the looms are continually being renewed, particularly where the policy of the mill management is to maintain the plant at the peak of operating efficiency.

In such cases complete analyses of the cost records should be kept in order to distinguish replacement items from those which are "incidental repairs."

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 appartaus 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, page 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,14 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.

The foregoing decision accords neither with good accounting principles, nor with the position of the Treasury. The case was brought under the 1909 law and may not be considered as a precedent for procedure under subsequent laws. It is inserted at this point as an illustration of the uncertainty of court decisions.

CERTAIN REPAIRS ARE PROPERLY CAPITAL EXPENDITURES.—Although it is an accepted rule that repairs and all other expenses of maintenance should be charged against profit and loss, an exception to this rule is found in cases where partly worn-out or run-down

34

14 Nashville, Chattanooga and St. Louis Ry. Co. v. U. S., 269 Fed. 351; certiorari denied, 255 U. S. 569, 65 L. Ed. 790, 41 Sup. Ct. 375.

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.15

Depreciation must be entered upon the books of a corporation. Neither the 1924, the 1921 nor the 1918 law specifies that depreciation must be charged off on the books of an individual or a corporation,16 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.1 The author has no sympathy for any corporation which is not willing to have its income tax returns agree with its books. The following regulation deals with this point:

17

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.)

15 Bulletin "F," page 29.

16 See page 1088.

[Former Procedure] Such a restriction upon corporations was contained in section 12 (a), second, of the 1916 law.

The 1913 law contained no such provision, but the Treasury required depreciation to be charged off.

BANKS MAY KEEP ADDITIONAL RECORDS FOR DEPRECIATION PURPOSES.-Banking house fixtures and furniture written down or written off may be restored, a supplemental set of books being used.18

The reason for these rulings is that the statements rendered to the federal or state authorities frequently include adjustments, for instance, the writing down of investments to market values or the inclusion in expenses of additions to the banking house or its equipment, which are not allowable deductions in income tax returns.

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,19 and any readjustment must be made by filing amended returns.20

Good accounting practice requires that lump sum purchases be segregated on the books of account. It is better to open too many accounts than too few, because experience demonstrates the fact that depreciation is more easily ascertained by the use of a number of ledger accounts than when undivided property or plant acccounts are kept.

When it is impossible definitely to allocate the cost, it should be prorated on some equitable basis or by a retrospective appraisal 21 made as of date of acquisition.

AMENDED RETURNS MAY BE NECESSARY.-It may be necessary to prepare amended returns 22 from 1913 to the time when the adjustments are made. If the amount involved is substantial there is no other way of correcting the former erroneous practice.

The regulations are fair and reasonable in that taxpayers are required to make each year's return include accrued depreciation for only one year. The adjustment of accounts will work out to the advantage of the government and to the disadvantage of the taxpayer if the depreciation allowance is decreased during a period of high taxes and vice versa. But taxpayers should keep in mind that actual depreciation, in almost all cases, was far greater during the years 1917 and 1918 than during the pre-war period.23

18 C. B. 4, page 64; A. R. R. 377; C. B. I-2, page 48; A. R. M. 172.

1 C. B. 4, page 180; O. D. 948. Bulletin "F," page 35.

20 See page 90 et seq.

See page 1165.

Or to submit to the Treasury a revised statement of income, together with a recomputation of the tax for each year involved.

23 See pages 1094 and 1115.

AMENDED RETURNS ACCEPTABLE TO TREASURY.-If original returns were made in good faith, they may be corrected if found to be erroneous.24

Depreciation should be based on cost or value March 1, 1913, whichever is greater.-The 1924 law [section 204 (c)] specifically provides that the basis for depreciation shall be the same as provided in section 204 (a) or (b). 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. Property received as a gift, or transfer in trust, after December 31, 1920 or 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.25

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, the cost of which is not deducted as an expense in the taxpayer's return, 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 new rule of using cost or March 1, 1913 value, whichever is greater, involves the determination of both cost and March 1, 1913 value, where in many cases heretofore the taxpayer has had to concern himself only with March 1, 1913 value for depreciation purposes. It will be remembered that subdivisions (a) and (b) of section 204 prescribe the basis to be used to determine gain or loss. from sale. In commenting on 204 (b) the Senate Finance Committee Report (page 19) says of the new rule, that is, using cost or March 1, 1913 value, whichever is greater:

This change, which operates in favor of the taxpayer, simplifies exceedingly the rule in effect under the present law.

That may be true for the purpose of determining gain or loss on sale. But when section 204 (c) provides for using the same basis for depreciation purposes, new complications are introduced, such

24 Bulletin "F," pages 33-34.

25 See Chapter XXIII.

as going back of March 1, 1913 to the date of original acquisition, computing depreciation to March 1, 1913, and then comparing this depreciated cost with the March 1, 1913 value, to determine "whichever is greater."

Again, 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.26

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.27 The Treasury's refusal to allow depreciation of March 1, 1913 values of leaseholds has been overruled by the Tax Board.28

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, page 138; O.. D. 283.)

27

See page 1104 for further discussion in the case of reorganizations.
[Former Procedure]

RULING. Prior to the approval of Treasury Decision 2754 (August 23, 1918) depreciation allowances were required to be based on the cost of the property. This Treasury decision authorized depreciation deductions based on the value of property as of March 1, 1913, if acquired prior thereto. The basis in the case of property acquired on or after that date remained unchanged.

In an opinion rendered by the Solicitor of Internal Revenue it was held that Treasury Decision 2754 is applicable to returns for 1913 and all subsequent years. (Bulletin "F," page 19.)

See C. B. Ì-2, page 90; T. D. 3414 and the author's comments_thereon, pages 1122 and 1128. Also see, Appeal of Grosvenor Atterbury, 1 B. T. A. No. 72.