RAILROAD'S EXPENSING OF SMALL ITEMS CLEARLY REFLECTED INCOME, HELD COURT OF CLAIMS.

                   UNITED STATES COURT OF CLAIMS

The material facts are set forth at length in the findings of fact accompanying this opinion and will be summarized here for consideration of the controlling legal principles.

Plaintiff, The Cincinnati, New Orleans and Texas Pacific Railway Company, during the period in question, operated a railroad as a common carrier in interstate commerce, and as such was subject to the supervision of the Interstate Commerce Commission (ICC). It has consistently reported its income for tax purposes in accordance with the accrual method on a calendar year basis.

In its regulation of rail carriers the ICC has long required that financial statements be prepared in compliance with its "General Instructions of Accounting Classifications." From January 1, 1921 to January 31, 1940, the ICC required that in accounting for purchases of property (other than track) of less than $ 100, the railroads should charge the expenditure to operating expenses rather than to a capital account. ¹ This procedure is referred to as a "minimum rule."

In 1940 the ICC, after consideration of the economic condition of the railroads, determined that the minimum rule should be raised from $ 100 to $ 500. This change was made in light of the ICC's overall duty to protect the public. In the setting of reasonable railroad rates in the public interest it is imperative that the accounting methods prescribed by the "General Instructions of Accounting Classifications" lead to financial statements that clearly reflect income. In accordance with this consideration, the ICC concluded that the $ 500 amount, when considered in relation to the railroads' volume of business and volume of small items acquired, would allow the elimination of detailed, expensive bookkeeping without adversely impairing the ability of the financial statements to clearly reflect income. ²

The minimum rule in force during the years in question applied to the acquisition of property other than land, sections of track and "units of equipment" such as freight cars, locomotives, passenger cars or work cars. It further provided that:

* * *

     (b) The carrier shall not parcel expenditures or retirements

Although the defendant has proffered a number of justifications for the disallowance by the Commissioner of the claimed deductions, the essence of its position seems to rest on a few specific arguments. ³ Initially and with most force, defendant argues that the resolution of this litigation is controlled by section 24(a) (2) of the Internal Revenue Code of 1939 and Treas. Reg. 111, Section 29.41-3(2). These pronouncements are as follows:

     SEC. 24. ITEMS NOT DEDUCTIBLE.

In furtherance of this position defendant points out that the capitalization of assets such as furniture, office equipment and other small items is in harmony with a long line of cases deciding this question with respect to specific assets. ⁴ It is also noted that the Supreme Court has held in Old Colony R.R. Co. v. United States, 284 U.S. 552 (1932) that the accounting rules of regulatory agencies are not binding upon the Commissioner of Internal Revenue. In the same vein, it is defendant's position that under the Internal Revenue Code it is the nature of the property and not its cost which determines its classification as a capital expenditure or as a current operating expense.

Defendant's second major argument is that plaintiff cannot avail itself of the broad statements in section 41 of the Internal Revenue Code of 1939 and Treas. Reg. 111, Section 29.41-(3), which are set out in the accompanying footnote ⁵ because the minimum rule does not constitute a "method of accounting." Furthermore, assuming arguendo that the minimum rule constitutes such a method of accounting, defendant asserts that, "[w]here the treatment of expenditures made to acquire depreciable capital assets is concerned, the method of accounting provisions play no part in the allocation between current and deferred deductions. The capital expenditure and depreciation deduction provisions [Section 24(a) (2)] of the Code establish not only what may be deducted but also the timing of the deduction * * *."

For the following reasons these arguments of the defendant cannot be accepted.

The core of defendant's position that since the items in question admittedly have a useful life in excess of one year, the accounting for them must be in accordance with Section 24(a) (2) which requires the capitalization of "permanent improvements or betterments" and with Treas. Reg. 111, Section 29.41-3(2) which suggests the capitalization of items having a useful life which extends beyond the year in which they are purchased, is twofold. Primarily, it is an argument for an inflexible objective, ipso facto approach to the question of whether an asset is a capital item or one of current expense. That is to say, if an asset has a useful life greater than one year, or if it could be considered by itself to be a "permanent improvement" or "betterment", it must be capitalized automatically without consideration of any other factors. Secondly, defendant's position requires the conclusion that the method of accounting sections of the Code (sec. 41 of the 1939 Code and sec. 446 of the 1954 Code) are subordinate to the capital expenditure and depreciation sections of the Code (sec. 24 of the 1939 Code and sec. 263 of the 1954 Code).

Neither of these underlying precepts is acceptable. The first, the conclusiveness of the one year rule, simply does not square with basic philosophy concerning asset accounting as reflected in the regulations and in section 41. The opening sentence of section 41 permits the use of the taxpayer's regularly employed method of accounting in the computation of net income, as long as that method clearly reflects income. In harmony with this, Treas. Reg. 111, Section 29.41-3 recognizes that "no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose." The determinative question, therefore, is not what is the useful life of the asset in question, although that inquiry is relevant, but does the method of accounting employed clearly reflect income.

A recent case decided by the United States Court of Appeals for the Tenth Circuit, United States v. Wehrli, 400 F. 2d 686 (1968), considers the weight that is to be given to the rule that if an asset has a useful life in excess of one year it should be capitalized. ⁶ In his opinion Judge Murrah comments:

     This concept [the one year rule] has received rather wide

Apparently in order to prevent the conclusion that the one year rule is but one test in deciding whether the accounting for an asset is proper, defendant contends that if there is a conflict between the capitalization and depreciation sections and the methods of accounting sections the former must be given preeminence. If this were so, the one year rule which is an adjunct of the capitalization and depreciation sections would be carried along to a dominant, if not determinative position. This contention is likewise rejected.

In a recent case concerning the proper allocation of overhead costs in regard to self-constructed assets, Judge Tannenwald, of the Tax Court of the United States, dealt with the exact contention raised by the defendant herein:

     We reject as without merit respondent's contention that section

By the same token, one cannot rigidly and automatically allocate expenditures as "amounts paid for * * * permanent improvements or betterments" simply by looking at the nature of the item in isolation, and without regard to particular circumstances, the taxpayer's method of accounting, and its consistent practice. Like the concept of "repair", neither the term "ordinary and necessary" nor its opposite, "permanent improvements or betterments", can be given a "narrow, restricted, dictionary-type meaning." See Kennecott Copper Corp. v. United States, 171 Ct. Cl. 580, 629-30, 643-44, 347 F. 2d 275, 304, 313 (1965). Three earlier comments by the Tax Court point up these basic propositions: "In the ordinary conduct of a manufacturing business the differentiation of capital expenditures and operating expense disbursements is largely a matter of sound discretion and experienced business judgment. The dividing line between the two classes cannot be defined by statute, and so far as has come to our attention, no court has ever yet attempted to make a definition that can apply to any case except the one under review * * *." American Seating Co., 4 B.T.A. 649, 657-68 (1926). "An item which may be classified as a capital expenditure under certain circumstances may, under different facts and circumstances, be considered expense." Libby & Blouin, Ltd., 4 B.T.A. 910, 914 (1926). "One taxpayer might be justified in capitalizing an expenditure for a mattress or a rug, whereas another, operating on a larger scale and with substantially identical recurring expenditures, might be justified in deducting the expenditure as an expense, if it consistently followed such a system of accounting and reporting its income." Manger Hotel Corp., 10 T.C. 520, 522 (1948). The Government has itself recognized that circumstances do make a difference by long ago promulgating, for instance, regulations allowing taxpayers operating mines to expense the cost of minor (later, all) items of plant and equipment necessary to maintain the mine's normal output. See Regs. 45, Art. 222 (1920); Regs. 111, Section 29.23(m)-15(b); Treas. Reg. Section 1.612-2(a).

We turn now to the ultimate question in this case, does the taxpayer's system of accounting which employs the minimum rule clearly reflect income in taxpayer's circumstances.

Plaintiff has introduced substantial expert accounting evidence, both the testimony of experts and numerous texts on the subject, which leads to the conclusion that the minimum rule as promulgated by the ICC and employed by the railroad is in accordance with generally accepted accounting principles. There is, however, a question raised as to the weight that is to be given, for tax purposes, to the finding that the method of accounting employed is one that is generally accepted by the accounting profession. Defendant points to Schlude v. Commissioner, 372 U.S. 128 (1963) and American Automobile Ass'n. v. United States, 367 U.S. 687 (1961) for the proposition that merely because the "method" taxpayer employs is in accordance with generally accepted accounting principles does not mean "that for income tax purposes it so clearly reflects income as to be binding on the Treasury." American Automobile Ass'n., supra, at p. 693.

While the American Automobile Ass'n. and Schlude decisions held that in the limited context of the accounting for received but unearned income the generally accepted method of accounting for such receipts does not clearly reflect income for tax purposes, those cases do not establish a general rule abrogating the presumption of correctness afforded by the regulations, Treas. Reg. 111, Section 29.41-2, Treas. Reg. 1.446-1(a) (2), ⁸ to generally accepted accounting methods. Schlude and American Automobile Ass'n. are based on the peculiar statutory history of the treatment by Congress of unearned, received income, and on the finding that for tax purposes the generally accepted methods treated such income in an "artificial" manner. Schlude v. Commissioner, supra, at 134-137. Neither of these conditions is evident in the case at bar, and therefore, while the cases are instructive in a general way, they are not determinative. In light of this discussion, however, it should be noted that because it is found in this case as a matter of fact that the methods employed by the plaintiff clearly reflect income, this court need not resolve the question of the proper weight to be given generally accepted methods of accounting beyond the mere statement that in considering the ultimate question of clearly reflecting income the use of generally accepted methods of accounting is entitled to some probative value. See, John Wanamaker Philadelphia, Inc. v. United States, 175 Ct. Cl. 169, 177, 359 F. 2d 437, 441 (1966).

Another fact which is entitled to appropriate probative value, but which is not conclusive, is the establishment by the ICC of the $ 500 minimum rule after careful consideration of the railroads' economic position. The testimony reveals that one of the prime considerations of the ICC in establishing the minimum rule was its effect on the ability of the railroads' financial statements to clearly reflect income. The ICC concluded that the imposition of the $ 500 minimum rule would not distort income. Although the accounting procedures required by the ICC are not binding upon the Commissioner of Internal Revenue, Old Colony R.R. v. Commissioner, 284 U.S. 552, 562 (1932), they are entitled to probative weight in the appropriate case. Northern Natural Gas Co. v. O'Malley, 277 F. 2d 128, 137-38 (8th Cir. 1960); Portland General Electric Co. v. United States, 189 F. Supp. 290, 298 (D. Ore. 1960), aff'd. 310 F. 2d 877 (9th Cir. 1962).

The most convincing evidence that the Commissioner has abused his discretion in prohibiting the plaintiff from treating items with a useful life in excess of one year which cost less than $ 500, not as "permanent improvements or betterments" but as current operating expenditures, is the statistical analysis proffered by the plaintiff which indicates the relationship of the quantum of minimum rule expenses to other substantial income and balance sheet figures.

Plaintiff's exhibit 1, which is reproduced in the accompanying findings of fact, ⁹ is a compilation of significant data for the 17-year period from 1940 to 1956. With the exception of two categories of data, one of which determines what the plaintiff's depreciation deduction would have been had it employed the defendant's methods using an average useful life of 15 years, the other using an average useful life of 10 years, all figures used therein are actual figures taken from the plaintiff's records. This data reveals the following convincing relationships:

     1. For the 17-year period, the minimum rule expenses disallowed

As our findings show, the situation here would support such an explicit directive for this taxpayer. The burden on plaintiff, if the minimum rule is not to be followed for income tax purposes, would be heavy; at the same time, the clearer reflection of income would be exceedingly slight if there were any at all. It is obvious that, for comparable reasons, the Internal Revenue Service accepted for years a $ 100 minimum rule without demur. On the showing here, there is no adequate reason why the $ 500 minimum rule should not have been accepted for the years in question.

In summary, it is concluded that the items costing less than $ 500 are not of such nature or character in relation to the plaintiff's business to constitute permanent improvements or betterments as is contemplated by section 24(a) (2) of the Internal Revenue Code of 1939. Furthermore, plaintiff's method of accounting for items costing less than $ 500 is in accordance with generally accepted accounting principles and is not such that it inhibits the ability of plaintiff's financial statements to clearly reflect income for tax purposes.

Defendant's additional points that the Commissioner's disallowance of plaintiff's minimum rule is in accordance with a long line of cases, fn. 4, supra, dealing with similar assets, and that the treatment employed by the plaintiff is not such that it constitutes a method of accounting so as to be sanctioned by section 41 and Treas. Reg. 111, Section 29.41-3,are not tenable.

The short answer to the method of accounting proposition is that while no definition of the phrase "method of accounting" can be found in the regulation under the 1939 Code, the regulation to sec. 446 of the 1954 Code, which section corresponds to sec. 41 of the 1939 Code, provides that "[t]he term 'method of accounting' includes not only the overall method of accounting of the taxpayer but also the accounting treatment of any item."

There is no reason why this definition is not equally applicable to cases controlled by the 1939 Code. Accordingly it is concluded that the minimum rule constitutes a method of accounting as contemplated by section 41 and Treas. Reg. 111, Section 29.41-3.

The second proposition that a long line of cases dealing with similar assets controls the outcome of this case is answered by Treas. Reg. 111, Section 29.41-3. That section recognizes that different taxpayers require different types of accounting systems, provided that the system each employs clearly reflects income. Since it has been concluded that the methods employed by the plaintiff clearly reflect income and that the system of accounting is a somewhat individual matter, cases dealing with other taxpayers in other situations, although instructive, are far from binding in this instance.

Finally, defendant urges that, in any event, the use of a $ 500 minimum rule in place of the former $ 100 rule constituted an unauthorized change in accounting method because it was made without the approval of the Commissioner of Internal Revenue. See Regs. 111, Section 29.41-2; Hackensack Water Co. v. United States, 173 Ct. Cl. 606, 352 F. 2d 807 (1965). But the only change needing the Service's assent is a substantial or material one. See Commissioner v. O. Liquidating Corp., 292 F. 2d 225, 230 (3rd Cir.), cert. denied, 368 U.S. 898 (1961); S. Rep. No. 1622, 83d Cong., 2d Sess. 300 (on the 1954 Code provision). The raising of the dollar limitation from $ 100 to $ 500 in this instance had only a very slight effect on net income, and moreover came about because of a change, not in accounting method, but in the underlying facts, i.e., the increase in business occasioned by World War II. The relevant regulations proposed on this point for the 1954 Code make it clear that this kind of change does not call for approval. Proposed Treasury Regulations under Section 446(e) of the 1954 Code, Section 1.446-1(e) (2) (ii) (b), (c) and (2) (iii), Example 4, 33 Fed. Reg. 18936, 18937 (1968). It is also worth pointing out, in this connection, that the requirement of obtaining the Service's consent under Section 446(e) could prevent or screen the wholesale adoption of a minimum rule by taxpayers not already using one -- a result which the defendant says it fears if we uphold plaintiff. The Service can, of course, restrict use of the rule to those taxpayers whose circumstances sustain adoption of such a method and who also meet the stringent requirement of nondistortion of income met by the plaintiff here.

For the reasons stated, it is concluded that the Commissioner of Internal Revenue has abused his discretion under sections 24 and 41 of the Internal Revenue Code of 1939 in disallowing the use of the minimum expense rule, and therefore, plaintiff is entitled to recover. ¹⁰

FINDINGS OF FACT

The court, having considered the evidence, the report of Trial Commissioner William E. Day, and the briefs and arguments of counsel, makes findings of fact as follow:

     1. Plaintiff, The Cincinnati, New Orleans and Texas Pacific

5. Pursuant to section 20 of the Act to Regulate Commerce (1914), the ICC prescribed (effective July 1, 1914) that carriers under its jurisdiction were permitted, where the original purchase cost of a minor item of road and equipment property (under a general plan considered as a whole) was less than $ 200, to elect the option of charging such cost to the appropriate operating expense account. Such accounting procedure is generally known and referred to as a "minimum rule." The rule was not to be construed as authorizing the parceling of expenditures in order to bring them within the limit referred to above. By ICC order (dated July 19, 1915) said authority was withdrawn effective July 1, 1915.

6. On January 1, 1921, the ICC established a new minimum rule, which was prescribed as the second paragraph of section 2 of the "General Instructions," on page 9 of "Classification of Investment in Road and Equipment of Steam Roads," which provided as follows:

     If the total cost of additions and betterments to any class of

     (a) When the property change involves:

9. During the taxable years in issue (1947, 1948 and 1949), the pertinent part of section 2 of the "General Instructions of Accounting Classification" (1943 edition) prescribed pursuant to the Act of February 4, 1887 (c. 104, Section 20, 24 Stat. 386), provided as follows:

     (a) When the property change involves:

11. Plaintiff's federal income tax returns for the years 1921 through 1939 (in which the ICC minimum rule on items to be charged to operating expense was consistently applied), were accepted on audit by the Bureau of Internal Revenue. Upon audit of plaintiff's returns for the years 1940-1946, the application of the ICC minimum rule (among other items) was questioned, but all of such controversies for the years 1940-1946 were disposed of by settlement.

12. Commencing in 1940 (when the minimum rule amount was changed from $ 100 to $ 500) and during all years subsequent thereto, plaintiff made minimum rule expenditures, charging the cost of all minor items of property costing less than $ 500 to operating expenses.

13. On audit of plaintiff's federal income tax returns for 1947, 1948 and 1949, the Internal Revenue Service applied a $ 100-minimum rule and disallowed expenses for minor items of property costing at least $ 100, but less than $ 500. Depreciation in respect of depreciable minor items was computed on a group basis by the Internal Revenue Service for each of these years, on the assumption that such minor items had an average 15-year life, resulting in a net disallowance of deductions to plaintiff as follows:

                    Gross amount      Depreciation

14. Appropriate claims for refund on form 843, with respect to the issue involved in this proceeding, were timely filed for each of the years in question.

15. This suit was timely filed by plaintiff more than 6 months after the filing of claims for refund for 1947, 1948, and 1949, and within 2 years of the date of mailing of the Commissioner's statutory notice of rejection of said claims.

16. The purpose of the minimum rule prescribed by the ICC is to relieve carriers of the mass of detail required to keep accounting records for numerous minor items of property.

17. If there were no minimum rule, all items of property would be required to be charged to an asset account. Depreciation thereon would have to be computed monthly to spread the cost, less salvage, over the estimated life of the item of property. Upon retirement of such property, entries would have to be made to eliminate the item from the asset account, with a similar charge being made to the depreciation reserve. In addition, accurate valuation reports with respect to such property would be required to be made to the ICC.The application of a minimum rule makes all such detailed accounting, recordkeeping and reporting unnecessary.

18. In the case of railroads, the application of a minimum expensing rule is particularly significant and related to geography, because a railroad's property is spread over large areas and along many miles of track. In various locations along its line of railroad, a railroad will have office buildings, stations, yard offices, shops and numerous other structures. At all such locations, there are large numbers of small items of property purchased, used and moved at will from place to place. Detailed and burdensome accounting and valuation reporting in respect of all such items would be required in the absence of a minimum rule.

19. In connection with the administrative and clerical aspects of the handling of expense vouchers, all expense vouchers of plaintiff were processed, reviewed and recorded by the auditor's office in Cincinnati, Ohio. The vouchers so processed covered expenses of all nature, including purchase of materials and supplies, typewriters and many other items of property. Such vouchers were separated into categories of expenses, such as materials and supplies and items affecting the property or asset accounts.

20. As part of the voucher processing procedure, if such vouchers (which were carefully reviewed) covered an item of property costing less than $ 500 and coming within the minimum rule, the voucher would be recorded in the voucher record and the cost of such item would be charged to operating expense. If a voucher indicated that it involved expenditures amounting to $ 500 or more, or if the voucher contained an authority for expenditure (AFE) number, which indicated that the item affected the property accounts, such voucher would then be referred to the auditor of construction, Washington, D.C., for the appropriate capital or property account treatment.

21. Vouchers were carefully reviewed so as to follow the ICC accounting rules meticulously and consistently, including the minimum rule, so that the cost of items of property was properly assigned as between the capital accounts and operating expense accounts.

22. When an item is expensed by plaintiff, only a single piece of paperwork is involved -- the payment of an invoice. Whereas when an item is capitalized, in addition to the payment procedure, several steps are required to be performed over a period of years in order to account adequately for that item.

23. Among the additional steps required in the case of a capitalized item are:

     (a) The item must be entered into the capital accounting process

25. The uniform system of accounts prescribed by the ICC is designed to insure reliable accounting and statistical data for the information of the Commission in the administration of its function under the Interstate Commerce Act, with particular reference to the matter of reasonableness of rates. One of the primary purposes of the ICC system of accounts is to produce a clear reflection of income. The ICC has a duty to protect the public and in publishing the financial data received from the railroads, such duty extends to seeing that railroad accounting produces sound statements of earnings, assets and liabilities.

26. The concept of clear reflection of earnings, assets and liabilities and assuring the reporting of accurate statements of financial operations by railroads is of prime importance to the ICC and is a most significant consideration in the promulgation of its accounting rules, including the minimum expensing rule.

27. The prescribing of a minimum rule by the ICC was based upon the conclusion that accounting under such rule would clearly reflect income and that (from a practical standpoint) such practice would eliminate considerable detailed recordkeeping and accounting expense.

28. The dollar amount fixed in the minimum expensing rule by the ICC was a judgment factor based upon considerations of the volume of business, measured by gross revenues and the volume of small items acquired.

29. The ICC increased the minimum limit from $ 100 to $ 500 in 1940, because the volume of business and revenues of carriers had increased beginning with the outbreak of World War II in Europe. At that time the ICC concluded (after considering both higher and lower figures) that $ 500 was a reasonable amount, based upon a consideration of the need to prevent or avoid a distortion of income.

30. The minimum expensing method of accounting (charging to operating expense the cost of minor items) is used almost universally by businesses of all types and sizes and is considered a proper method of accounting by practising certified public accountants.

31. The minimum expensing method of accounting is recognized as a proper method of accounting by numerous accepted accounting authorities and is rejected by none.

32. Examples of the items of property small in cost, which are subject to expense treatment under the minimum expensing method are shown in Montgomery's Auditing (eighth edition, 1957) under the headings of "Machinery and Equipment," (p. 242) and "Small Tools," (p. 243),and under the heading of "Furniture, Fixtures and Office Equipment," (p. 243) -- desks, chairs, desk equipment, partitions, shelves, bookcases, floor covering, safes and tables.

33. The minimum expensing method of accounting is considered proper by accountants generally and by accounting authorities, because it is based on the fundamental accounting concepts of materiality and practicality; application of the method has no material effect on income and permits the saving of recordkeeping costs which are substantially higher where an item is capitalized rather than expensed.

34. There is no single figure that is generally accepted as the appropriate minimum figure to be used by all businesses in applying the minimum expensing method; the minimum figure or level at which items of property is expensed rather than capitalized depends upon the size and geographical spread of the particular business and the types of minor items involved. Accounting authorities, accordingly, suggest minimum limitations as low as $ 10 and as high as $ 1,000.

35. In the case of plaintiff, a $ 500 minimum limitation is appropriate, and plaintiff's minimum expensing method is in accordance with generally accepted accounting principles.

36. There is in evidence (without objection by the defendant), as plaintiff's exhibit 1, a comparative analysis of accounting for minimum items under the $ 500 minimum rule prescribed by the ICC and by use of 15-year and 10-year depreciable lives.

It is reproduced below with changes made only as an aid to such reproduction, except for one deliberate omission, being two percentage calculations. Columns 9 and 10 bear no headings in the reproduction.

The column 9 heading is "Allowable depreciation in respect of minimum items disallowed by IRS based upon assumption of an overall 15-year life including depreciation on assumed disallowances for prior cycle (15 years) /**/."

The column 10 heading is the same as that of column 9, except that it relates to 10 years. /**/

37. The comparisons shown by the tabulated figures in the preceding finding show that the application by the plaintiff of the $ 500 minimum rule did not result in a distortion of income for the years 1947, 1948 and 1949.

38. In financial accounting, a permanent improvement or betterment is a significant item of property having an extended life and requiring capitalization to reflect income clearly.

39. In financial accounting, the fact that an item has a useful life of more than a year is not in and of itself determinative of whether the item is a permanent improvement or betterment. Other factors should be considered, including the cost of the item in relation to the overall investment and capital expenditures of the business, the use of the item, and its location.

    (1)          (2)            (3)            (4)            (5)

41. Prior to 1942 taxpayer in its books of account and in its federal income tax returns, followed the retirement method of accounting for depreciation on its roadway and miscellaneous physical properties. The use of this method of accounting permits the taxpayer to take, as a rough equivalent of depreciation on all remaining assets in its property accounts, a deduction in an amount aggregating the total cost or other value (less salvage) of the items retired during the taxable year, plus the cost of various other items charged to expense. The Commissioner of Internal Revenue accepted this method of accounting (prior to 1942) with respect to taxpayer's roadway and miscellaneous physical properties.

42. By orders dated January 19, 1942, and June 8, 1942, issued by the ICC, the railroads (including the taxpayer) were required to change over from the retirement method to the ratable depreciation method of accounting for roadway and miscellaneous physical property. The ICC order did not require taxpayer to change its method of computing depreciation for tax purposes.

43. For federal tax purposes, a change from retirement to ratable depreciation accounting constitues a change in accounting method requiring the consent and approval of the Commissioner of Internal Revenue. Accordingly, on March 24, 1942, taxpayer requested the Commissioner's permission to change accounting methods for tax purposes. By letter dated August 12, 1943, the Commissioner granted permission to change from retirement to ratable straight line depreciation accounting effective January 1, 1942, on certain terms and conditions (hereafter referred to as the "terms letter").

The terms letter states:

     Reference is made to your letters of March 24, 1942 in which you

44. Plaintiff's minimum expensing method of accounting for minor items of property costing less than $ 500 clearly reflects its income within the meaning of section 41 of the Code.

45. Minor items of property costing plaintiff less than $ 500 do not constitute permanent improvements or betterments as defined in section 24(a) (2) of the Code.

Conclusion of Law

Upon the foregoing findings of fact, which are adopted by the court and made a part of the judgment herein, the court concludes as a matter of law that the plaintiff is entitled to recover and judgment is entered to that effect. The amount of recovery is reserved for further proceedings under Rule 131(c).

¹ From July 1, 1914 to July 1, 1915, a similar rule was in effect except that the amount was set at $ 200.

² Without a minimum rule the railroads would be required to charge each item or group of items purchased to an asset account. The useful life of the items would need to be determined and a depreciation account established so that a ratable amount of the cost could be charged off during each accounting period. When the items were retired, entries would be required to eliminate both the asset and depreciation accounts from the ledger. Furthermore, periodic valuation of the property would be required for ICC purposes. The institution of a minimum rule eliminates the need for all such accounting and reporting.

³ In addition to the arguments discussed in the body of this opinion, based upon construction of the Internal Revenue Code of 1939 and appropriate Treasury regulations, the defendant asserted another position before the trial commissioner based upon an agreement reached in 1942 between the parties. That agreement referred to as the "terms letter" because it set the terms under which the Commissioner of Internal Revenue consented to the plaintiff's changing its method of accounting for certain numbered asset accounts from the retirement method (see Boston & Maine R.R. v. Commissioner, 206 F. 2d 617 (1st Cir. 1953) andRev Rul. 67-22, 1967 -- 1 Cum. Bull. 7) to the ratable depreciation method -- requires, inter alia, "that complete depreciation accounting in accordance with all the applicable sections of the Internal Revenue Code and Regulations shall be adopted for these accounts * * *." Since the accounts referred to above contained the same type of assets as those involved in this litigation (except that their cost was in excess of the amount prescribed by the minimum rule in effect at the time of their purchase or that they were excepted from minimum rule treatment for some other reason), the defendant argued that the accounting for these after-acquired assets is required by the terms letter to be the same as that employed in accounting for the assets covered by the letter, i.e. the ratable depreciation method.

Plaintiff, on the other hand, asserted, and it is concluded that it is correct, that the terms letter requires only that "complete depreciation accounting" be employed with respect to those assets which under the Code are properly classified as capital expenditures rather than items properly includable in current operating expense. In other words, if an item is to be classified under the Code as a capital asset, the terms letter requires that it be accounted for under the complete depreciation method rather than some other permissible method.

The pivotal question for determination in respect to defendant's argument concerning the terms letter is, therefore, whether or not under the Code and applicable regulations the asset is properly one for capitalization or deduction as a current expense. This is precisely the same question which controls the outcome of this case without reference to the terms letter, and, therefore, the remainder of this opinion is without reference to the terms letter.

⁴ Defendant cites the following cases: Hotel Kingkade v. Commissioner, 180 F. 2d 310 (10th Cir. 1950) (hotel furnishings and equipment); Patricia Griswold, 21 T.C.M. 33 (1962) (printing dies and filing cabinets); F. A. Wilson, et al., 1 T.C.M. 571 (1943) (adding machine); Arthur J. Marks, et al., 9 B.T.A. 1047 (1928) (stock brokerage blackboard); Alling & Cory Co., 7 B.T.A. 574 (1927) (filing cabinets); Henry I. Brown, 4 B.T.A. 1129 (1926) (office furniture and equipment); Larrowe Milling Co., 3 B.T.A. 245 (1925) (typewriters, desks and chairs); Wemple State Bank, 1 B.T.A. 415 (1925) (bank posting machine).

⁵"SEC. 41. GENERAL RULE.

The net income shall be computed upon the basis of the taxpayer's annual accounting period (fiscal year or calendar year, as the case may be) in accordance with the method of accounting regularly employed in keeping the books of such taxpayer; but if no such method of accounting has been so employed, or if the method employed does not clearly reflect the income, the computation shall be made in accordance with such method as in the opinion of the Commissioner does clearly reflect the income. If the taxpayer's annual accounting period is other than a fiscal year as defined in section 48 or if the taxpayer has no annual accounting period or does not keep books, the net income shall be computed on the basis of the calendar year."

"SEC. 29.41-3. Methods of accounting. -- It is recognized that no uniform method of accounting can be prescribed for all taxpayers, and the law contemplates that each taxpayer shall adopt such forms and systems of accounting as are in his judgment best suited to his purpose. Each taxpayer is required by law to make a return of his true income. He must, therefore, maintain such accounting records as will enable him to do so. * * *" [Treas. Reg. 111].

⁶United States v. Wehrli, supra, concerns the application of the one year rule in the context of repairs to already existing assets rather than in the context of recently acquired assets. This difference, however, does not alter the analytical position taken by the Tenth Circuit with respect to the case presently at bar.

⁷ Section 263(a) (1) of the Internal Revenue Code of 1954 corresponds to section 24(a) (2) of the 1939 Code and section 446 is the 1954 equivalent of section 41.

⁸ Treas. Reg. 111, Section 29.41-2:

"Bases of computation and changes in accounting methods. -- Approved standard methods of accounting will ordinarily be regarded as clearly reflecting income. * * *"

Treas. Reg. Section 1.446-1(a) (2):

"(2) It is recognized that no uniform method of accounting can be prescribed for all taxpayers. Each taxpayer shall adopt such forms and systems as are, in his judgment, best suited to his needs. However, no method of accounting is acceptable unless, in the opinion of the Commissioner, it clearly reflects income. A method of accounting which reflects the consistent application of generally accepted accounting principles in a particular trade or business in accordance with accepted conditions or practices in that trade or business will ordinarily be regarded as clearly reflecting income, provided all items of gross income and expense are treated consistently from year to year."

⁹ Finding 36.

¹⁰ In its answer, defendant, by way of set-off, alleged that plaintiff was not entitled to Mexican foreign tax credits taken in its federal income tax returns for 1947, 1948 and 1949. At this time, the parties are considering the settlement of this issue. Therefore, plaintiff's recovery is to be reduced by any set-off agreed upon in the settlement proceedings.

² Plaintiff, a second-tier subsidiary of Southern Railway Company, is a member of the Southern Railway System. To save clerical costs, the accounting for all companies in the System is handled centrally. The System pays approximately 30,000 invoices a month, some 10,000 of which include charges attributable to plaintiff.

/**/ The amounts of minimum expenses assumed to have been disallowed during the prior cycle and therefore subject to depreciation in 1940 and subsequent years were computed in accordance with the provisions of section 2.013 of the Revenue Agent's Audit Manual. This portion of the Manual was produced by defendant pursuant to Order dated May 24, 1968. section 2.013 of the Revenue Agent's Audit Manual. This portion of the Manual was produced by defendant pursuant to Order dated May 24, 1968.

To calculate the amounts of assumed disallowances during the prior cycle, the Total Railway Operating Expense for each prior year involved was multiplied by a fraction, the numerator of which was $ 229,810 (the total of Minimum Items Disallowed by the Internal Revenue Service from 1940 through 1956), and the denominator of which was $ 401,592,320 (the Total Railway Operating Expense from 1940 through 1956). The resulting amounts were then treated as having been included in the depreciation base and depreciated using 15-and 10-year lives and the standard half-year convention. For the 15-year life computations, it was therefore necessary to begin with assumed minimum expenses in 1925 in order to determine the correct amount of depreciation in 1940. In the case of the 10-year life computations, 1930 assumed minimum expenses were the earliest to be considered.

Depreciation on minimum expenses disallowed beginning in 1940 was based on the actual amounts of the disallowances and was computed using 15- and 10-year lives and the standard half-year convention.