DEPRECIATION OF LEASED MACHINERY.—

RULING. The M Company owns certain apparatus which it leases under contracts for a period of years at an agreed rental. The contracts provide that the lessor shall maintain the apparatus for the period of the contract without charge to the lessee and that the apparatus shall remain the property of the lessor. Although the apparatus is of some value at the expiration of the lease, such value is less than the cost of its removal and it is therefore abandoned by the lessor at the expiration of the lease.

The expenditure for labor incident to the installation of the apparatus, being possible of allocation thereto, and the cost of the material entering into the installation are held to be capital expenditures, recoverable through depreciation spread over the term of the original lease. If the apparatus had a salvage value at the expiration of the lease it would be necessary to take this value into consideration in computing deductions for depreciation as provided in article 161 of Regulations 45. (C. B. 5, 175; O. D. 1082.)

The costs of maintaining the apparatus under the terms of the contract are, of course, chargeable against current income.

DEPRECIATION OF RAILWAY ROADWAY OFFSET BY MAINTENANCE AND APPRECIATION.-In a litigated case, the court held that no deduction for depreciation in value of the roadway of a railroad may be taken where, because of repairs, renewals and replacements, the roadway as a whole is as valuable at the end of the taxable year as at the beginning. (Nashville, Chattanooga and St. Louis Ry. Co. v. U. S., 269 Fed. 351; certiorari denied, 255 U. S. 569.)

CERTAIN REPAIRS ARE CAPITAL EXPENDITURES.-Although it is an accepted rule that repairs and all other expenses of maintenance should be charged against income, an exception to this rule is found in cases where partly worn-out or run-down plants are purchased with the intention on the part of the new owners to rehabilitate them so that they can be operated efficiently. It may be assumed that the purchase price takes the poor condition of the plant into consideration, in which case the entire cost of repairs and renewals necessary to bring the plant to a satisfactory operating condition, may properly be capitalized.

REGULATION. Amounts paid for increasing the capital value or for making good the depreciation (for which a deduction has been made) of property are not deductible from gross income. . . . . (Art. 292.)

If the replacements are of a permanent nature they are chargeable to capital. (Bulletin "F," page 29.)

Improvements upon public property.-In many cases improvements are made upon land not owned by nor under lease to the person who pays the cost. In the case of short-term leases, when the circumstances all point to a continuance of occupancy there is much to be said for spreading the depreciation over the life of the improvements. This point is discussed on page 979. In the case of sidings on the land of a railroad company, paid for by the user, the cost may be deducted as an expense in the year incurred. (See page 1002.) In the case of expenditures upon land owned by a state or a municipality the capital value frequently rests upon the whim of political bodies. The reasonable method of treating such expenditures is to charge them off as incurred.

In Edwards' Appeal (3 B. T. A. 889) the taxpayer constructed tunnels under a street. The Commissioner disallowed the deduction and was upheld by the Board. The Board said the improvements had a capital value "so long as the franchises continue or the permits are not revoked." It would be a wise man who could compute a proper rate of depreciation under such contingencies. The opinion is not convincing.

Depreciation must be entered upon the books of a corporation. The law does not specify that depreciation must be charged off on the books of an individual or a corporation (see page 941), but in other sections of the law the Commissioner is given ample power to enforce proper accounting methods. It may be assumed, therefore, that all corporations and all individuals who keep books must enter depreciation on their books, or it will not be allowed as a deduction. The restriction is a proper one. The author has no sympathy for any corporation which is not willing to have its income tax returns agree with its books, unless orders of public service or banking commissioners are a factor.

REGULATION. A depreciation allowance, in order to constitute an allowable deduction from gross income, must be charged off. The particular manner in which it shall be charged off is not material, except that the amount measuring a reasonable allowance for depreciation must be either deducted directly from the book value of the assets or preferably credited to a depreciation reserve account, which must be reflected in the annual balance sheet. The allowances should be computed and charged off with express reference to specific items, units, or groups of property, each item or unit being considered separately or specifically included in a group with others to which the same factors apply. The taxpayer should keep such records as to each item or unit of depreciable property as will permit the ready verification of the factors used in

computing the allowance for each year for each item, unit, or group. (Art. 169.)

BANKS MAY KEEP ADDITIONAL RECORDS FOR DEPRECIATION PURPOSES.-Statements rendered to the federal or state authorities frequently include adjustments, for instance, the writing down of investments or the inclusion in expenses of additions to the banking house or its equipment, which are not allowable deductions in income tax returns. Banking house fixtures and furniture written down or written off may be restored, a supplemental set of books being used.9

Only charges applicable to current year deductible.-Treasury rulings have now settled beyond question the principle that only those depreciation charges which are properly applicable to the current year may be deducted in that year,10 and any readjustment must be made by filing amended returns.

AMENDED RETURNS ACCEPTABLE TO TREASURY.-If original returns were made in good faith, they may be corrected if found to be erroneous. (Bulletin "F," page 33. See also page 56.)

Depreciation based on cost or value March 1, 1913, whichever is greater."-The law [section 204 (c)] specifically provides that the basis for depreciation shall be the same as provided in section 204 (a) or (b).12 Subdivision (a) provides that cost shall be used in the case of property acquired after February 28, 1913, except that property received as a gift before December 31, 1920, or by inheritance is to be taken at market value at date of gift. For depreciation of property received as gift see page 956.

'C. B. 4, 64; A. R. R. 377; C. B. I-2, 48; A. R. M. 172. 10 C. B. 4, 180; O. D. 948. Bulletin "F," page 35.

"[Former Procedure] After the Supreme Court rendered the Flannery decision (see page 436), there was for a while some question as to whether the decision upset the basis for depreciation under the 1921 and prior laws. The court said that only actual losses could be deducted, and that the March 1, 1913 provision in the law merely limited the amount of the loss.

The Treasury has decided that the Flannery decision does not affect the basis for depreciation. Returns for years made under the 1921 and prior laws are being audited by allowing depreciation and depletion on March 1, 1913 values. (See C. B. IV-2, 162; S. M. 4110.) See also J. J. Gray's Appeal, 2 B. T. A. 672 (A).

12 For discussion of depreciation and depletion, see Notes on the Revenue Act of 1924, Income Provisions, by Roswell F. Magill, Columbia Law Review (December, 1924).

Property acquired in certain types of reorganization after December 31, 1917 and 1920, respectively, is to be taken at the same basis as in the hands of the predecessor owner. However, in Taft v. Bowers (U. S. Dist. Ct., S. D. N. Y., Aug. 5, 1926) Judge Knox held that the value of the property at the time of the gift was capital and that Congress had no power to treat any part of it as income. It would seem that this decision, if sustained, is authority for the proposition that the value of the property at the date of gift is the basis for depreciation purposes.

REGULATION. The capital sum to be replaced by depreciation allowances is the cost or other basis of the property in respect of which the allowance is made. (See article 1602.) To this amount should be added from time to time the cost of improvements, additions, and betterments. and from it should be deducted from time to time the amount of any definite loss or damage sustained by the property through casualty, as distinguished from the gradual exhaustion of its utility which is the basis of the depreciation allowance. . . . . (Art. 164.)

....

The rule of using cost or March 1, 1913 value, whichever is greater, involves the determination of both cost and March 1, 1913 value. To go back to original costs in the hands of predecessor owners in the case of gifts, trusts and the many types of reorganizations involving thousands of corporations since 1917, is imposing a gigantic additional task on both taxpayers and the Income Tax Unit. (See page 954 for further discussion in the case of reorganizations.)

These rules, of course, depart from the usual accounting procedure because of the insertion of March 1, 1913, as the date for establishing a value for purposes of depreciation. The ordinary practice is to take original cost, determine a liberal depreciation rate and, when the reserve equals the original cost, discontinue depreciation. The Treasury's refusal to allow depreciation of March 1, 1913 values of leaseholds has been overruled by the Tax Board. See C. B. I-2, 90; T. D. 3414; Income Tax Procedure, 1926, page 1429. Also see Appeal of Grosvenor Atterbury [1 B. T. A. 169 (A)].

If depreciation allowances have been based on cost but March 1, 1913 value was substantially in excess of the cost less depreciation to that date, amended returns for subsequent years embodying revised depreciation allowances would be in order. If, however, depreciation allowances for property acquired prior to March 1, 1913, are greater on the basis of original cost than on the basis of March

1, 1913 value, the increased allowances are deductible beginning with 1924, but are not retroactive to previous years.

FUTURE REPLACEMENT COST NOT A FACTOR.

RULING. Replacement value of property can not be substituted for the cost of the property as the cost of replacement at a time some years in the future is a speculative figure which can not be used as a basis for determining an annual depreciation charge. . . . . (C. B. 1, 138; O. D. 283.)

Depreciation computation in case of reorganizations.-As previously stated, section 204 (c) sets forth the rule 13 that reorganizations and exchanges which are treated as "continuing transactions," and in which no gain or loss is recognized or is recognized only in part, are also so treated for depreciation purposes. Such a theory is sound. No complaint could be lodged against the Treasury, which drafted the provision, except for its retroactive features, which under section 204 (a-7) may be carried back to December 31, 1917. Certainly this is not a step toward simplification.

For full discussion, see "Retroactive Features of Tax Bill," The National Income Tax Magazine, April 1924, page 113.

DEPRECIATION ON INCREASED BASIS PRIOR TO JANUARY 1, 1924.— The provisions of paragraphs (7) and (8) of subdivision (a) of section 204 of the 1924 law and 1926 law limiting the basis in the case of reorganizations after December 31, 1917 and 1920, respectively, applied only from January 1, 1924. Deductions for depreciation on the increased basis, allowed under the 1921 law for the years 1921, 1922 and 1923, were not affected.

Depreciable and non-depreciable property acquired after March 1, 1913.

REGULATION.

In the case of the acquisition on or after March 1, 1913, of a combination of depreciable and nondepreciable property for a lump price, as, for example, buildings and land, the capital sum to be replaced is limited to an amount which bears the same proportion to the lump price as the value of the depreciable property at the time of acquisition bears to the value of the entire property at that time. .. (Art. 164.)

This is a reasonable and practicable rule.

13[Former Procedure] See Income Tax Procedure, 1926, page 1393.