Another instance where the reserve ratio test would be misleading is a situation in which a taxpayer, or perhaps a number of taxpayers in an industry, "mark time" in their retirement and replacement policy while awaiting the development to commercially feasible use of a new type of machine or a whole new process innovation which would outmode their old equipment, but would itself probably be subject to faster wearing out or obsolescence. The situation here would call for shorter lives for the new equipment, not longer lives dictated by the artificially delayed retirement of the older type of equip ment. While a "facts and circumstances" analysis, if administratively feasible, might prevent these results, the reserve ratio test itself would be inadequate in such cases. Furthermore, its false signals might tend to prejudice the negotiation of a correct forward-looking life by the taxpayer and the revenue agent. RESERVE RATIO TEST NEVER A PRACTICAL REALITY From its inception the reserve ratio test exhibited a number of serious difficulties, both practical and conceptual. The problems arising from its application and its impact on taxpayers using the guideline lives were recognized to be so great that the 1965 transition rules were adopted to extend the 1962 moratorium so that the test would not begin to have practical effect for a number of additional years. As a practical matter, therefore, there generally has been little or no reserve ratio test in effect for the nine years since introduction of the guidelines in 1962, although the transitional allowance is phasing out so that the test would begin to have real potential effect for 1971 and later years. COMPLEXITY OF THE TEST In the opinion of many observers, the complexity of the reserve ratio test in its two alternative forms and its related rules, options, transitions, phaseouts, and adjustments has made it virtually unworkable.45 During August of 1962, following promulgation of Revenue Procedure 62-21, two or three senior revenue agents from each of the 60 district offices were brought to Washington for intensive training as instructors in the guideline procedures. They, in turn, conducted training sessions in each of their respective district offices for all of the resident revenue agents. Despite these efforts some 87 percent of the experienced revenue agents in the Service at the present time consider the reserve ratio test of the guideline procedures to be unworkable and impractical because of its complexity, its tolerances or limitations. Eighty-eight percent of experienced revenue agents favor abandoning the test. Thus, despite intensive training of revenue agents in the intricacies of the reserve ratio system, few agents are able to apply the test in all its complexity." 46 "See, e.g., Hearings on the Proposed Regulations Under Section 167 of the Internal Revenue Code of 1954 Relating to the Asset Depreciation Range System before the U.S. Department of the Treasury, Internal Revenue Service, at 331 (1971) (testimony of Charles W. Stewart). ("[T]he reserve ratio test is unworkable, is so complex as to be beyond the comprehension of many corporate taxpayers, and not likely to lend itself to meaningful, equitable, and consistent administration.") [These hearings are hereinafter cited as ADR Hearings.] Others have suggested that the reserve ratio test is relatively easy to compute. Id. at 222a-23 (testimony of Martin David); Id. at 545-46 (testimony of J. D. Coughlan). 46 The percentages cited above were derived from a survey of Internal Revenue Service revenue agent and engineer personnel conducted in May 1971. Over 3,500 Internal Revenue Service employees with over five years' experience responded to a questionnaire prepared by the National Office of the Internal Revenue Service. The survey was designed by experienced Internal Revenue Service officials to determine whether the administrative difficulties with the reserve ratio test system perceived by Seventy-five percent of the IRS conferees who handle disputed or agreed depreciation issues beyond the revenue agent level have found that the reserve ratio test is not helpful in reducing controversies over useful life. Furthermore, the complexity of the test suggests that its application is an unwarranted burden to taxpayers. The application of the reserve ratio test is not a unitary proposition for each taxpayer. Rather, it is a multiple procedure since it has to be repeated for each guideline class (a taxpayer would typically have several classes) with subcomputations for property under different depreciation methods. For many taxpayers both the tabular and the alternative guideline form would need to be explored year after year, with possible projections into the future, to get some evaluation of the taxpayer's probable tax depreciation status-an important consideration in financial planning and investment decisions. RISK OF ADJUSTMENTS IN USEFUL LIFE The United States was unique in providing a reserve ratio test. No other country apparently has employed an objective rule of this type in its depreciation system. Comparison of guideline lives in the United States with tax lives provided in other countries therefore has been misleading to the extent it ignored the existence of the reserve ratio test in this country, which introduced a risk or contingency element in depreciation allowances not apparent from the guideline life structure by itself. V. Reasons for Adoption of ADR System There are two major sets of considerations which led to the decision to adopt the ADR system— (1) The necessity from the standpoint of administration of the internal revenue laws for a comprehensive and improved system for dealing with the National Office personnel were consistent with the views of field personnel. This IRS survey has been made available to the public. The percentages in the text may be ob tained from Part II, Questions 4 and 10. [This survey is hereinafter cited at IRS Field Survey.l "IRS Field Survey, Part III, Q. 4. allowance for depreciation and the integrally related problem of repair and maintenance expenditures; the long history of unsatisfactory controversy over Bulletin F; the fundamental defects of the reserve ratio test; the magnitude of the problem of extensive facts and circumstances disputes with a substantial number of taxpayers; the logic, practical importance, and greater equity of relying on industry average lives; the need to move towards neutralizing depreciation as a competitive factor; and the necessity of providing a depreciation accounting system which would produce regular, systematic data for use in establishing industry lives and repair allowances-all these factors dictated the adoption of the ADR system. (2) The statutory requirement that depreciation deductions include a "reasonable allowance for obsolescence" required a recognition of changing circumstances, current and anticipated, which call for permitting taxpayers to select lives from a range which includes lives shorter than those permitted by existing guidelines. The ADR system recognizes current and potential obsolescence as a result of recently imposed environmental control requirements, an increasing level. of foreign competition, and high rates. of capital formation since 1962 which suggest rapid incorporation of technological improvements. These and other factors indicate that depreciation allowances should not be tied to the past history of the individual taxpayer an unreliable guide to the period of future productivity of the taxpayer's stock of capital assets. tion accounting, the intricacies of which are growing in scope. Despite intensive training within the Internal Revenue Service, few revenue agents are able to apply the reserve ratio test in all its complexity. Nor are they generally qualified to make engineering judgments about the useful lives of individual assets or asset classes. More often than not, revenue agents have been forced to use industry norms, or published guides such as Bulletin F, as a ceiling without regard to individual retirement practices.48 The specialists qualified to do this work are able to consider depreciation issues in roughly 10,000 tax returns annually (one-tenth of 1 percent of returns with such issues), and these are primarily returns of larger corporations.49 48 See IRS Field Survey, Part I, Q. 10, which indicates that prior to the issuance of Revenue Procedure 62-21, 80 percent of IRS revenue agents accepted lives claimed by taxpayers as long as the lives claimed equaled Bulletin F lives without regard to individual retirement practices During this same period, about 60 percent of field revenue agents indicated that they recognized a 10 percent or greater tolerance in the depreciable life claimed by the taxpayer before proposing adjustments (Part I, Q. 11), and almost half of the revenue agents permitted useful lives after audit shorter than that reflected by actual retirement practice. 49 Essentially all of the depreciation issues in the National Office of the Internal Revenue Service are handled by the Appraisal Section of the Engineering and Valuation Branch with a present staff of 14 technical man-years. Approximately 30-50 percent of the Appraisal Section's time is presently devoted to depreciation case issues (four to seven man-years). Other activities deal mainly with valuation matters and investment credit issues. Of the field engineering staff totaling 224 specialists, 87 are natural resource engineers whose time and efforts are devoted largely to depletion and valuation issues in the oil, timber, and mining industries with only relatively minor emphasis on the depreciation issue. The remaining 137 engineers and appraisers devote their efforts primarily to depreciation, valuation, and repair issues in the manufacturing, construction, transportation and public utilities industries. Generally, this latter group of engineers consider depreciation and repair issues in every case, but these are not generally the primary issues. The average workload of this group is 20-30 taxpayer cases per year and each case may involve two to three tax return years per taxpayer. Therefore, it may be estimated that engineer specialists consider depreciation and repair issues in about 10,000 tax returns each year (mostly large corporations). The institution of the guidelines in 1962 and the effective suspension of the reserve ratio test until the present time have resulted in taxpayers generally using the guideline class lives or shorter lives. When the guidelines were introduced the reserve ratio test was suspended because it would have resulted in widespread disqualification for use of the guideline class lives and consequent inequities. When the test was about to take hold in 1965 it was effectively suspended again to prevent failures. Rather than seek ways to postpone further its effect Treasury considers it sounder to acknowledge the basic and irreparable defects of the test and abolish it. If the test were applied, all taxpayers who fail the test could be expected to assert that they are entitled to the guideline class lives on a facts and circumstances basis.50 If this should occur among only 5 percent of taxpayers claiming depreciation, audits would be required in 500,000 cases if the tax laws are to be applied uniformly-an increase of 20 percent in the total number of audits performed in 1969 and far beyond the present capacity of the Service to accomplish effectively and equitably. Taxpayers are not required to elect guidelines in their tax returns, as ADR would require but may wait until audit to do so.51 Since a small percentage of 50 The IRS Field Survey suggests that a significant number of taxpayers claiming depreciation during the period since 1962 have used "facts and circumstances" to justify the tax lives claimed rather than the reserve ratio test or the other rules of Rev. Proc. 62-21 (Part II, Q. 8). 61 Depreciation Guidelines and Rules, U.S. Treasury Department, Internal Revenue Service Publication No. 456, Revised Aug. 1964, Question 66, at 75. The 1966 Statistics of Income, Business Income Tax Returns, U.S. Treasury Department, Internal Revenue Service, Publication 438 (6-69) reports approximately 9 million returns claiming depreciation deductions of which roughly 7.4 million were proprietorships, partnerships and subchapter S corporations. Of this total, 62,000 or less than 1 percent-showed that they had elected to employ Revenue Procedure 62-21 (the depreciation guideline system). Id., Table 2A at 24-25, Table 3.9 at 170, and Table 4.5 at 190. Since taxpayers are not required to elect Rev. Proc. 62-21 in their returns but are permitted to wait until audit to do so, this figure probably taxpayers have formally "elected" guidelines, a great number of taxpayers. are apparently claiming lives even shorter than the guidelines on their returns. This circumstance makes even more apparent the administrative impossibility of evaluating depreciation deductions claimed by a large percentage of taxpayers on the basis of facts and circumstances. Thus, continuation under Revenue Procedure 62-21 without a major change was not possible. Further, the guidelines made no provision for, but in fact exacerbated, the problem of expensing or capitalizing repair and maintenance expenditures. The shorter guideline lives gave rise to a greater number of disputes because revenue agents often asserted that particular repair expenditures should be capitalized because they would extend the life of the assets beyond the guideline life. Depreciation allowances and repair and maintenance expenditures are intertwined for any business taxpayer and require an integrated solution, as ADR provides. Similarly, the issue of salvage value must be resolved in any comprehensive system for dealing with depreciation. If this is not done, the area of dispute will merely shift to the salvage issue. The ADR system requires that salvage be established when assets are first placed in service. Certain property which is eligible for ADR will also qualify under section 167 (f) of the Internal Revenue Code which permits salvage value to be reduced by 10 percent of the basis of property. In no event may assets be de vastly understates the number of taxpayers who are relying upon using the guideline lives. However, the majority of IRS experienced revenue agents indicated that most taxpayers do not use the depreciation guidelines, and as the size of the taxpayer decreases, the number of taxpayers using the guidelines decreases. IRS Field Survey, Part II, Q. 1 and 2. This feature of the Guideline system further complicates administration. Taxpayers will often claim depreciation deductions based on useful lives shorter than the guideline life intending to argue "facts and circumstances" with the knowledge that they may elect the guideline life upon audit. This would not be permitted under the ADR system; taxpayers would be required to elect the ADR system at the time of filing their income tax returns. Reg. § 1.167(a)–11(f) (1). preciated below salvage value. However, since the determination of salvage ever, since the determination of salvage value is at best an estimate, minimal adjustments to salvage value will not be made. ADR provides that the taxpayer's estimate will not be disturbed unless the proposed adjustment would unless the proposed adjustment would change the estimate by more than 10 percent of the cost of the assets in the account. On the other hand, if the adjustment would exceed this limitation, the entire adjustment will be made. Thus, the rule is merely a constraint on audit adjustments; it is not an additional 10 percent expansion of the rules of section 167 (f). The Guideline system-for nine years while the reserve ratio test has been made largely ineffective-recognized the impossibility of administering the depreciation provisions on an individualized basis. The ADR system is realistic and forthright in recognizing this same impossibility. ADR gears the annual depreciation allowance and the repair allowance to industry average lives and experience. This avoids the inordinate complexities of the reserve ratio test, the competitive inequities between new and old businesses posed by the reserve ratio test, the artificial and unwise pressure to scrap stand-by and other usable but unused facilities, and the fundamental error of the test in looking at an individual's past practices to judge the period of future utilization of the newly acquired stock of capital assets. In holding that a "reasonable allowance" for depreciation (including a "reasonable allowance" for obsolescence) should be based on industry experience, not the individual taxpayer's past experience, ADR adopts a rational concept. Taxpayers in a particular industry, competing in free markets, will tend to move toward similar production processes, will tend to use similar equipment, and will tend to retire equipment on similar schedules. Over any given time period, however, the individual taxpayer is subject to events which are both nonrecurrent and unique to that taxpayer. In addition, individual experience is frequently weighted by results of negotia tion with revenue agents. The Treasury survey in 1959–1960 of tax depreciation rates in use by large corporations for property acquired after 1953 disclosed variances among taxpayers in the same industry. For example, the responses of two major companies who manufacture electronics equipment indicated that one company was basing its depreciation deductions on an average useful life of 6 years, while the other was claiming an average life of 11 years on its tax returns. Such differences in useful lives are far larger than could be accounted for by differences in asset mixes; over time, varied "settlements” in different IRS field offices, involving concessions on various issues, and the application of ad hoc standards, had produced a bewildering array of useful lives. An industry as a whole is much less sensitive to such events, and, consequently, industry experience is more reliable than individual experience. Thus, ADR represents the Treasury Department's conclusion that a reasonable allowance for depreciation (including a reasonable allowance for obsolescence) need not necessarily be based on the taxpayer's individualized experience but may be based on industry-wide experience. The past experience of the particular taxpayer is not a better guide to the future period of productivity of assets newly being acquired than the experience in the taxpayer's industry as a whole. The taxpayer's own past experience may well have been affected by a variety of abnormalities—difficulties in obtaining financing, labor difficulties, a period of depression in the taxpayer's business, or other factors. ADR recognizes that neither the reserve ratio test nor any other objective rule is an adequate guide to depreciation deductions, and that resort to a myriad of individualized "facts and circumstances" is simply administratively unworkable, given the number of potential disputes that would arise. The commitment to use industry experience makes appropriate a range of allowable lives which includes the experience, in general, of those taxpayers in the industry who have shorter replacement cycles. This will prevent competitive inequities, and reflects the likelihood that taxpayers will tend toward use of the most efficient production processes and thus the most efficient turnover of their capital assets. Allowance of shorter lives is also necessary in order to avoid having a large percentage of taxpayers continually seeking to establish that their own individualized prior experience, based on a mass of historical data from which they may make selections, justifies a shorter tax life. The burden of additional controversies that would result is manifest. Accordingly, ADR permits use of any life 20 percent shorter to 20 percent longer than the guideline class lives. The ADR system will largely end the bulk of disputes in the depreciation and repair and maintenance categories and will enable the Internal Revenue Service to use its limited audit personnel for more intensive audit of other issues, such as tax fraud, for which standardized treatment is not appropriate. At the same time, the ADR system establishes a comprehensive system of depreciation accounting which permits the retrieval of annual, systematic, nation-wide data on asset acquisitions and retirements. Thus, the periods of actual use of assets, as well as equivalent data on repairs and maintenance expenditures, will be available for study. The key to this system is a requirement that closed-end vintage accounts be used so that asset acquisitions and retirements in a guideline class may be identified by years. The ADR system also establishes a data analysis program in the Internal Revenue Service which will provide a basis for future changes in guideline classes, guideline lives, and repair allowances as dictated by actual industry experience; for the adoption of new guideline classes and lives; and for other monitoring of the effectiveness of the ADR system. More explicitly, the ADR system requires detailed reporting by all taxpay ers who elect to use it and establishes 456-113 0-72- -34 an Office of Industrial Economics in the Internal Revenue Service. This office is separate from offices directly concerned with taxpayer compliance. Taxpayers will be required to file schedules annually with their returns showing basis of assets, salvage value, and other data which will permit determination of retirements for each ADR class. The reporting requirements will not be burdensome to taxpayers; they call only for basic information essential in determining depreciation. The functions of the new Office of Industrial Economics will include (1) Collection of data, maintenance of information files, and regular publication of analyses. Data pertaining to industrial asset management practices will be derived from tax returns, other government sources of information, published materials in the private sector, and special surveys by the Office of Industrial Economics. (2) Receipt of petitions from taxpayer representatives seeking revisions in asset classifications or prescribed ranges; conduct of investigations needed to evaluate proposals to amend or revise asset classifications ranges; and recommendations of changes that appear to be justified. and (3) Maintenance of direct liaison with the Bureau of the Census and the Office of Business Economics within the Department of Commerce for the purpose of enlarging the economic data base relating to capital stocks, obsolescence rates, and capital consumption. RECOGNITION OF CHANGES IN CONDITIONS As stated by President Kennedy and Treasury Secretary Douglas Dillon in 1962, and as restated by President Nixon and Treasury Secretary David M. Kennedy in 1971, depreciation allowances must be periodically updated to reflect modern industrial practices. Despite the inadequacy of currently available data with regard to historical obsolescence and the impossibility of predicting future obsolescence with certainty, the Treasury Department is charged by the Internal Revenue Code with the responsibility for estimating obsolescence in order to permit reasonable depreciation allowances. Precise measurement of the rate of economic and technological obsolescence is, of course, not possible.52 It appears, however, that technological changes and other events which have occurred since 1962 will have the effect of rendering machinery and equipment obsolete more rapidly; that is, the average period of economic useful life of assets is likely to continue to decline. 52 The lack of such information becomes apparent from a review of the methodology of the survey of depreciation practices which led to the 1962 depreciation revision. In establishing guideline lives in 1962, the Treasury Department relied primarily upon a survey of depreciation claimed on tax returns. Only in nine industry categories were engineering studies conducted and these studies proved inconclusive with respect to estimating historical obsolescence and were to a large part ignored in setting the present guideline lives. The determination of a single guideline life from such data necessitated a judgment based upon a variety of factors. Unfortunately, when the guideline lives were set in 1962, no method for obtaining data with respect to actual retirements of assets by vintage was provided. The depreciation revision of 1962 did not specify any method of accounting for tax purposes which would produce such information. No limitation on the form of accounts was imposed; old assets were included in the system, and no requirement that taxpayers maintain records pertaining to acquisitions by year was included. Thus, no information with respect to the age of assets when retired from business use is currently available. A new survey of taxpayers or collection of information from taxpayers to determine the useful lives currently being used for tax depreciation purposes would not be meaningful. Useful lives for each industry category will generally range from periods shorter than the guideline life to the guideline period. From about 1962 through 1970, the guideline lives have generally been accepted by the Internal Revenue Service without question, and it is unrealistic to believe that depreciation lives longer than the guideline period have been used to any significant extent. Some information could be collected to indicate roughly the current "reserve ratios" and thereby provide some information as to the amount of fully depreciated assets still in use. But since old assets are currently kept in the same accounts as new assets and records pertaining to acquisition and retirement by vintage have not previously been required, such information would not be particularly meaningful in evaluating the adequacy of the present guideline lives. The ADR system provides for the first time for systematic periodic collection of information with respect to the age of business assets at the time of their retirement. 515 During the past half-dozen years, the United States has experienced a growing under-utilization of manufacturing capacity—even in times of full employment. This growth in excess capacity during periods of full employment suggests increasing obsolescence resulting from a high rate of investment which has enabled taxpayers to introduce new technology at rates faster than usual. In previous periods of relatively full employment, such as 1950 to 1953 and 1965 to 1966, the ratio of manufacturing output to capacity was about 90 percent. Since 1968, however, there has been a dramatic increase in "excess" capacity as measured by business survey responses. The volume of excess capacity rose significantly during 1968-69, years of full employment. In both years, U.S. businesses were producing an additional 4.5 percent of output a year while adding roughly 6.5 percent a year to capacity. When excess capacity is increasing at a time. of full employment, increased obsolescence is suggested: new machines and equipment are producing at a greater rate and old machines are less utilized. There is other evidence of technological change which suggests a decrease in the useful economic lives of assets and an increasing rate of obsolescence.53 The dramatic shift to automation in recent years represents a marked change in production technology. This trend toward automation suggests a shortening in the periods of economic usefulness for equipmenteven for the first wave of automated equipment such as computers. Other specific illustrations of the effects of technological change have been presented in the machine and tool industry,54 railroad industry, 56 paper industry,57 and Federal and state pollution control legislation and regulations enacted since 1962 will also require the replacement of significant amounts of equipment. Moreover, the trend toward even stricter environmental control standards is likely to produce additional legislation and regulations which will result in further obsolescence of plant and equipment.59 In 1962, the Treasury Department recognized that allowing depreciation 5 Id. at 561-63 (testimony of Frank E. Barnett, discussing the replacement of telegraph communications by dial-type telephone operations and the imminent replacement of microwave system by underground cable communications). See also, Id. at 579 (testimony of Paul M. Zeis, discussing obsolescence in railroad rolling stock caused by special, equipment-tailored cars built for individual shippers). 57 Id. at 759, 766-67 (statement of Thomas R. Long, discussing the trend toward large, single in-line processing units and the use of diffuser washers in the last 10 years as a control device in connection with the use of lasers to control knives and trimming). 58 Id. at 647 (testimony of John C. Dunn); Id. at 665-67 (testimony of Gordon Corey, discussing the recent trend toward nuclear power); Id. at 498, 500 (testimony of James H. Maloon, discussing the development of liquified natural gas). See, e.g., ADR Hearings at 69-70 (testimony of Congressman John B. Anderson, discussing the general impact of national environmental policy to hasten the replacement of business assets); Id. at 117 (testimony of Clifford D. Siverd, discussing the effect of pollution control legislation on the chemical industry); Id. at 339 (testimony of Charles W. Stewart, discussing the impact of pollution control legislation on the types of furnaces used in the foundry business); Id. at 449 (testimony of Ward C. McCallister, discussing the effects of pollution control and federal safety legislation on capital requirements of the gas industry); Id. at 505-06 (testimony of H. W. Close, discussing the expenditures required as a result of pollution control legislation in the textile industry); Id. at 618 (testimony of Fred W. Peel, discussing the impact of pollution control and mine safety legislation on obsolescence in the mining industry); Id. at 657, 659, 664 (testimony of Gordon Corey, discussing the shortening of useful lives in the electrical industry due to pollution control legislation); Id. at 680, 683 (testimony of Herbert Cohn, discussing the impact of pollution control legislation in the electric industry); Id. at 760 (testimony of Thomas R. Long, discussing the equipment changes in the paper industry for environmental improvements). based upon the guideline lives would not be sufficient to place American producers on a comparable basis with foreign competitors with respect to the tax treatment of capital investments. A substantial reduction in depreciation lives coupled with the investment tax credit was considered necessary to approach the goal at that time.60 Today, there is evidence that foreign producers in many. industries have more modern facilities than their U.S. counterparts,61 and that the force of international competition will necessarily result in an increasing rate of retirement of U.S. plant and equipment in favor of modernized facilities. This modernization is essential if American producers are to compete effectively with those of foreign nations. The United States has the lowest percentage of investment in productive facilities in relation to Gross National Product of any of the principal industrialized nations.62 Depreciation allowances for machinery and equipment in the United States have been far less than the com 60 Statement of Secretary Dillon, July 11, 1962. Secretary Dillon added: "Depreciation has been a major problem of U.S. tax policy for decades. As a deduction used in determining the taxable income of a business, it directly affects the rate of recovery of invested capital. For that reason, it plays a vital role in business investment decisions a major factor in determining a nation's rate of economic growth. Faster economic growth is essential if we are to reduce unemployment and provide jobs for the millions of workers coming into the labor force. Equally important, the investment level is closely related to productivity, hence, plays an important part in determining the competitive position of U.S. producers in world markets. We must be competitive if we are to reduce our balance-ofpayments deficit and stem the drain on our gold stocks. Depreciation rates are, therefore, important not only to the welfare of business, but to the welfare of every American citizen." The investment credit was terminated by the Tax Reform Act of 1969. See Internal Revenue Code of 1954, § 49, added by Pub. L. 91-172, § 703 (a) [C.B. 1969–3, 10]. Report of the President's Task Force on Business Taxation at 7-11 (Sept. 1970); ADR Hearings at 59, 62-63 (testimony of Congressman John B. Anderson); ADR Hearings at 33 (testimony of Senator Charles H. Percy). 62 Organization for Economic Cooperation and Development, The Growth of Output 1960-1980, at 46 (Dec. 1970). |