yard” Transfer. — In this transaction, the Government transferred various improvements to petitioner for $25,000 in lieu of complying with a contractual requirement that it restore land leased from petitioner to its original condition. While this transfer seems to have resulted from bargaining, it does not appear from the record that the Government was intending to confer a benefit upon petitioner; rather, it appears the Government was attempting to protect its own interest by reducing its costs. The fact that petitioner was required to pay $25,000 suggests the Government was seeking to transfer property with a value equal to the costs of restoration and not to confer an additional financial benefit or to provide assets for petitioner to use in the production of additional income.
We conclude that the Government was merely making petitioner whole for injuries sustained as a result of the failure to comply with contractual obligations. Here, as in the other transactions, there was a specific quid pro quo which did not improve petitioner’s economic position. As a result, this transaction, as well, possesses attributes which are fatal to the characterization of the transferred facility as a contribution to petitioner’s capital.
Neches River Crossing. — Here, an existing bridge was replaced with a bridge that had greater clearance for navigation, pursuant to an order of the Secretary of War. Some of the costs were paid for by the Government. The record as to this transaction is inadequate for us to conclude that it had the characteristics of a contribution to capital. The fact that the contracting agency was the Army Corps of Engineers strongly suggests the contrary. Furthermore, the bridge construction does not appear to be significantly distinguishable from projects involving the installation of safety equipment at Government expense. Under the authority of the decided cases dealing with such equipment, we hold that this transaction did not involve a contribution to capital.
Santa Clara River Bridge. — When a dam owned by the city of Los Angeles broke and washed out petitioner’s bridge, petitioner filed a claim against the city. As a result, the city paid for the construction of a new bridge. The main distinction between this project and the typical transaction at issue is that, here, the construction of the replacement asset was not planned in advance. In all other respects, the transaction does not appear to differ from the others in any meaningful way, and the result for tax purposes should be the same. Moreover, to the extent petitioner was being made whole by the governmental body, this project is similar to the Roseville “Hold Yard” Transfer, and our discussion relating to that transaction has pertinence here as well.
In sum, we hold that petitioner did not acquire any of the property at issue as a nonshareholder contribution to capital under section 113(a)(8) of the 1939 Code and therefore is not entitled to the depreciation deductions it claims herein. 320
We decide this issue for respondent. 321
XIV. Grading and Tunnel Bore Useful Life 322
This issue presents the following questions for our consideration:
Whether petitioner has established that the useful lives of its grading and tunnel bores were reasonably ascertainable in 1954 so that it is entitled to ratable deductions under section 167 during the years in controversy.
Whether the grading and tunnel bores at issue had any salvage value.
Whether petitioner, in commencing ratable depreciation, requires the consent of the Commissioner because it is changing its method of accounting under section 446(e).
FINDINGS OF FACT
Issue (jyp)
The parties filed no stipulation of facts pertaining specifically to this issue. To the extent that the stipulations of the parties pertaining to other issues in this case and to general matters are relevant to the questions raised by this issue, such stipulated facts (with associated exhibits) are incorporated herein by this reference.
This issue involves the grading and tunnel bores of various predecessor and subsidiary companies whose railroad lines comprised the Southern Pacific Lines, as well as the grading and tunnel bores of the St. Louis Southwestern Railway Co. and its subsidiaries. These lines are more fully described in the general findings of fact. All of the relevant railroad companies are hereinafter referred to collectively as petitioner, and all of the relevant railroad lines are hereinafter referred to collectively as petitioner’s lines.
As of the years in controversy, petitioner’s lines consisted of several connected routes. The terrain traversed by the Southern Pacific Lines was of great variety, crossing a number of mountain ranges. In passing through mountainous country, the lines often ran through canyons. Portions of the lines ran along ocean bluffs. Further, the lines ran partly through foothills, plateaus, deserts, salt flats, valleys, and other low level areas. The lines crossed over the Great Salt Lake in Utah. In western Texas, the lines wound and twisted through mountainous country after leaving the Rio Grande Valley, and then ran through rolling hill country and the Texas and Louisiana coastal plain. In Louisiana, there were severe swamp conditions. The terrain traversed by the St. Louis Southwestern lines was comparable to that in Texas and Louisiana.
Railroad line is constructed on right-of-way land, long strips of land which vary in width from 100 to 400 feet. 323 Grading, comprising open cuts (excavations) or fills (embankments), or both, provides a smooth and shaped roadbed for the railroad track or tracks. Grading can also involve clearing and construction of drainage ditches, water channel changes, and the sloping of unstable ground. The roadbed constructed by grading is narrower than the right-of-way and constitutes an improvement placed upon the land.
The railroad track consists of rail secured to ties placed upon ballast (granular material). Items of other track material, such as track spikes, affix the rail to the ties and hold the rail properly aligned in place. The ballast rests upon the roadbed and is significantly narrower than the roadbed, e.g., 14 feet wide, compared with a roadbed section 26 feet wide.
Tunnels are subsurface structures in the nature of improvements similar to grading. Where it is impracticable in hilly or mountainous terrain to make an open cut, a tunnel is bored through the hill or mountain. The result of this excavation of rock and earth, without more, is called a tunnel bore. The tunnel bore may or may not be reinforced with a lining, depending upon such conditions as the stability of the material through which the bore is driven. The floor of the tunnel serves as roadbed upon which railroad track is placed in a manner similar to its placement upon grading. Like roadbed, tunnels are narrow in comparison with the width of the right-of-way.
There were numerous tunnels at various points on the Southern Pacific Lines in Oregon, California, Nevada, Arizona, and New Mexico where the lines ran through mountainous terrain. As of the years in controversy, all tunnels were located west of El Paso.
The Interstate Commerce Commission’s Uniform System of Accounts for Railroads prescribes that investment in right-of-way land, grading, tunnels, and the track elements be charged to separate accounts, each with its own instructions. The right-of-way land is covered by Account 2, to which is charged the cost of all land acquired for transportation purposes. The grading is covered by Account 3, to which is charged the cost of clearing and grading the roadbed, and constructing protection for the roadbed. Tunnels are covered by Account 5, to which is charged the cost of constructing tunnels, including the cutting of the bore and the placing of portals at the entrances to and lining within the tunnels. The track eleménts are covered separately by Accounts 8 to 12. The foregoing investment accounts generally cover investment attributed, roughly speaking, to the physical assets themselves. Related investment amounts are charged to other accounts. 324 Repairs to grading are charged to operating expense Account 202, and repairs to tunnels are charged to operating expense Account 206. While there have been some changes in the details, the general intent of the Interstate Commerce Commission’s accounting rules has been carried forward from the inception thereof — from at least as far back as 1914.
Over the years, petitioner’s grading and tunnel bores have been retired in order to make railway line improvements which would increase traffic capacity and speed, reduce operating and maintenance costs, eliminate grade crossings, improve structures and restrictive clearances, and decrease service interruptions owing to the poor quality of the roadbed. These improvements have involved physical changes such as (1) reduced curvature and grade; (2) shortened alignments; (3) added sidings; (4) double tracking; (5) new structures; and (6) enlarged, daylighted or eliminated tunnels. Additional causes of retirements of grading and tunnel bores have included the discontinuation of service on a line for economic reasons, the providing of service to customers over alternate routes, and the abandonment of unneeded portions of a line.
One of the most frequent causes for retirements of grading and tunnel bores by petitioner is a line change. A line change often involves building an improved new segment of a line at a new location on a new roadbed, and retirement of the inadequate old segment which the new supplants. The new segment of the line generally is improved by a reduction in curves or grades, or both. Some line changes are made in order to shorten the length of the same line; some are made when it becomes difficult to accommodate traffic over the old line; and some are made as an alternative to reconstructing some part of an existing line. While it is generally possible to increase line capacity by widening the existing grading to accommodate the further tracks, it is not always feasible to do so where, for example, the soil is unstable.
Wide loads have sometimes necessitated line changes, though wider loads have also been accommodated by enlarging tunnels, or by constructing additional line, without necessarily retiring old line. Larger and heavier cars and locomotives are likely to result in future tunnel retirements, incident to line changes to avoid the inadequate tunnels.
Some line changes occur due to public construction projects such as those described in the portions of this opinion entitled, “Issue (rr): Deductions Incident to Relocation Projects” and “Issue (aaa): Depreciation of Replacement Facilities.”
Service over petitioner’s railroad lines is sometimes terminated and the lines abandoned for “economic” reasons, i.e., when costs of operation and maintenance exceed revenues. Every line that is potentially a candidate for abandonment of service is subjected to profit ability analysis (a comparison of revenues and costs). The initial decision to list a line as a prospective candidate for abandonment of service is usually made by personnel in the field. They consider the extent of the traffic on the line and the physical condition of the line.
Grading and tunnels like petitioner’s require constant repairs. Filled embankments are vulnerable to washouts due to flooding, and cuts deteriorate from weathering. Tunnel bores similarly suffer from erosion, and from alternative freezing and thawing when they are wet. Operations over the railroad lines can cause physical deterioration. The pounding of trains can cause settlement and it can cause underground moisture to come upward through capillary action and deteriorate the roadbed. In the event of a washout, or some other casualty which causes some grading to disappear, the cost of restoring the grading is charged to the above operating expense Account 202 as a casualty-repair maintenance expense.
Generally, grading improves with use because the fills become more seasoned and compact. In certain problem areas, where soil conditions are poor, petitioner experiences some settling or sliding of the grading with resultant lack of stability. Stability is also a problem where petitioner’s railroad lines cross former lake beds or traverse areas with moist clay soil. When there are problems due to unstable soil, they are made greater by increased loads on trains and by increased speed.
Damaging earthquakes are a common experience on the Southern Pacific lines and they are expected to continue. Ordinarily, damage from earthquakes and floods is repaired.
Tunnels present special maintenance problems. If they are timber-lined, the lining must be regularly inspected. Where deteriorated, the wood lining must be replaced or reinforced, or tunnels can be concrete-lined. Track maintenance is more expensive in a tunnel because of constricted work area, and where tunnels are wet, as they often are, the track deteriorates more rapidly. Tunnels in the high mountains also present ice problems, and freezing and thawing will cause some spalling of the rock. Extra maintenance costs result.
Petitioner’s railway lines have a variety of grades and curves. Some of the most extreme grades and curves are found in mountainous areas. Curves require increased maintenance. Very long trains sometimes have difficulty maintaining equilibrium on severe curves, and operating costs for trains are greater than on straight and level lines.
With proper maintenance, neither grading nor tunnel bores have determinable physical lives.
The decision to retire a line from service must be approved by Federal and State regulatory authorities. In considering an application to abandon service, the Interstate Commerce Commission considers public benefit as well as profitability. In deciding to apply for abandonment of service, possible public opposition is considered.
With the abandonment of service, the grading and tunnel bores (and other facilities) are retired.
Where a tunnel in its dimensions is a constriction in a line, an alternative to a line change or to enlarging the tunnel bore (to accommodate larger loads) is to daylight the tunnel. Tunnels are daylighted also in order to avoid reconstruction or installation of concrete lining. Where the tunnel lining has deteriorated to the point that large repair expenditures are necessary, daylighting will be considered. The process involves the destruction of the tunnel structure by excavating all the overburden. The tunnel sides are removed, and an open cut is made. After daylighting, the former tunnel looks like any open cut, and the tunnel is retired.
Grading and tunnel bores are retired incident to shifting operations to other lines owned by the railroad. For example, a major segment of petitioner’s South Line between Tucson, Ariz., and El Paso, Tex., originally constructed by the El Paso & Southwestern Railroad, was retired when, after study, it was concluded that the capacity of one of two main-line segments should be increased to handle all through traffic by installing centralized traffic control (CTC). 325 The retired main-line segment of the South Line thereafter served no further railroad purpose.
Grading and tunnel bores will be retired if railroad line is sold. Railroad lines as such are not sold often. The typical occasion for such a sale would be the sale of a spur line to an industry. The only sale of a major stretch of line by petitioner involved a California route (from Jojave to Needles) to the Atlantic & Pacific Railroad, now the Sante Fe.
When a railroad line is retired for any of the above or other reasons, all amounts charged to property accounts such as those previously mentioned with respect to the assets in such line must be cleared from those accounts. In the case of Account 2, the previously recorded investment in right-of-way land is cleared from the account, and the amount is transferred to the investment account for miscellaneous physical property, Account 737, to evidence that while still owned the land is no longer used for transportation purposes. In the cáse of Accounts 3 and 5, the grading and tunnel investment amounts are cleared from those accounts, and the amount is written off by charges to an operating expense account (or in the case of certain elements not here at issue as to which ratable depreciation has been accrued, to a depreciation account).
Under the Interstate Commerce Commission’s accounting rules, any amount charged to one of the property accounts must be written off when the asset, the investment in which was the occasion for the charge, is retired, regardless of amount. 326
When a tunnel is daylighted and the tunnel is retired, the total investment in that tunnel is cleared from Account 5, and the cost of the tunnel bore is charged to an operating expense account. When a tunnel is daylighted, and an open cut is created, the cost of removing the overburden is charged to Account 3, grading, as is an amount equal to what would have been the cost of excavating the tunnel bore area, at current prices. Operating expense is decreased by a credit thereto in the latter amount. Petitioner has not reduced its operating expenses for salvage upon retirement of grading or tunnel bores.
In the case of a line change, in which the old roadbed and tunnels are retired, the investment therein is cleared from the property accounts and charged to operating expenses. The cost of new roadbed, and any new tunnel, located elsewhere, is capitalized by a charge to property Account 3 and Account 5.
Retirements of grading and tunnel bores have been a constant feature in the life of railroads. Petitioner has retired grading every year. From 1916-73, petitioner had retirements out of investment for most vintage years, beginning with grading constructed and placed in service in 1853. 327
Retirements of tunnels have also not been uncommon. Of all 334 railroad tunnels which had ever existed on petitioner’s lines, 111 had been entirely retired from railroad service by the end of 1973, and there had been retirements of portions of 33 other tunnels. The oldest of the tunnels had been placed in service in 1866. As in the case of grading, tunnels of various vintages have been retired, including an 1866 vintage tunnel. 328
The several railroads of which petitioner is now comprised, and which represented the preponderance of the Southern Pacific lines, continued to grow physically as a railroad system until 1929, when they peaked in size with 13,848 route miles. 329 As of June 30, 1916, the same railroads had only 10,956 route miles. By the end of 1961, the comparable route mileage had declined to 12,017 miles.
The route mileage figures show the net effect of railroad line construction and railroad line retirements and abandonments. Petitioner has had retirements of railroad line from virtually its beginning, but such retirements have become greater in recent years. Petitioner has had some railroad construction in every year, but the construction was principally in the earlier years. Prior to the date of valuation, which generally was June 30, 1916, for petitioner’s lines, about 800 route miles of railroad line had been retired. There were only limited retirements from June 30, 1916, to 1929. From 1929 through 1961 there were 1,831 net route miles retired. From 1962 through 1975, a further 1,042 net route miles were retired. For the railroad industry as a whole, retirements of line since 1916 have been greater than construction.
The retirements of petitioner’s lines prior to 1929 were virtually all due to line changes intended to improve curvature and grade, or where operating problems called for line relocation. From 1929 on, line changes continued to be made, but line abandonments accounted for many of the retirements.
Railroad transportation service is closely tied to the economic activity in the territory being served. Despite attempts at innovative change, much freight traffic has been lost by the railroads to other modes of transportation.
After World War I, highway trucks began to perform short-haul transportation services. This activity, involving the transportation of small loads over short distances, increased as roads and highways improved throughout the Country. After World War II, motor carrier activity grew at a very rapid rate, and by the early 1950’s, highway vehicles were emerging as a dominant mode of transportation.
Truckers were able, generally, to render more prompt service than railroads and to cause less damage to cargo. Because of the ease of entry into the trucking industry, there has been a proliferation of trucking competitors. Relatively low capital investment is required, though there are high labor costs. When, in 1935, truck transportation was subjected to regulation, certain agricultural commodities were exempted, and truckers were able ultimately to make severe inroads into rail traffic, undercutting railroads in charging for movement of agricultural products. This competitive advantage permitted truckers to enjoy fairly stable operations in moving agricultural products, and railroads tended to share in that traffic mainly during seasonal peaks when truckers could not handle the loads. The result was spotty and uneconomic utilization of freight cars.
Motor carrier transportation evolved after World War II from the short-haul activity of the 1930’s into long-haul transportation, partly because in the late 1940’s and early 1950’s motor carrier transportation began to change from mainly small-scale activity by individuals and many small firms into large firms with extensive route networks. State regulations on use of highways were progressively being relaxed during the 1940’s and 1950’s, permitting highway motor carriers to haul larger and heavier loads. As a result, truckers were encouraged to travel greater distances.
In the early and mid-1950’s, plans for major new interstate highway construction and improved truck equipment promised increased opportunity for long-haul motor carrier transportation. Development of the turbo super charger in the early 1950’s enabled truckers to haul heavier loads. Motor carriers provided strong competition in virtually the entire territory served by petitioner. Abandonments of railroad lines, particularly shorter lines, due to competition by trucking companies occurred throughout petitioner’s railroad system.
After World War II, rail passenger service began to diminish substantially, with intercity passenger services being handled by other modes of transportation, particularly the airplane.
Pipelines represent still a further mode of conveyance. Products conveyed today by pipeline were previously carried by railroad tank cars. There have been virtually no new petroleum tank cars built since World War II. Pipeline transportation is economical mainly in the area of high-volume liquid-bulk traffic, but even solids can be so transported. Research and development of slurry pipelines was underway in the early 1950’s, and a coal slurry pipeline went into service in the east in 1956. Coal, and other solids moved as slurry, would be transported by railroad if they were not moved by pipeline. 330
Water transportation, while no longer the dominant mode of transportation it was in the early 19th Century, has nevertheless continued. Steamship lines and barge lines have continued to compete with railroads for certain types of traffic. There was growth in river and canal transportation. Water transportation, where available, could be provided at lower cost than railroad transportation, and competition from water transportation has been particularly significant in the case of bulk products such as coal, grain, and various chemicals.
The opening of the Panama Canal early in the 20th Century greatly affected petitioner’s transcontinental operations. There was also competition by water carriers along the Pacific Coast, and there has always been competition from water carriers operating on the Mississippi River and other inland waterways in the Midwest and Gulf states. Competition from water carriers had substantial impact on petitioner’s operations in the San Joaquin and Sacramento Valleys when, first in 1933, a ship channel was extended into Stockton, Calif., bringing water transportation into the heart of those agricultural areas. The inroads made by water transportation caused petitioner to retire some of its shorter railroad lines.
Many shippers turned to other modes of transportation. The transportation service offered by railroads was generally a little cheaper but slower than that of trucks, while faster but more costly than that of water transportation. Railroad transportation occasioned more damage to lading than truck transportation. Railroad costs were higher than pipeline costs.
In addition to being confronted with competition from other modes of transportation, railroads in the United States competed with each other. In the mid-1950’s, petitioner was confronted with increased competition from both the Union Pacific and the Santa Fe when those roads shortened the scheduled time for freight service between Chicago and Los Angeles by 24 hours.
Competition by other railroads and by other modes of transportation caused petitioner to seek further to improve its rail lines. Petitioner had improved its lines every year from the time they were first built in order better to meet competition. Improvements to the lines included line changes. Line improvements, including line changes, can be expected to continue to be made.
The year 1954 stands as a sort of pivotal year insofar as the long-time role of railroads as the dominant mode of transportation is concerned, for in that year it was clear that such dominance was ending. Statistics on intercity tonnage of freight show that, following World War II, there was a general downward trend in the tonnage carried by rail. The tonnage carried by nonregulated trucking, on the other hand, increased very rapidly. Similarly, tonnage carried by regulated truckers increased rapidly. The same growth in tonnage developed in oil pipeline transportation and water transportation on rivers and canals. By the early 1950’s, railroad transportation was declining at a rapid rate. While total tonnage carried by all truckers had not reached that carried by railroads in 1954, the trends indicated that trucker tonnage would soon equal that of the railroads.
By 1954, some emerging new technologies were important. New freight car orders began to be almost uniformly for larger and more modern cars, rather than for mere replacements of the old stock. New 50-foot freight cars were supplanting the old 40-foot freight cars, and a trend towards still larger cars was started. Shippers saw advantages in larger units of haul, and began to insist upon them.
In 1952, petitioner recognized that major changes would be needed to meet the intensifying competition and, under the direction of its president, inaugurated an extensive long-range planning program to identify necessary changes in the system and its operations. This program produced many specific recommendations for line changes that would entail retirements of grading and tunnel bores. These recommendations were in addition to anticipated abandonments and line changes which petitioner had included in its long-range planning over the years.
Line abandonments became a standing project for petitioner after World War II, and monthly progress reports were prepared for authorized abandonments-of lines which had ceased to be useful or had become uneconomical to operate. In addition, petitioner maintained running lists of proposed line changes, showing location, length of the line to be changed, present curvature and proposed curvature, present speeds and proposed speeds, and approximate cost of the line-change project. Even where line changes have been made in the past, additional line changes could be made in the same location to achieve further improvement of the railroad lines.
In 1954, it was becoming clear that the railroads were rapidly passing to a more specialized support role as a result of competition, and it was foreseeable that there would have to be many changes in railroad service. 331 These changes would both directly and indirectly lead to the retirement by petitioner of grading and tunnel bores as a consequence of improvements to existing lines and the outright abandonment of lines which no longer served a useful economic purpose.
While a trend toward larger freight cars began during the 1950’s, certain factors were limiting the size of such cars: tunnel dimensions, bridge and overpass clearances, track curvatures, and the inner space distance between parallel tracks. Because of the need for larger cars, it was foreseeable to petitioner in 1954 that there would be substantial new railroad construction and retirement of old line. 332
Although petitioner’s lines were located in areas generally favorable for rail traffic, the rapid growth of competitive forces made it apparent in 1954 that the pace of its grading and tunnel bore retirements would increase.
In its book accounting, petitioner has never assigned a salvage value to grading and tunnel bores upon their retirement. (Salvage value would reduce the charge to the operating expense account upon retirement.) For tax purposes, however, ordinary deductions have been disallowed by respondent where there was incidental use of retired grading, and in one instance, the disallowance was upon the theory that there was some salvage value.
It is rare for railroad service to be reintroduced once it is terminated, and it is therefore rare for railroad track to be reinstalled on grading once the grading is retired. The circumstances surrounding these rare instances of reuse have been unique and involved minimal amounts of grading. 333 Typically, retired grading is left in place without any further use of any sort after service over the line is terminated.
Railroad grading and tunnels have real value only as elements of a railroad line as support for track. If railroad transportation service is discontinued, the grading and tunnels typically have little or no value. In most instances, grading has a negative value when railroad transportation service ends, for it generally must be removed in order to put the land to another use.
When grading and tunnels are retired on right-of-way land owned by petitioner, petitioner continues to have the responsibility to maintain drainage and to control brush and weeds on the land. In the case of retired tunnels, the continuing responsibility can be very costly. 334
There have been isolated instances of tunnels being used incidentally for other purposes after the retirement of a line. In one such instance, a portion of the right-of-way land including that on which the tunnel was located was sold to a third party and the third party has been using the tunnel as an atomic-safe vault for storage of records and microfilms. Another tunnel has been leased to the city of Brisbane to serve as the city’s corporation yard, for storage of city machinery. In the cases of both the above tunnels, the incidental use after retirement occurred some time after the abandonment of railroad service.
Although some salvage value may exist when alternative use is made of a tunnel, it would generally be minimal when compared to the cost of the tunnel. Only where the alternative use is for (nonrailroad) transportation purposes (as was the case when, after the years in controversy, petitioner donated retired grading to the State of New Mexico for use as a highway) will there be substantial value.
Studies were made in an effort to determine a reasonable estimate of salvage value of grading and tunnels for purposes of this issue. These studies included the grading and tunnels of which incidental use was made for various purposes, after their retirement from railroad transportation service, as described above. In these studies detriment from the presence of grading and tunnel bores in many instances was ignored.
As to grading, data was first accumulated with respect to sales of railroad line and to the portion of the sales price attributed to grading from 1916 through 1973. The total amount received from sales of grading was $153,581, compared to total investment in grading retired for the same years of $29,966,246. The salvage value obtained upon this basis was 0.51 percent. 335
The similar study on tunnels disclosed only three instances in which consideration was received or value was determined for tunnels which were sold, leased, or donated after rail service was abandoned and lines retired. The amount received upon one sale with respect to the tunnel, and the value of the one tunnel leased (value determined by capitalizing rentals at 10 percent), totaled $12,600. When that figure is compared with the $4,760,226 total investment in tunnels retired, the salvage value obtained is 0.26 percent. 336
In 1976, a study was conducted for petitioner by A. V. Fend, a mathematician and statistician employed by the Stanford Research Institute. Fend made a life analysis of the investments in Accounts 3 and 5 that are currently not being depreciated, for purposes of the trial of this issue. Fend used various data retrieved from petitioner’s files, including investment and retirement amounts, and other data from open literature, with the objective of determining an expected life and a remaining life for petitioner’s investments in grading and tunnel bores. Fend applied the “retirement rate” method of statistical analysis in making his estimates. 337 The procedure requires a data base which lists total dollar investments by vintage year, with each retirement classified by the calendar year of retirement and the vintage year of investment. A continuous band of calendar years, called the experience band, is selected and analysis is restricted to the retirements which occur during this period. The “retirement rate” method then provides a straightforward mathematical algorithm which determines the annual rate at which investments were retired, and from this, a frequency function or empirical survivor curve may be constructed. It is possible, through the use of this method, to make reasonably acceptable estimates of the useful lives of assets such as petitioner’s grading and tunnel bores.
Fend’s estimates of expected useful life and of remaining life were made as of 1954. The conclusions reached from the “retirement rate" life analysis were that, as of 1954, the expected whole life for grading was 95 years, with a remaining life of 54 years, and the expected whole life for tunnel bores was 85 years, with a remaining life of 45 years.
The life analysis which resulted in the above conclusions entailed five sometimes-overlapping steps:
(1) Fend analyzed the investment and retirement data which reflected petitioner’s actual past experience to 1954 in order to quantify past retirement patterns in terms both of annual retirement numbers and retirement rates, and then to identify any trends that might exist. This quantification would serve as the base for determining an average life.
(2) From the preceding analysis, Fend generated a stub survivor curve. A number of actuarial procedures are available for doing this, and several were reviewed. He considered the “retirement rate” method most appropriate. The survivor curve under that method shows the percentage of original investments surviving as of the ages and years already experienced. The survivor curve generated was a stub (partial) curve, showing that less than a complete life cycle had been experienced up to 1954.
(3) Fend then selected a family of theoretical complete survivor curves. There are various families of curves available, and the choice is made by considering which family of curves is most compatible with (a) the past as evidenced by the stub curve and (b) reasoned future expectations. Fend chose the standard Iowa family of curves as the most suitable for petitioner’s grading and tunnel bores. 338
(4) Fend then selected the specific complete curve within the Iowa group which best fit his stub curve. This fitting can be done visually or by the mathematical procedure known as “least squares.” (The R2 curve was chosen as best fitting the stub curves for both grading and tunnel bores.)
(5) Fend then arithmetically calculated the expected whole life and the remaining life of the investments. The expected whole life is the arithmetic mean of the theoretical complete curve which was chosen as best fitting the stub curve. The remaining life at any given age is calculated from standard conditional probability formulas.
In the foregoing procedures, there was application of judgment throughout, although some steps were more mathematical in nature. The selection of a complete survivor curve to which to fit the stub curve involved primarily informed judgment. For example, a curve which mathematically “fit” the stub curve perfectly could still yield absurd results. A purely retrospective analysis can lead to obviously unreasonable estimates for the future. Such estimates are avoided by studying the factors that have caused the patterns displayed in the data on past experience, appraising likely changes in circumstances which would occasion shifts from the past patterns, and choosing a curve consistent with the logical constraints and the expected changes. If there are logical or factual reasons for concluding that the best fitting curve will yield an unrealistic result, the second or third best fit may be selected if one of these falls close to the life and dispersion which is dictated by informed judgment.
Fend was required to make a reasoned assessment of the future. He looked to three sources to find probable future retirements of investments in grading and tunnel bores which would serve as boundaries to his statistical analysis of past retirements and help him select an appropriate curve: (1) The several projections of retirements of grading and tunnel bores made by petitioner; 339 (2) an independent study by Stanford Research Institute evaluating past economic, technological, regulatory, and public policy factors and forecasting probable future changes in such factors and their impact on retirements in the future; 340 and (3) the work already done by other analysts in evaluating grading and tunnel bores and also other assets having similar retirement patterns. 341
The average age of grading investments on hand in 1954 was 49.5 years. By coincidence, 49.5 years was also the average age of existing tunnel bores in that year. In reaching the conclusion that the remaining useful lives in 1954 were 54 years (grading) and 45 years (tunnel bores), Fend did not merely subtract the average ages of the assets from their full useful lives. To produce a more accurate statistical projection of remaining life, Fend used a procedure which involved the fitting of a new mathematical curve and produced estimates which exceeded the arithmetical difference between whole life and average age.
The retirement data furnished to Fend showed all retirements by vintage year for the period 1916 through 1973 in the case of grading, and for the period 1865 through 1973 in the case of the tunnel bores, but Fend chose the period 1930-54 as the experience band in his final life analyses in the cases of both the grading and the tunnel bores. 342
Fend screened all the data furnished to him on past retirements to see if any retirements should be eliminated as “outliers.” In the case of the tunnel bores, he eliminated for life-analysis purposes the retirement of one tunnel which had survived only 4 years as a temporary tunnel built in connection with the construction of the Shasta Dam. He also eliminated all tunnels located in Mexico. Fend found nothing in the data furnished to him on past grading retirements which he considered to be an “outlier” to be eliminated for life-analysis purposes. He did not eliminate any retirements due to public construction projects.
In preparation for this trial, a depreciation study was made for respondent by Harold Heidrick, a depreciation engineer. He concluded it was not possible to arrive at a reliable determination of service (useful) lives for petitioner’s grading and tunnel bores. Heidrick used the vintage data prepared by petitioner and applied the “retirement rate” method. Using a purely mathematical process of curve-fitting, Heidrick came up with widely divergent useful lives and concluded the “retirement rate” method used by Fend to estimate the lives of the assets at issue was inappropriate for that purpose. 343
Petitioner has filed claims for refund, predicated on deductions with respect to its grading and tunnel bores, beginning with the year 1954. Claims for years prior to those at issue herein remain pending. On February 9,1979, 344 petitioner amended the portion of its petition relating to this issue to read in part as follows:
(3) Life analysis based on a great quantity of data showing retirements and other information now has established that as of 1954 for grading the expected whole life was 95 years, with a remaining life of 54 years, and for tunnel bores the expected whole life was 85 years, with a remaining life of 45 years. There was no salvage value.
* * * * * * *
(5) The Commissioner has failed to allow claims by the former Southern Pacific Company and the other railroad members of the consolidated group for depreciation deductions with respect to grading and tunnel bores upon the basis of the foregoing lives * * *
ULTIMATE FINDINGS OF FACT
The useful lives of petitioner’s grading and tunnel bores were reasonably ascertainable in 1954 by reason of their anticipated obsolescence.
As of 1954, the useful lives of petitioner’s grading and tunnel bores were as follows:
Account Average whale useful life Average remaining useful life (195U)
No. 3 Grading 100 years 59 years
No. 5 Tunnel bores 90 years 50 years
The grading and tunnel bores in issue had no salvage value.
OPINION
Issue (pp)
This issue involves petitioner’s claim for ratable deductions under section 167 for its grading and tunnel bores by reason of their anticipated obsolescence. In filing its Federal income tax returns for the years 1959,1960, and 1961, petitioner claimed no depreciation deductions with respect to its grading and tunnel bores. However, petitioner now contends that, by the year 1954, it was possible to ascribe useful lives to these assets and that petitioner is therefore entitled to an annual ratable allowance for depreciation during the years at issue. 345
Section 167(a) states:
There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)—
(1) of property used in the trade or business, * * *
Section 1.167(a)-l, Income Tax Regs., states:
(a) Reasonable allowance. Section 167(a) provides that a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or of property held by the taxpayer for the production of income shall be allowed as a depreciation deduction. The allowance is that amount which should be set aside for the taxable year in accordance with a reasonably consistent plan (not necessarily at a uniform rate), so that the aggregate of the amounts set aside, plus the salvage value, will, at the end of the estimated useful life of the depreciable property, equal the cost or other basis of the property as provided in section 167(g) and sec. 1.167(g)-l. * * *
(b) Useful life. For the purpose of section 167 the estimated useful life of an asset is not necessarily the useful life inherent in the asset but is the period over which the asset may reasonably be expected to be useful to the taxpayer in his trade or business or in the production of his income. This period shall be determined by reference to his experience with similar property taking into account present conditions and probable future developments. Some of the factors to be considered in determining this period are (1) wear and tear and decay or decline from natural causes, (2) the normal progress of the art, economic changes, inventions, and current developments within the industry and the taxpayer’s trade or business, (3) the climatic and other local conditions peculiar to the taxpayer’s trade or business, and (4) the taxpayer’s policy as to repairs, renewals, and replacements. * * * If the taxpayer’s experience is inadequate, the general experience in the industry may be used until such time as the taxpayer’s own experience forms an adequate basis for making the determination. The estimated remaining useful life may be subject to modification by reason of conditions known to exist at the end of the taxable year and shall be redetermined when necessary regardless of the method of computing depreciation. * * *
Section 1.167(a)-9, Income Tax Regs., states:
Obsolescence.
The depreciation allowance includes an allowance for normal obsolescence which should be taken into account to the extent that the expected useful life of property will be shortened by reason thereof. Obsolescence may render an asset economically useless to the taxpayer regardless of its physical condition. Obsolescence is attributable to many causes, including technological improvements and reasonably foreseeable economic changes. Among these causes are normal progress of the arts and sciences, supersession or inadequacy brought about by developments in the industry, products, methods, markets, sources of supply, and other like changes, and legislative or regulatory action. In any case in which the taxpayer shows that the estimated useful life previously used should be shortened by reason of obsolescence greater than had been assumed in computing such estimated useful life, a change to a new and shorter estimated useful life computed in accordance with such showing will be permitted. No such change will be permitted merely because in the unsupported opinion of the taxpayer the property may become obsolete at some later date. * * *
The instant issue presents the question we dealt with in Chesapeake & Ohio Railway Co. v. Commissioner, 64 T.C. 352 (1975), 346 wherein we held that the taxpayer’s grading and tunnel bores could be ratably depreciated under section 167 because these assets had reasonably determinable useful lives over which their costs could be allocated. Here, as in C & O, “the critical threshold inquiry is whether petitioner has demonstrated with adequate proof that its claimed deductions * * * embody sufficiently ‘accurate estimation^]’ of their useful lives so as to render the resultant allocations ‘meaningful.’ Massey Motors, Inc. v. United States, 364 U.S. [92] at 104.” Chesapeake & Ohio Railway Co. v. Commissioner, supra at 378-379.
As we pointed out in the C & O case ( 64 T.C. at 379 ):
The difficulty of such a showing [of useful lives] is compounded where, as here, the alleged exhaustion is wholly the result of obsolescence rather than physical deterioration. As explained by the Supreme Court in U.S. Cartridge Co. v. United States, 284 U.S. 511 , 516:
“Obsolescence may arise from changes in the art, shifting of business centers, loss of trade, inadequacy, supersession, prohibitory laws, and other things which, apart from physical deterioration, operate to cause plant elements or the plant as a whole to suffer diminution in value.”
See also Real Estate Title Co. v. United States, 309 U.S. 13, 16 . Unlike physical exhaustion through use which more readily lends itself to empirical study and follows more predictable patterns, exhaustion through obsolescence often defies observation while in progress, succumbing to certainty only in retrospect. This is in part a reflection of the fact that obsolescence is to some extent a function of managerial policy rather than a physical phenomenon. Yet it is clear that, by including obsolescence within the ambit of section 167, the statutory scheme which demands to know the useful life of property prior to its expiration is sufficiently flexible to accommodate some degree of uncertainty and its concomitant inaccuracy. * * *
Given the inherent flexibility of the statutory scheme, we need not look for precision in petitioner’s estimates. For petitioner to prevail in its position that its grading and tunnel bores are ratably depreciable, the record herein need only establish that these assets have reasonably determinable useful lives. See Chesapeake & Ohio Railway Co. v. Commissioner, supra at 376-377, 383, and see Spartanburg Terminal Co. v. Commissioner, 66 T.C. 916, 929, 932 (1976), a case which also involved claimed depreciation deductions for grading and tunnel bores. Clearly, “it would be unreasonable * * * to put upon the taxpayer

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Source: Frix Law Library, https://www.frixlaw.com/law-library/cases/4484347. Public record. Not legal advice.